Baldor Electric Co. Q3 2008 Earnings Call Transcript

Baldor Electric Co. (BEZ)

Q3 2008 Earnings Call

October 24, 2008 11:00 am ET

Executives

Tracy Long - VP of IR

John McFarland - Chairman and CEO

Ron Tucker - President and COO

Analysts

John Franzreb - Sidoti

Jason Feldman - UBS

Eric Glover - Canaccord

Jon Braatz - Kansas City Capital

Erik Valentine - Abedos

Mike Schneider - Robert W. Baird

Kristine Kubacki - Avondale Partners

Fla Lewis - Weybosset

Bob Franklin - Prudential Financial

Tom Lamb - Weybosset

Presentation

Operator

Good morning, ladies and gentlemen and welcome to Baldor Electric Company's third quarter 2008 earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Please note that this conference is being recorded. I will now turn the call over to Miss Tracy Long, Baldor's Vice President of Investor Relations. Miss Long, you may begin.

Tracy Long

Thanks, Teresa. Good morning, everybody. With us today is John McFarland, our Chairman and CEO, and Ron Tucker, our President and COO and we appreciate the time they have taken to be with us today.

Our press release came out yesterday afternoon and a copy is on our website if you don't have one. I just want to remind everybody that some of the comments we make today may be forward-looking statements. Those statements are not guarantees and of course the actual results could be materially different. And with that, I'll turn it over to John.

John McFarland

Thank you, Tracy. Good morning, everyone. We're again pleased to report record sales for the quarter of $506, 154,000 up 5% over the third quarter 2007. Net income was the second best ever at 25, 810,000, up 5% from the same quarter in 2007. Earnings per share at $0.55 cents compared to $0.53 cents last year.

As with every quarter, there were some things that we were pleased with and some others that we were not pleased with. And so I'd like to comment on a variety of things this morning.

First, starting with sales. Sales of our power transmission products were up slightly during the quarter because we included one month of the Maska acquisition. Without the Maska sales, mechanical power transmission sales would have been approximately flat. We've invested in our sales force to sell the DODGE products and added some important new products that we feel will yield sales growth in the future.

The DODGE mechanical power transmission products have been heavily tied to the aggregate and cement industries. During the last year, we've been diversifying our OEM customer base into other industries so that we are not so heavily tied to home building and construction.

We have almost 100 new customers at DODGE and many other prospects that we believe will become customers. We're employing the Bounty Hunt strategy that we've used so successfully before in our motor business. In addition to this, we have a number of new products that we have been introduced over the last year that we have high expectations for.

One of those new products is the MagnaGear which is a large gearbox. We are currently quoting about $2.5 million a month in Magna gear. We have received a number of orders and we have now begun production of this important new product.

During the quarter, we had the grand opening of our expanded plant in China. While our business was flat in Asia during the quarter, our incoming order rate in China was strong, a strong double-digit increase. The new larger plant allows us to expand the production of our DODGE CST product line. And we are beginning limited production of motors.

We expect to produce motors in China in a more meaningful way around the middle of next year. Motor sales grew during the quarter by 8%. Our high efficiency Motor Line Super-E continues to grow at more than 25%. The larger and stronger sales force we now have selling motors and in particular large motors is being very effective. Our backlog of large motor orders is up. We're working to reduce lead times and increase output in our large motor plants and believe when we're able to do so we can have even more success.

OEM sales were steady during the quarter and continue steady into October. Distributors who can quickly stop purchases when they're concerned about the future did so in mid-August and that continues into October. We've now rebuilt our motor inventories and we're in very good position with inventory to take advantage of the opportunities that come when distributors reduce their inventories. In other words, our distributors have been reducing their inventories and we believe they'll work more out of ours and we're in a position to take advantage of that.

In total, our backlog of orders grew from just over $235 million at the end of the second quarter to more than $260 million at the end of the third quarter. Based on our current order rates, our backlog and the number of days we have in the current quarter, we expect fourth quarter sales to be up mid-single digits, about the same as the third quarter.

