Apr 30, 2008
Executives
Eric Boni - Director IR Frank L. "Hank" Waters - VP and President, Ashland Water Technologies and Ashland Performance Materials J.
Marvin Quin - Sr. VP and CFO James J.
O'Brien - Chairman and CEO
Analysts
Jeffrey Zekauskas - J.P. Morgan Mike Sison - KeyBanc Capital Markets John P.
McNulty - Credit Suisse First Boston John Roberts - Buckingham Research
Operator
Good day ladies and gentlemen and welcome to the Q2 2008 Ashland Earnings Conference Call. My name is Lisa and I will be your coordinator for today.
At this time all participants are in a listen-only mode. We will be facilitating the question-and-answer session towards the end of this conference.
[Operator Instructions]. I would now like to turn the presentation over to your host for today's call Mr.
Eric Boni, Director of Investor Relations. Please proceed sir.
Eric Boni - Director Investor Relations
Thank you, Lisa. Good morning and welcome to Ashland's second quarter fiscal 2008 conference call and webcast.
We released our second quarter results at 8 o'clock Eastern Time today. These results are part preliminary until we file our 10-Q in May.
With me here today are Jim O'Brien, Ashland's Chairman and Chief Executive Officer; Marvin Quin, Senior Vice President and CFO; Lamar Chambers, Vice President and Controller who will succeed Marvin as CFO effective June 1st, Hank Waters, President of Ashland Performance Materials and Ashland Water Technologies and Michael Meade Assistant Controller External Financial Reporting. Before, we get started I will give you an outline of the call.
First, I will review Ashland's results Hank will then discuss the specifics of the Water Technologies and Performance Materials Businesses. Marvin will review Ashland Distribution and Valvoline and then Jim O'Brien will conclude with the outline.
After that we will take your questions. On slide 2, we provide our cautionary language regarding forward-looking statements.
Statements maybe made during the course of this presentation that constitute forward-looking statements as that term is defined in relative Securities Laws. If such statements are made they will be made, they will be made on a number of assumptions such as price, supply and demand, market conditions and operating efficiencies.
Ashland believes these expectations regarding operating performance are based on reasonable assumptions but it cannot assure that these expectations will be achieved. Therefore any forward-looking statements may prove to be inaccurate.
Please turn to slide 3. Ashland's operating income for the second fiscal quarter declined 15% versus the prior year quarter, if you exclude the impact of key items in both periods.
Our 2008 second quarter results did however show sequential improvement in three of our four businesses with the exception of Ashland Water Technologies. Ashland Performance Materials are still challenged by the impacts of the housing and transportation end markets as evidenced by the 14% operating income decline versus the same prior year quarter grew operating income 67% over the December quarter.
Ashland Distribution has been working hard to increase pricing and reduce working capital. The team showed substantial progress on both this quarter.
As a result while operating income declined 35% from the year ago quarter, sequentially operating income more than doubled. Ashland continued to perform and achieved a record second quarter and first half.
In sharp contrast, Water Technologies lost $2 million this quarter. For the company as a whole, working capital improved by $57 million versus the December quarter, despite revenue growth of 8%.
I'll talk more about working capital improvements in a few moments. Please turn to slide 4.
Revenues increased 8% to $2.1 billion in the second quarter of 2008, as compared with the same quarter in 2007. Cost of sales and operating expenses also increased going up 10%.
Thus gross profit percentage was down 160 basis points, our gross profit dollars decreased $6 million. As we experienced reduced volumes during the down part of the cycle, we continue to review opportunities to reduce SG&A expenses without damaging long-term effectiveness.
Our SG&A expenses show a 6% improvement here please remember that the 2007 figure includes a $25 million charge related to a reserve for our voluntary severance program. Also the expense for this most recent quarter includes a $4.5 million write-off related to a joint venture project to manufacture bio-based propylene glycol.
Thus, on an apples-to-apples basis, SG&A increased about 1% versus the 8% increase in sales, resulting in an 80 basis point reduction in our SG&A expenses as a percentage of sales. Please turn to slide 5 to see our business specific operating income.
This chart summarizes our operating income by segment versus both the same quarter last year and versus the December 2007 quarter. I will discuss business specific results in detail later.
Let me note that operating income increased by $5.1 million versus the December quarter, primarily due to $7.8 million improvement in our Performance Materials business and a $7.1 million improvement in the Distribution business. As compared with the year ago quarter, operating income increased by $10.7 million.
I will note that in the unallocated and other line, the March 2008 quarter included the previously mentioned $4.5 million write-off related to our joint venture projects with Cargill. Due to persistently high glycerin input cost, the project has been suspended for the time being.
And, the March 2007 quarter included the previously mentioned $25 million charge related to our voluntary severance program. In the December 2007 quarter, we benefited from $2.8 million of income related to deferred compensation; on the current quarter this item was a $1.7 million expense.
Also included in our results for the 2008 quarter is an additional $6 million of depreciation and amortization as compared with the same quarter last year. Ashland's overall financial results continue on slide 6.
The March 2008 quarter also included a net gain of $22 million related to the MAP transaction, of which $23 million is from the partial resolution with Marathon of certain tax related matters. The 2005 IRS audit that we have discussed in previous calls remains open.
We believe that it will likely be resolved in the next two to four months. Though note our net interest and other financing income declined to $8 million as we have been adjusting our cash portfolio during the quarter.
At the end of the quarter, we had more than $300 million in auction rate securities, primarily student loans. These are AAA rated securities, the vast majority insured by the Federal Family Education Loan Program, the U.S.