During the quarter, we had the lowest manufacturing expense we've had since the acquisition of Reliance Electric in January of 2007. We continue to follow our strategy of combining the Reliance and Baldor Motor businesses and product lines. We're also sharing best practices throughout all of our plants and saw good improvement in productivity during the quarter.

Material costs were a headwind again this quarter with increases in steel costs that were affected the first of July. In reaction to this, we raised our prices as quickly as quickly as we could. And that became effective at the end of July. This difference in timing, the cost increase at the beginning of July and prices increases at the end of July hurt margins and earnings in the quarter.

We expect some further price increases for components used in our DODGE business and will have a small price increase of approximately 4.5% for the DODGE products at the end of November. We don't expect material cost inflation to be the headwind next year that it has been this year.

Now, let me talk a little about our balance sheet. During the quarter, our debts went up by a little over $20 million primarily because of the acquisition of Maska. We are very proud that Maska is now part of Baldor. Maska has above average company profitability, faster sales growth than the company overall and gives us a second facility in China that helps us reduce the amount of capital investment required to get into the motor business there.

During the final quarter of this year, we expect to make modest debt reduction. Our ability to reduce our debt during the current quarter is being impacted by our near term copper hedges. As copper has dropped during the past month, we've been required to make cash prepayments for copper that we will take delivery of in the next few months. This causes the shift of cash for debt reduction from the fourth quarter to the early part of 2009.

During the quarter, our inventories grew by about $25 million. About half of this growth is a result of the acquisition of Maska and the balance being a planned increase in inventories because of the year end holiday schedules. Trade receivables increased by approximately $22 million during the quarter due primarily to the addition of Maska, but also increased sales during September 2008 as compared to June and also because of the timing of some customer payments.

We're managing our trade receivables carefully and have made progress during the quarter that is probably not apparent in the financial data presented. Our quarter ended on September 27th and so some regular customer payments that were received on time were received after the end of the quarter, one very large payment in particular.

Domestic DSOs have improved by about a half a day from the end of the second quarter. Overall, the quality of our accounts improved during the quarter. We know of no customers who are having problems securing loans. We are managing our receivables with the same intensity as the other aspects of our business.

We also realize that investors are concerned about the liquidity and the debt structure of our company. So let me run through that a little bit. We're fortunate that our financing was structured for the long term. Most of our debt has rates that are fixed until 2012. And we only have to pay back $2 million per quarter for the next four years or about 1% amortization of the term loan.

We have sufficient liquidity with our $200 million revolver and we don't have any additional financing needs today. We have approximately $425 million in debt that floats against the 30-day LIBOR and our margin above LIBOR is a very attractive 1.75%. Some investors have asked about our debt covenants. And if we might have problems with them in the downturn.

We have and will continue to analyze them carefully. And we ran a number of scenarios based on a difficult year in 2009. We are confident that cost reduction measures we're taking today as well as those that we are prepared to take and expect that that repayment will allow us to stay in compliance with all covenants.

And finally, our employees have been part of a profit sharing plan at Baldor for over 51 years. So we don't have any issues with respect to funding of pensions.

Lastly, our incoming order rate is stable. And as I mentioned earlier, we're expecting a sales increase during the fourth quarter in the mid single-digit range. We have much less visibility to sales in 2009 and are concerned about the current events in our economy and how they might affect us. For this reason, we have taken a number of steps in anticipation of a tougher environment in 2009.

These steps include advancing some integration activity to the current period. They also include carefully watching our inventories and production levels to be sure that we keep them balanced with sales and don't allow our inventories to grow beyond what's needed. We're reviewing our inventories and our production levels weekly and making adjustments as necessary.

We're also reducing a number of discretionary spending items and planning very conservatively for next year. We've had a hiring freeze in place for most of the quarter that will continue indefinitely. Since the beginning of the third quarter, we have reduced the number of employees we have by about 3% or 250 people. We are attempting to get out in front of a possible downturn in business and we may be overreacting. If we overreact, we will adjust accordingly, but we will not under-react.

So, with that, I'd like to thank you again for joining our call this morning, and we're anxious to open up the line to your questions.

Question-and-Answer Session

Operator

(Operator Instructions). We'll go first to Steve Sanders, Stephens Inc.