Department of Education Program. We have reclassified $260 million of these student loan auction rate securities from short-term to long-term assets and recorded a $6 million unrealized loss directly to shareholders equity, an adjustment we expect to be temporary.
These changes reflect the current limited liquidity of the auction rate securities market in the view that this market or some of these instruments may not return quickly. Our tax expense decreased by $10 million due to favorable developments with regard to a certain foreign tax matter thereby reducing our effective tax rate for the second quarter to 12.3%.
Our effective tax rate for the quarter excluding the effects of both the Marathon tax related settlement and the foreign tax item was 33%. Diluted earnings per share on a GAAP basis were $1.13 for the quarter.
Please turn to slide 7 to review certain salient components of our earnings per share. Our diluted earnings per share from continuing operations for the March 2008 quarter were $0.80 as compared with $0.73 in the March 2007 quarter on certain components are excluded from both periods.
The income bridge on slide 8 shows the impact of volume and margin reductions in our businesses and their effect on Ashland's overall performance. Most of our business units recorded volume declines versus the prior year quarter with an overall impact on operating income of $10.6 million.
As you can see, gross margin reductions negatively impacted Ashland's results by $10 million. Gross margin reductions were spread across our businesses.
The impact of currency translation on our earnings has been a positive versus the prior year quarter. The improvement in net SG&A reflects a heightened focus on expense management across our businesses and resource groups.
SG&A decreased in all of our business segments except for Water Technologies versus the year ago quarter when adjusted for currency. You may recall that this bar in our December 2007 quarter was a negative $4.9 million.
The bar titled Other is almost entirely reflective of last year's VSO. Please turn to slide 9 to review our cash flow.
Ashland generated significant operating cash flows during the second quarter, totaling $114 million after deducting $42 million of capital expenditures. This was due to income from operations and significant improvements in working capital.
Adding the $27 million of cash generated in the first quarter, we have generated $141 million in operating cash flows, net of capital expenditures in the first half of the fiscal year. Earnings before interest, taxes, depreciation and amortization or EBITDA when adjusted for key items as shown in our appendix was $92 million in the March 2008 quarter versus $96 million in the prior year quarter.
Slide 10 shows our operating segment trade working capital metrics that we are now posting monthly on the business fundamentals page of our website. Since our last earnings call, we have reduced trade working capital by 2.3% of sales and a 1% of sales below our year-end 2007.
That said, we still have much work to do to reach our business segment goals. Inventories have been reduced by $88 million over the past three months, largely in our Distribution business both in North America and in Europe.
We have also seen significant inventory reductions in our Performance Materials business. Accounts receivable increased during the quarter, primarily due to increased sales in the March quarter versus the December quarter.
On a percentage of sales basis combined operating segment accounts receivable increased by 20 basis points. We did make progress in the quarter in combined operating segment trade and other payables.
As they increased over the December quarter by nearly $100 million or 60 basis points on a percentage of sales basis. Although this performance is still well below our target.
With that I will turn the call over to Hank Waters who is responsible for both our Water Technologies and Performance Materials businesses.
Frank L. "Hank" Waters - Vice President and President, Ashland Water Technologies and Ashland Performance Materials
Thanks Eric. Good morning everyone.
As Eric mentioned Water Technologies had a disappointing quarter. I am sure you are all wondering what happened and if you will bear with me for a few minutes I will help you understand a number of items that affected our results.
As you can see on slide 11 Ashland Water Technologies reported an operating loss of $2 million on sales of $217 million. This compares with operating income of $6.2 million and sales of $190 million in the March 2007 quarter.
Please note that more than two-thirds of our revenues are generated outside the United States. Much of the volatility in sales and SG&A expenses is due to the translation impact of a weakening U.S dollar.
Also keep in mind that the year ago quarter included non-American results for the month of December, while this year's results include the month of March, a result of Ashland's elimination of a one month reporting lag. Excluding these effects as well as the impact of transferring certain sales from the Performance Materials Division to Water Technologies sales increased by 2%.
On the same basis SG&A increased by 12%. Gross profit for the quarter was 37.3% which is 150 basis points lower than the year ago quarter.
Margins for January and February were depressed and recovered somewhat in March. Let's look more closely at the factors affecting our operating income on slide 12.
The net effect of sales growth and margin compression overall was positive by $500,000. However, there were many positive and negative swings within these two categories.
Two operating issues negatively effected margin by $5.5 million following the implementation of our GlobalOne SAP system in North America, we experienced some invoice accuracy issues which we have been working to clean up. During the quarter we corrected $2 million of billing errors that had benefited prior reporting periods.
The second issue relates to sales of products manufactured in Germany and sold to customers and affiliates outside of the European Union. We manufacture granular polyacrylamide and their remediates in Germany and ship them to other regions of the world to support local sales and manufacturing efforts.
The recent strength of the euro has significantly increased our cost on these shipments and we have been unable to pass the majority of this increase on to our customers. This issue negatively impacted margin for the quarter by approximately $3.5 million.
Raw material cost increased 6% to 7%, excluding currency translation effects. Impacting margin by approximately $4 million to $5 million compared to the prior year quarter.
Increases were driven primarily by increased cost for solvents, acrylic acid and acrylic based derivatives. Sales growth, sales transferred from performance materials and modest price increases more than offset these negative items.
SG&A cost for the quarter excluding currency translation increased by $9.4 million. The business transferred from Performance Materials contributed $1.2 million of this increase.