Steve Sanders - Stephens Inc.

Good morning.

John McFarland

Good morning, Steve.

Ron Tucker

Good morning, Steve.

Steve Sanders - Stephens Inc.

Thanks for the additional color on the balance sheet and some of the things you guys are doing to prepare for tougher times. John, I just want to revisit the comments on the order rate. So, September and October for OEMs remain fairly stable, distributors got soft and the guidance for the fourth quarter would anticipate that those order rates are relatively flat over the next couple of months. Is that fair?

John McFarland

Yes. Yes, we just looked at it this morning, went back to the first of August up until today and looked at the OEM and distributor rate separately, incoming order rate separately. And there has been virtually no change in the incoming order rates on OEMs.

And what we're hearing from OEMs are that their schedules are solid in the near term. We have had a few say that their backlog has decreased a little bit, but we haven't seen any of that in our order rates. They've been very consistent since the 1st of August.

The distributor side of the business, though, did change. July was a good month. And then in August, distributors did back their purchases down. On the one hand, you'd say, well, that's kind of a sign that things might get bad. But on the other hand, Baldor has the largest inventory of industrial motors in the industry.

And so, as distributors begin to reduce their inventories, they start to rely on us more for motors from inventory and we've done a good job of rebuilding our inventories on motors in particular and we have good inventories at DODGE as well and so if the distributors are going to operate without less inventory, they can rely on us to have the motors and stock and the DODGE products and stock they need.

Steve Sanders - Stephens Inc.

Okay. Okay, thanks. And then Asia sales in the quarter were relatively flat. I guess currency may have played a role there, but the orders were strong. Can you just comment on what you saw for the quarter specifically in China and why it was flat in the quarter and against good order rates?

John McFarland

Yes, the order rates in China. I was just looking for the exact amount of increase, I don't know that I have it in here, but the booking rates in China, incoming order rates in China were very strong double digits. It is just the shipments that were about even with last year. And the shipments may have been impacted by the currency and I don't know by how much, but it was just a flat quarter for shipments.

The products that we make in China are large Soft Start gearboxes for the coal mining industry and they are real expensive. And each individual product is real expensive and we also collect the money for those products in advance. And so if we have a collection issue right at the end of the quarter that causes us not to collect some money, then it'll affect the billings. The incoming order rates in China specifically in China were up 18.5% during the quarter.

Steve Sanders - Stephens Inc.

Okay. Okay, thank you. And then on the cash flow, again, you gave us quite a bit of color. Ron, can you give us what the net cash impact in the quarter was of the facility sale and the Maska acquisition.

Ron Tucker

If you net the two, the Maska acquisition was a little more than was the asset sale, to the tune of around $20 million or so.

Steve Sanders - Stephens Inc.

Okay. Okay and then I guess you are not giving us an updated number on the debt reduction target? I think, John, your comment was modest debt reduction in the fourth quarter. As we think about 2009, is it reasonable to think about the $125 million number as being the right number? What kind of guidance could you provide us there?

John McFarland

Well, I think if we had a year, about like this year that would be a pretty reasonable number. It just depends on of course what the top-line is. We've been looking at some scenarios that would show a decrease in sales for example and what impact would that have on our ability to pay debt and actually at a slight decrease in sales. It looks like at least initially, we could pay a little bit more debt off than if we had an increase in sales and that's primarily of course because your receivables come down, your payables come down, your inventories come down to adjust to that level.

Reducing the debt is our number one priority for free cash flow and as I said in my opening comments, we're a little affected this quarter because we've got some hedges in place on copper that are causing us to have to prepay some of that copper cost. So I would expect some modest decrease this quarter and a little better progress in the first quarter.

Ron Tucker

And one more thing I'd want to mention about the cash flow, we haven't mentioned yet. If you look at the year-to-date cash flow '08 to '07, there was an additional bond payment in '08 that we didn't have in '07 because of the acquisition. There's a February payment of bond interest in '08 but there wasn't in '07. That's the difference in the year-to-date cash flow.

Steve Sanders - Stephens Inc.