The second quarter of 2007 included a $1.1 million income benefit in SG&A that was not repeated in 2008. Higher than normal SG&A expenses in areas such as severance, consulting fees and additional write-downs related to our discontinued Packard [ph] business added $3.3 million versus the same quarter last year.
Net of these items, SG&A for the quarter was up $3.8 million or 5%. This increase was largely driven by cost incurred to support growth in China and to support the implementation of our GlobalOne SAP system.
Obviously, we are not satisfied with our results. Let's move to slide 13 and discuss what we are doing to improve our performance.
We are focusing on five fundamental issues; fixing the operating issues that I discussed earlier, improving our pricing process, reducing our cost structure, improving the efficiency of our supply chain and aligning our operating metrics and incentive systems. First, we must fix the invoice accuracy in German polyacrylamide margin issues.
We have been working on the invoice accuracy issue for several months. We are now cleaning up more issues each month than we are creating, which indicates that we are making progress.
This issue impacted operating income in the second quarter by $2 million we expect to have it substantially mitigated by the end of the fiscal year. We are also working the German polyacrylamide margin issue.
We are considering several ways to reduce its impact including targeted price increases and different sources of supply. This issue impacted income in the second quarter by $3.5 million and we expect to make good progress on this issue by the end of the fiscal year.
Second, we must improve our pricing process. We will need to change both our systems and our culture to make this happen.
We need to set clear profitability expectations, get accurate data about the true profitability of individual customers and improve the user friendliness of our price management systems. Culturally, we need to be more confident about asking for a fair price for the value that we provide.
Few recent market studies suggest that our customers are extremely satisfied with the value we provide compared to what they pay for that value. This seems to indicate that many of our customers are paying less than market price for our services and gives us confidence that we can affect prices in the market.
We will measure the success of this initiative by tracking average selling price, the percentage of customers that are meeting profitability expectations and importantly, margin percentage compared to our external benchmarks. We expect to see improvements from this initiative over the course of the next 12 months.
Third, we are examining every aspect of our cost structure. We have implemented a more efficient field sales and service model to take better advantage of the specialized skills of our sales and service people.
We have also identified some significant inefficiency in our administrative functions. We are developing a short-term plan to address these inefficiencies.
This will not be easy work but it is necessarily... it is necessary and we will move quickly.
We will measure the success of this initiative, primarily by comparing our SG&A expense to external benchmarks. Fourth, we need to improve the efficiency of our supply chain.
We have too many products and far too many of them are not meeting profitability expectations. As our technical people focus on solving customer problems, we often develop customized products for individual customers rather than using combinations of standard products to achieve comparable results.
This customization results in SKU creep and high support costs in product management and supply chain. Reducing the number of SKUs that we need to manage should enable us to reduce cost in manufacturing, logistics and service.
In addition, we are evaluating options to reconfigure our supply chain, to reduce the delivery cost and to further improve the efficiency. By the end of the fiscal year, we hope to have announced and implemented some elements of these plans.
Additional improvements should come in our 2009 fiscal year. We will measure the success of this initiative by tracking supply chain costs compared to our historical performance.
Finally, we need to align on our operating metrics and incentive systems to derive better decision making. Historically, we have rewarded customer retention and therefore encouraged over servicing of accounts rather than driving a focus on growth and earning an acceptable return for our efforts.
We expect to improve these systems for next fiscal year. Obviously, these are not the only initiatives going on within Water Technologies but they are the five most vital to improving our near term profitability.
We plan to report our progress in these areas in the coming quarters. As I said earlier, we are not satisfied with our current results but we do believe that Water represents a great opportunity for Ashland.
The end markets are growing and our much less cyclical than many of our other businesses, and the basic industry dynamics are solid. We have a plan in place to get this business on track and we believe we can deliver a healthy and profitable business.
Now let's turn to our performance materials business on slide 14. Performance materials volume per day increased 2% versus the March 2007 quarter.
As I mentioned earlier, the months included in March... in the March quarter changed this year for our non-North American businesses and we transferred some sales from performance materials to Water Technologies.
On a comparable basis, volume per day declined by 1% versus the prior year quarter. A strong European and Asian sales continued to significantly offset weakness in North America.
Let me note that we are investing in continued growth in Asia. We currently have a significant plant expansion coming on line in China for our composite polymers business and we are scheduled to break down for a new plant in Northern China later this summer.
Sales and operating revenues for the 2008 second quarter amounted to $398 million, an increase of 6% over the 2007 quarter. Excluding the items I mentioned earlier and the favorable impact of currency translation, revenues declined by 2%.
SG&A expenses for the quarter were flat. Performance materials earned operating income of $19.5 million in the fiscal second quarter.
This compares with operating income of $22.7 million in the same quarter last year. Again on a comparable basis, operating income would have been $4.6 million higher a year ago, making the income reduction closer to 29% rather than the 14% shown.
Looking at how our business units within performance materials performed during the quarter, our casting solutions business unit increased profitability by roughly a third. Composite polymers, which has been challenged off late due to weakness in the North American housing and transportation markets was flat for the quarter.
Composites benefited from strengthen in Europe, China, the Middle East and Brazil and strength in our premium product lines such as our DERAKANE and Heteron [ph] brand resins compensated for weaker sales of products used in housing and lower end automotive applications. Our specialty polymers and adhesive unit continued to struggle in the quarter, largely due to our inability to recover raw material cost increases and on lower volumes.
Let's look at slide 15 for the factors affecting our operating income. As you can see margin is the biggest factor driving the earnings variance between the quarters.
Our specialty polymers and adhesives business was the primary contributor, experiencing weaker margins in both the packaging and converting and building and construction markets. As I mentioned, we had difficulty raising prices to keep pace with increasing raw material costs.
With that I will turn the presentation over to Marvin Quin to discuss our other businesses.
J. Marvin Quin - Sr. Vice President and Chief Financial Officer
Thank you, Hank. Let's look at distributions performance on slide 16.
As you heard Eric say, Ashland distribution has achieved some success in improving its operating income and reducing inventories. Volume per day was on 5% versus the March 2007 quarter, due primarily to the combination of a maintenance shutdown at a major hydrocarbon solid supplier, determination of the Dow U.S.
plastic supply agreement and then our decision to forgo certain low margin business. The Dow contract terminated as of March 1, 2007, so it will not be impacting our quarterly comparisons as we go forward.
Sales increased 7% to 1.1 billion for the quarter. We were able to increase average unit selling price by more than 14% versus the same quarter last year.
Our 7.7% gross profit was unfavorable to the prior year by 130 basis points. Our focus on gross profit yielded an increase of 20 basis points over the December 2007 quarter and 70 basis points over the September quarter.
We had a slight decrease in SG&A expense versus the year ago quarter, in spite of currency translation impact from our European entities. Operating income of 13 million was down 35% versus the March 2007 quarter, but more than double the December 2007 quarter.
On slide 17, you will see that volume from the terminated Dow business and from other volume reductions we discussed on the prior slides was the primary reason that distribution was operating income decline. You remember in a last few presentations of distribution, the earnings decline discussion focused on margins.
Improvements we have been making have ameliorated the margin impact. Lets look...
lets turn to slide 16 to see our margin trend. As you can see from this chart, average selling price, the top blue line is up 6% sequentially.
Our average cost per pound increased $5.5 per pound. As a result, our unit gross profit increased by more than half a cent per pound versus the December quarter.
Unit margins are now starting to move back to more of a normal range that we have experienced in prior years, prior to the dramatic fall off that occurred in the third quarter of 2007. Let's turn to Valvoline on slide 19.
Valvoline's operating income increased 8% of the prior year quarter to $24 million, a record for the quarter. Volume was up 1%.
Our margins increased 5%, excuse me, while revenues increased 5% to $401 million, due largely price increases, including those implemented in February and March. Significant income growth from both Valvoline instant oil change and our Valvoline International business drove results for the quarter.
Earnings at Valvoline instant oil change excluding store closure charges grew 144% over the March 2007 quarter and Valvoline International's earnings grew 67%. Valvoline instant oil change continued the positive trends and average ticket and increased premium oil change services that we saw in the prior quarter.
A 4% increase in the number of premium oil changes contributed to a 7% increase in average ticket. The margin improvement accounted for more than half the earnings improvement at Valvoline International.
Now let's look at Valvoline's income bridge on slide 20 to delve a little deeper into the factors affecting its performance in the quarter. We had some makeshift during the quarter toward private label in our DIY business.
We still have a negative impact on earnings. The cause of the makeshift average DIY selling price increased only 1% while cost of goods sold increased 4% in the quarter, explaining some of 120 basis point gross margin degradation.
Also remember that Valvoline incurred the base for cost increases from November during the entire quarter while the benefit of price increases to customers was not fully realized in the quarter due to timing lags. Although the key items; margin, currency translation and SG&A expenses, each provided positive impacts on operating income.
Now let's turn to slide 21 and Jim O'Brian will provide our outlook for the remainder of the year. Jim?
James J. O'Brien - Chairman and Chief Executive Officer
Thank you, Marvin. As we look to the remainder of the fiscal year, we are entering Valvoline's traditionally stronger half as the summer driving season begins.
Base overall cost increases ranging from 7% to 10% were announced in February and March to take effect this quarter. In addition, addictive cost increase from 7% to 9% were announced mid February.
On March 31st we announced price increase of 6% to 10% depending upon the product to market, effective in May and June. These price increases should offset raw material increases although there will be a timing lag during the quarter.
Our DIY branded lubricant business experienced some negative shifts in volume in the second quarter due to the timing of our promotions and during the calendar year versus last year. We had some significant promotions during the second quarter last year, while more promotions are scheduled for the third quarter of this year.
As a result, we expect favorable volumes in the third quarter. Looking ahead the Valvoline business faces continued challenges in this environment of rising costs and soft lubricants demand.
Nonetheless we expect our Valvoline's all change and Valvoline international segments to continue the positive trends of the first half of the year and we remain generally positive about the outlook for Valvoline. Please turn to slide 22 for Water Technologies outlook.
In our Water business, we started making changes over a year ago and the progress has been slower than we would like. We are trying to change the culture of the organization, to one that not only focuses on satisfying customers, but also focuses on finding more economical ways of doing so.
We have successfully fixed businesses before and we have every reason to believe, we can do it again. It will require a substantial work to improve or performance and execute on these key issues.
But I believe it is essential to get this business turned around. The water business provides significant upside once we get this right and we will get this right.
Let's go to slide 23, for a performance materials outlook. The North American housing and transportation markets remain depressed.
In spite of this weakness in our end markets in April we received significant raw material cost increases. To help offset the impact our composite polymers unit announced price increases of 5%-7%, effective, May 1st.