Okay. Okay and then final question on the copper hedging. We've obviously seen copper fall pretty dramatically here in the last month or so, down $1 plus a pound. When would we start to see those kind of decreases flowing through your business? So in other words, are you pretty hedged through 1Q and so you don't really get the benefit of some $2 copper until second Q or the third quarter, but just help us quantify that a little bit.

John McFarland

Yes, we're pretty much hedged through the first quarter. And so we would see benefit after that.

Steve Sanders - Stephens Inc.

Okay.

John McFarland

You would say a little bit than in the first quarter because, again, remember the reason we hedge as the dollar average is down. So as you move forward, there will be a little bit of a benefit. Not the kind of benefit you're seeing in the stock market right now. We will get some of that after the first quarter.

Ron Tucker

Yes, let me just say, we never paid $4 for copper. We were never close to paying $4 for copper. Our hedging strategy kept that from happening, but at the same time, as copper goes the other direction and especially when it goes as fast as it has, it prevents us from paying the spot price for a few months. So, I think a decrease in copper prices is a positive thing for the long term.

Steve Sanders - Stephens Inc.

Right. Okay. Thanks very much

John McFarland

Thank you, Steve.

Operator

And our next question comes from John Franzreb, Sidoti.

John Franzreb - Sidoti

Good morning, guys.

John McFarland

Good morning, John.

Ron Tucker

Good morning, John.

John Franzreb - Sidoti

First kind of a big picture question here. When you purchased Reliance and DODGE you kind of indicated that you had worked through every potential scenario and that it looked like a great buy all the way around, no matter how you did the math. Given the current economic environment, did you kind of incorporate currently the current economic environment we're in, in those scenarios or is this above and beyond of what we're looking at?

Ron Tucker

I would say we incorporated much worse environment scenarios than we are currently in. I mean I think we looked at it when we did the acquisition. We're looking at it now. We routinely go through with the covenants and the cash flow and everything else. We've looked at this morning again. And we feel very confident.

John McFarland

Yes, and just to add to that, John, the scenario that we were in through before the acquisition, actually before our bid, was we said what if 2008, 2009, and '10 were like '01 and '02 and '03. And we used that as our assumptions that DODGE and Reliance would perform exactly as they did in those three years and Baldor would perform exactly as it did in those three year.

And of course, I don't think that would happen, because we've made a lot of changes in the company, and we're really a totally different company, either one of us in '01, '02, '03. But that was the scenario that we were in. And in that case, we wanted to know, could we continue to pay our dividend, would we be able to meet our debt obligations.

And the answer to that was we could continue to pay our dividend, we could continue to meet our debt obligations, invest what we needed to in the business for the future, and we could actually delever a little bit, not as fast as we have so far and not as fast as we want to, but we could still even delever.

Ron Tucker

And to reiterate what John said on the opening comments, I think the other difference is we're certainly going to overreact now. And again, if we overreact, we're going to adjust it. But we're going to be ahead of the situation if we see things get soft and we're already starting to do some things, even though we really haven't seen that softness yet.

John Franzreb - Sidoti

Great. That's comforting. Now, what about the current credit conditions and the impact on Reliance's customers? Are you hearing anything on that side that they may be pulling back on the (inaudible) based on costs for them on financing or what are you hearing on that side of the business?

John McFarland

We are really not hearing anything about financing. I mean we are not having any customers tell us they can't pay us, because they can't get a loan from their bank. We're just not hearing anything about it. I know it's a big issue nationwide, and it's something we all read about in the newspaper, and we've been concerned that we might see it in our receivables, but we haven't.

John Franzreb - Sidoti

Okay. One last question. The revenue increase that you're forecasting for the fourth quarter, you had price increases in July; you're talking about another one in November. How much of that revenue increase has pricing embedded in it and how much has volume embedded in it?

John McFarland

Well, we would expect in the fourth quarter that the unit volume would be down some. Most of the increased sales fourth quarter in dollars is related to price increases. And also, we have a calendar favors us in the fourth quarter. We have a few extra days. And so, we would expect the volume to be down in the fourth quarter.