We continue to focus on higher growth markets and opportunities in areas such as more, environmentally friendly products. Business continues to be strong for corrosion resistant resins and applications such as power plant, of Flu gas its authorization and particularly in the Middle East, water desalination using a Huricane and HetchOne resin systems.
As we already discussed the SP&A has underperformed recently. We believe that we have been in too many niche segments and have not been focused as an organization.
To this end we have refocused SP&A in core segments and consequently have implemented staff reductions. I will talk more broadly about cost reductions within Ashland in a minute.
Overall the June quarter is historically performance materials strongest quarter. All that said our optimism is tempered by the uncertainty in our end markets.
Now just look at distributions outlook on slide 24. Softness persists in the North American market well growth in the rest of the world appears to be relatively strong given our suppliers options outside the North America.
As a result in April suppliers pushed our product cost significantly higher and in turn we have increased prices across our various product groups. We have been making a number of changes in the distribution organization.
In order to focus on pricing buying and targeting the areas of potential market growth, we have implemented our new pricing process within our chemicals line of business, which is providing more discipline in consistency and our pricing to customers, using better and more comprehensive data. We also believe there are additional opportunities for pricing process improvements and our plastic, composites and environmental services lines of businesses, which we currently implementing.
Our centralized line approach is reaping rewards in terms of both our product cost and significant reductions in excess inventory. We have in fact reduced inventories by nearly $80 million just within this quarter.
The process changes we have made should enable this to be a permanent step like shift in our inventories for this business. While distributions third quarter performance will likely continue to be affected by weakness in North American industrial output.
The business also traditionally benefits from seasonality. We continue to be focused on both margin improvement and volume growth and targeted markets and are positioned well within the distribution market place.
Let's go onto slide 25. We continue to take action to improve Ashland's performance.
We are evaluating how to change our structure to reduce our cost position. The changes I noted in SP&A are further along and just one step in that process.
We have initiatives in place across all of Ashland that we expect to generate $14 million in run rate savings by the end of this fiscal year and a cumulative, $40 million in run rates savings by the end of fiscal 2009. In addition, we are pursuing business model changes and have set an objective to drive an additional $25 million of savings by the end of 2009.
Let's open the line for questions. Question And Answer
Unidentified Company Representative
We have any questions?
Operator
Thank you. [Operator Instructions].
Our first question comes from Jeff Zekauskas from J.P. Morgan.
Please proceed.
Jeffrey Zekauskas - J.P. Morgan
Hi. Good morning.
Unidentified Company Representative
Good morning, Jeff.
Jeffrey Zekauskas - J.P. Morgan
Can you quickly talk about the foreign tax item? Did that relate to prior periods or to the current period?
Unidentified Company Representative
We establish a reserve several years ago for a tax audit related to a European entity and there is further clarity on that audit and it appears that our liability will be materially less than we had originally were concerned.
Jeffrey Zekauskas - J.P. Morgan
Thank you. In you performance product area, what was the volume contraction level in the United States in the quarter and can you talk about how that the entire segment is performing in April?
Unidentified Company Representative
Roughly the decline in the U.S. markets were in the order of 10% that we...
the offset that you see in the volume is coming from places like Europe and the Middle East and Asia.
Jeffrey Zekauskas - J.P. Morgan
And how did April go for that segment as a whole.
Unidentified Company Representative
April isn't over.
Jeffrey Zekauskas - J.P. Morgan
Well, you guys have SAP right so you could track it on a daily basis. Do you have a good idea?
Unidentified Company Representative
Jeff generally as we look at this business through the March quarter, the relationships that we talked about, Europe still having some fairly strong demand as well as Asia and the U.S. market being down, that relationship does not change.
So I think as you look forward, we have seen in this business as well and it should be stronger in this quarter coming but the softness in U.S. is still there but we are still seeing strength in Europe and Asia.
Jeffrey Zekauskas - J.P. Morgan
In terms of acquisitions, has Ashland come close to making any acquisitions or are you far away from making them, sort of how do you stand and what's the size that you are currently looking at?
Unidentified Company Representative
The situation has not changed since the last call and we are still looking at acquisitions, the $100 million to $500 million as being our primary target, although we would consider larger ones if they would create shareholder value. As far as our ability to execute these transactions we have as we stated several opportunities that we have evaluated fully and we would execute them given the right sort of negotiated deal but again it all is determinant on the creation of shareholder value and that will be the basic determinant of whether something gets done or not.
Jeffrey Zekauskas - J.P. Morgan
And then lastly, can you talk about your head count currently and what it was at the beginning of your fiscal 2008 and where are you expected to be at the end of the year?
Unidentified Company Representative
When you take a look at last year, we had the VSO, which was the voluntary severance and we took out about a 100 people, 100, 120 people and as we sit and evaluate our corporate SG&A that has not changed. We have had a basically a high a hiring freeze the whole year and basically the head count has remained very, very stable, so we are very proud of that.
And what I discussed at the end of my preparations are really changes on where to make in the operating side of our business and we have already started as I was talking about SP&A and we have expectations of additional $14 million coming out within a year and we have plans that are being put in place in fact even more materially next year. So the numbers I gave you are more than the operations and not the corporate side of our business.
Unidentified Company Representative
Jeff we actually have growth in employees in places like Europe and China where our growth opportunities are more and we are pretty much holding it steady or declining in our U.S headcount.
Jeffrey Zekauskas - J.P. Morgan
Okay thank you very much.
Operator
Our next question comes from Steven Velgot from [indiscernible]. Please proceed.
Unidentified Analyst
Thank you. Two questions from me, first I was I wondering if you could talk at all about the rate of increase in crude prices this month and what kind of impact you would expect that to have also on the natural gas side and then I had a follow up question?
Unidentified Company Representative
Well obviously the cost of crude is impacts materially almost every input that we have across all of our lines of business so for us to be successful in this type of environment we have to push price increases through. And that is our intent and that's what we attempt to do in every market that we serve.
The lag effect that we described we have contracts for certain customers as well as just the physical challenge of trying to get your sales force to have all the communications necessary with the number of customers that we have we normally have a month to two months lag in lot of our businesses before the price increase takes effect. So I think as you look at our businesses which you will see as a softening of our gross margin and then strengthening towards the end of a quarter if the price increases were announced in the first part of the quarter.
So that's what we faced with to this type of environment is a little compression and then expanding them back to a more normal margin through the period as we push our prices through.
Unidentified Analyst
Okay, and just the price increases in crude and to a lesser extent natural gas this month has that changed your view at all about what type of price increases you would need to put through or is there also a lag in terms of how those cost increases effect you?
Unidentified Company Representative
Well the ....I guess the good news of having crude so visible and there maybe news almost every night as our customers are totally aware that this pressure exists. So that standpoint is more of market reception knowing that energy has to be reflected in the price of the products and then the discussion that we gave we talked about even in the forward-looking look we have seen for the coming quarter and in this quarter as far as the cost increases that we have incurred and then how much we are going to raise our prices to reflect those increases.
So our standard pricing model as we want to recover the price of our materials because of necessary margin to cover our services and the growth that's required for re-investment. So that's how we look at it, so you have to get more then just the raw material cost.
Unidentified Analyst
And then one last question, you described the new pricing process within your chemicals distribution business has been implemented and as far as plastics and composites and the rest of the distribution business what's your time frame on implementing those new or that new pricing process?
Unidentified Company Representative
Yes, this kind of goes back to SAP where we talked about in GlobalOne the ability of having some higher transparency into our cost as well as to be able to segment our customers better. Its more of a segmentation model and having our sales people have better transparency and to how costs have impacted their margins, how it impacts particular customers, existing customers and we've been fairly successful in the chemical line and through this quarter, we are going to continue to roll it out through our plastics and composites and environmental.
So the bigger test sort to speak was done through chemicals and our rolled out through the rest of the distribution businesses. So this was one of the primary benefits that we see of the investment we made in GlobalOne is the ability to do the segmentation work, get better transparency and the profitability of our customers to help us value price, segments versus just having a gross price increase across all segments where you may or may not be successful, so it think it's a little more sophisticated and its gives us a higher probability of success and we've seen that through the quarter as we did it in chemicals.
Unidentified Analyst
Thank you.
Unidentified Company Representative
Thanks.
Operator
And your next question comes from Mike Sison from KeyBanc. Please proceed.
Mike Sison - KeyBanc Capital Markets
Hi good morning.
Unidentified Company Representative
Good morning Mike.
Mike Sison - KeyBanc Capital Markets
Can you sort of discuss a lot of negative issues that you where in the Water treatment in the second quarter, can you just sum up with the total impact from all those where in and how much of that reoccurs going forward or maybe how much of that sort of you work through and doesn't become as a negative as we had for the rest of the year?
Unidentified Company Representative
Yes, the operating issues summed up to $5.5 million.
Mike Sison - KeyBanc Capital Markets
Okay.
Unidentified Company Representative
The two issues related to the invoice accuracy and the margin issue we have related to shipping German product around the world. Those two issues we believe we can have significantly mitigated by the end of the year.
The other issue is the restructuring types of things. You were still in the midst of our restructuring so I would expect a couple of more quarters of those kinds of costs.
Mike Sison - KeyBanc Capital Markets
Okay. Okay.
And Jim, when you think about water treatment, may be if you can just revisit why is this scenario that makes sense for Ashland, it was an area that you had talked about historically, may be a focus for acquisition, do you think that's the case, and then you sort of alluded to the fact that you saw a significant potential here and may be can you just sort of give us an idea of what the potential is?
James J. O'Brien - Chairman and Chief Executive Officer
Sure. When you look at the water space general, obviously it's going to be an area of concern for the world as far as sourcing fresh water and from an industrial point of the world, how to use less of it, and when you do use it, how you clean it and put it back into use.
So we see it as far as just the gross economics of the business being very, very favorable over a much long period of time. So it's something that we think as an attractive marketplace.
We have an opportunity here to participate. Now, our feeling now to this point is that we have not effectively and efficiently operate inside of that space, so the trials were going through right now was really changing the culture as Hank described and getting the management team in place that we believe can lead this organization in a manner that we could be profitable and get a return on the investments that we have made.
So, I think operationally is really the challenge that we have. Its not a structure issues as far as the marketplace, it's not really an issue around whether we need different products or different services, its more around us, more effectively operating.
So its sort of a good news in a sense, its all inside our control and the bad news is, is we haven't effectively achieved it yet. So we keep making changes and try to accelerate this change and more we change the business obviously the more impact it gets and we put a lot of change on this business over the last year and half to two years.
So, some of it is self inflicted, I will admit that and we are getting more and more focused. I think the management team is becoming more effective, so I am encouraged as I look forward that we are going to get this right.
So it's a great market place. I think we have a very strong position as far as the products or services that we offer.
So worldwide business, two-thirds is outside the U.S., so its something we want to strengthen and build but, we don't have the right yet.
Mike Sison - KeyBanc Capital Markets
So if I think about may be two years out or so and you work through the issues that you talked about I mean how should we measure your success in your margins be at a certain level, should you be at $80 million up income sort of, is there a sort of number out there that we can sort of track?
Unidentified Company Representative
Well as we have stated in the past we believe as a minimum, this should business should have 8% margins, EBIT margins. So that is the near term target.
That's all the work that's been done is trying to get a business structure that delivers as a minimum 8% EBIT margins. Now if we achieve that, it becomes even more effective obviously, it could grow as high as double-digit type margins.
I think that's exhibited some businesses like ours in the market place so I don't think it's out of the question. But, first we got to the get to the point that we deliver at least high single-digit margins and all the work that's going on today in the change in the structure, in the focus of the market place to pricing, all the things that Hank discussed is to drive the business to 8% EBIT margins as a minimum.
Mike Sison - KeyBanc Capital Markets
Okay. And last question, you sort of outlined a lot of run rate savings for '08, '09 and some additional, the additional $25 million, could you give us an idea of where those savings will come from by business?
Unidentified Company Representative
Yes. We are looking at through our operations of our that business so primarily, it's going to be in the water business, SP&A and composites.
As I mentioned it is $14 million that we have actually identified which would take place this year and then upwards as a total aggregate about $65 million run rate by the end of next year. So, that would imply that there is some pretty aggressive change in the model as well as supply-chain that supports it.
Supply chain is a big part of this as well. And all that together will have to change the business models and we will have to make significant change in how we operate internally and we are going to be close, somewhat aggressive on this because we think, once we cleared SAP, we have the I think the ability now to operate differently and we are going to make those changes through this year and then the next.
Mike Sison - KeyBanc Capital Markets
Right. Thank you.
Unidentified Company Representative
Thanks, Mike.
Operator
Our next question comes from Laurence Alexander from Jefferies. Please proceed.
Unidentified Company Representative
Good morning, Laurence.
Unidentified Analyst
Hi, this Lindsey Watson speaking for Laurence. I just had a question with respect to your inventory reduction, what is your expected impact in the back half of the year?
Unidentified Company Representative
We are not forecasting but I think we have talked about. In general, we would like to reduce our overall working capital as a percentage of sales of by roughly 1% over the year and we don't want to get into and try to forecast any one component.
But, I think it's fair to say in the case of inventory, we still have further to go, as we get into this so I think we are feeling more optimistic about our abilities to drive working capital, it's a question of timing and effort and process and we have all three at this point.
Unidentified Analyst
Okay and going back to the Valvoline segment, have your price increases exceeded raw material pressure and can we expect the margins to continue at this run rate, through the back half of the year?
Unidentified Company Representative
What you'll see through the period is that you will get some contractions of margins as we lag the price increases to us. And as these price increases are moved through the marketplace you will see them expand back to the levels that you have seen over the last six months so that's the, how we are playing our pricing and where we want the pricing to land when we are done.
Unidentified Analyst
Thank you.
Unidentified Company Representative
Thanks.
Operator
Our next question comes from, Robert Bliss [ph] from Kedon [ph] and Company. Please proceed.
Unidentified Analyst
Hi guys just two follow up quickly on Valvoline. Given the timing lag between the cost increases and base oil and additives which have been pretty massive and the pricing that you have implemented, on an absolute basis, do you think third quarter operating income will be up year-over-year, and if so, what are the offsetting factors to the price cost gap which seems as though its going to widen?
Unidentified Company Representative
I think that the, whether we exceed last years number is going to be determined on the ability of that Valvoline's more time to continue its performance, because that business is doing very, very well, well positioned to market place, has an excellent value proposition and I think that they are really achieving a high performance. Other part will be the international business if they continues to perform and grow and that will be mitigating circumstance, and will affect the U.S business.
When you look at our total volumes, our volumes have shifted somewhat much less to do it yourself, to much more to do it for me. So that marketplace we've been successful with having the pricing be transferred more quickly into the DIY, so really kind of our business mix has changed over the last couple of years and net loss would be a helping factor, so determining how all these components come together will be kind of, will decide the outcome of how the earnings come in, but I think the mix we have is less sensitive to the DIY business that has been in the last several years, so at that standpoint I am little more confident that we will be able to maintain our earnings and continue to grow the earnings, but there is still variability, so I really cant give you a definitive answer there.
Unidentified Analyst
Okay and in terms of the pricing that you've implemented or announced, is it enough to offset both the cost and re-coupe the margin or just the cost?
Unidentified Company Representative
No re-coupe the cost in the margin, but it will have to go through that lag I described just about two months, so you will see a... like you see in the past, the margin will peak, it will slide off and it will start peaking backup again to a...
normalization, was different this time then we had a couple of years ago is the leap of price increases, are spaced about a quarter apart, when we ran into trouble with Katrina we had price increase that we happening, weeks apart and that was the big difference.
Unidentified Analyst
Okay and then lastly slipping over to distribution, you've continued to make nice sequential progress there, I am kind of wondering at what point we should expect to see your year-over-year improvement, does that happen in the third quarter or should we expect it in the fourth quarter when you have pretty weak comps?
Unidentified Company Representative
No we don't forward forecast, but obviously one think in our favor is the Dallas [ph] contract will be on the same basis going into next year, so I have that headwind to discuss as far as having that business lost, now we been to build the business backup through our new suppliers and getting new customers. So that part will be helpful, and I think that we will be kind of showed from last quarter to this quarter.
The business seems to be building back to momentum which I'm pleased to see and we will see how it plays out in the next quarter.
Unidentified Analyst
So, it sounds like we hopefully should get a quarter of year-over-year improvement in the third quarter?
Unidentified Company Representative
I think in the presentation, I said I am encouraged by the progress, so I continue to be encouraged.
Unidentified Analyst
Right. Thanks for taking the question.
Unidentified Company Representative
Okay.
Operator
Our next question comes from John McNulty from Credit Suisse. Please proceed.
John P. McNulty - Credit Suisse First Boston
Yes, good morning.
Unidentified Company Representative
Hi John.
John P. McNulty - Credit Suisse First Boston
And also just a quick congratulations Marvin. You have been a lot of help over the years, so I definitely appreciate it.
Couple of questions on the water treatment area. With regard to the portion that is marine focused exclusively, should we assume that the operating margins in that business are in a double digit area and as the rest of the business it's dragging down.
Is that a fair assumption at this point?
Unidentified Company Representative
Yes.
John P. McNulty - Credit Suisse First Boston
Okay and then with regard to the and it's my understanding that the industrial portion of your water treatment sector is about 40% of the total operating sales for that business. Is that business big enough on its own at this point even with the five initiatives that you are really pushing in that area to hit the targets to get that business itself to kind of an 8% EBIT margin or do you really need to make acquisitions in this area to kind of improve the scale overall?
Unidentified Company Representative
I think we can get there with the business that we have and we're the third biggest player in the market at this point in time. Obviously more scale will be great, but we got what we need to make that business successful in my opinion.
Unidentified Company Representative
John I ... there was a question asked earlier about acquisitions in this area and you are kind of implying that, as we really need to get this business model operating well before we try to grow it rapidly.
Unidentified Company Representative
Fixed first, growth second.
John P. McNulty - Credit Suisse First Boston
Okay. Fair enough.
And then just to be clear to make sure I understood what you were saying before. In terms of the cost cuts that you are initiating across the firm right now, you would hope to be at a $14 million run rate by the end of this fiscal year and a $60 million run rate by the end of '09, so an incremental $40 million in '09, is that right?
Unidentified Company Representative
If everything comes together as we described, this $14 million that we would achieve this year and then there is a run rate which includes the $14 million and $40 million and we have an additional change in business model, we could bring another $25 million. So if you look at the total program, there would be a total of $65 million run rate if we can get everything.
And then obviously, that we were communicating at this stage that we are highly confident to get us the 14 and we are working on plans to move aggressively against the 40 run rate and we hopefully by that early part of next fiscal year to have the 25 identifiers are acting against that.
John P. McNulty - Credit Suisse First Boston
Okay, great. Thanks for clearing it up.
Operator
[Operator Instructions]. Our next question comes from John Roberts from Buckingham.
Please proceed.
John Roberts - Buckingham Research
Best wishes Marvin.
J. Marvin Quin - Sr. Vice President and Chief Financial Officer
Thanks, John.
John Roberts - Buckingham Research
Could you update us on where we are in the discussions with the IRS on the review at Marathon transaction and if there is any updated thoughts on the timing for resolution?
J. Marvin Quin - Sr. Vice President and Chief Financial Officer
Well as we said in the prepared remarks, we are expecting in two to four months, I would say it's, if you talk to try tax people, they think it will be resolved this quarter. We had one small issue come up with the IRS which is totally covered by our indemnity with marathon and there are really no major issues and its just the time that takes to work through it.
But our best estimate would be roughly three months, we should have this or last we should have this resolved. It's just that there is obviously uncertainty because we don't what...
we only control one half of this.
John Roberts - Buckingham Research
Great. I jumped on late.
Thanks for the update.
J. Marvin Quin - Sr. Vice President and Chief Financial Officer
Thanks.
James J. O'Brien - Chairman and Chief Executive Officer
We kind of conceded an hour. Just kind of close out here if we could, and I think as we look at the company, we have really challenging environment but we believe our businesses are well positioned to compete and be rest assured that we are taking the decisive actions to prove our Water Technologies before this material businesses and to lower our overall cost.
And obviously our solid balance sheet enables us to strengthen our competitive position in the quarter ahead and we look to the remainder of the year with some tempered optimism. But before we close, I get this opportunity to thank Marvin Quin, who as we, I have announced earlier is retiring at the end of the May for his outstanding service to Ashland.
And Marvin you have had a remarkable carrier over the last 16 years as CFO and your influence on Ashland has been and will be significant and lasting. You have been a teacher and mentor to many and I have personally gained much from your council [ph] over the years and I wish you and Terry all the best.
J. Marvin Quin - Sr. Vice President and Chief Financial Officer
Thank you, Jim. After 36 years of Ashland, I do feel its time to pursuer some of my personal interest.
I will turn 61 this summer and I would like to spend more time with my family, perhaps more time sailing and if I can convince my wife to go sailing that will be great, get two berries with one stone. It's never easy to pick the time to retire but I do have a lot of confidence in the financial team here, I have confidence in the company, I will continue to be a large shareholder and it's really been a pleasure working with you the analyst investment community.
You challenged me, you provided valuable perspective and I have really enjoyed and hope you continue to provide that with Lamar. Jim?
James J. O'Brien - Chairman and Chief Executive Officer
Thank you again Marvin and thank you everybody for joining us today on the call. We look forward to speaking again in the future.
Operator
Thank you for participating in today's conference. This concludes the presentation.
You may now disconnect. Have a great day.
Thank you very much.