But it's always down in the fourth quarter compared to the third quarter because of the Thanksgiving holidays and Christmas holidays. And the Christmas holidays this year fall in the middle of the week. I think Christmas is on Thursday and New Year's is on Thursday. Our year doesn't technically end until the Saturday after New Year's this year.

But those two Fridays that, you know, are workdays. There will be a lot of people that won't be working.

John Franzreb - Sidoti

I know I can use the break. Okay. Thanks a lot, guys.

Operator

We'll go next to Jason Feldman, UBS.

Jason Feldman - UBS

Good morning.

John McFarland

Hi, Jason.

Jason Feldman - UBS

So we talked about copper a little bit earlier, but the scrap prices are down which I know kind of hurts on the margins. Have you seen any easing in electrical grade steel prices?

John McFarland

We buy three types of steel. That's a very good question. We buy three types of steel. We buy sheet steel, which is like you'd use in an automobile. We buy bar steel and electrical steel. And the sheet steel and bar steel, we've seen easing in price. But the electrical steel, we actually took a price increase on the 1st of October.

Electrical steel is 85% of what we buy. Now, when we buy the steel, we then punch it and make motor laminations out of it and all of those punchings that come out of it end up being sold to scrap. And the steel prices that we have are tied to scrap prices. And we have seen the scrap prices go down.

Now, that's a bad thing in that the steel prices are remaining high and the scrap price is going down, which means it's increasing our costs. And we are working with our steel suppliers now to see if we can't make some adjustments in response to that.

Jason Feldman - UBS

Okay. Also, with the strengthening dollar, I mean I know some of it's been fairly recent move, but have you seen any impact either in terms of foreign competitors maybe getting more competitive or changing the sales to domestic OEs, the 50 hertz motors, for export?

John McFarland

The domestic 50 hertz motors were up 48% during the quarter. So, we really haven't seen any change in the competitor landscape. The dollar has fallen and that obviously has a little bit of an impact on us from the translation point of view. But I think the dollar is still valued at a rate that won't harm our competitiveness.

Jason Feldman - UBS

Okay and then a last thing, when there have been a lot of price increases this year. And the net amount has gotten pretty big. Copper is already coming down. It looks like electrical steel prices maybe sometime next year will be better. How comfortable are you given what you're hearing from distributors and OEs that you're going to be able to hold on to a portion of that price increase when the commodity costs come down?

John McFarland

Of course, number one commodity costs have to come down and stay down and I'm not trying to avoid your question, but I don't really want to get into pricing issues.

Jason Feldman - UBS

Okay.

John McFarland

On a conference call with 100 people listening, but we look at our pricing and we are going to do everything we can to get a fair price for our product. And be fair with our customers and that is the way we have always been, that's been our strategy and that has yielded fair returns for our shareholders, so that's the way we'll approach it this time.

Jason Feldman - UBS

Fair enough. Thanks for your time.

John McFarland

Thank you, Jason.

Operator

We will go next to Eric Glover, Canaccord.

Eric Glover - Canaccord

Good morning.

John McFarland

Hi, Eric.

Eric Glover - Canaccord

A quick question on replacement sales. Typically about half of the total, do you expect that percentage to increase materially if we are really heading in to a serious economic downturn?

John McFarland

Yes, I would. Always in the past, Eric, when the economy was strong, OEM sales would grow a little faster than distributor sales because people often replace equipment rather than repair it in good times. And actually, that's what we're seeing today. The OEM sales are stronger than the distributor sales.

But in past downturns and I've gone through four or five of them at Baldor, the distributor business gets stronger than the OEM business because people then tend to repair things rather than replace them. So we would expect to see a small amount of shift. It's usually about two points towards the distributor business away from the OEM business.

Eric Glover - Canaccord

Okay and then turning to the efficient motors, what end markets seem to be adopting these motors most rapidly?

John McFarland

Well I would say the HVAC market and the pump market are the two places that have really adopted high efficiency motors. And it makes a lot of sense for them to do so because HVAC units often times run around the clock and of course we don't make home HVAC units. All of ours go in large buildings and large projects, but these things often run around the clock and so it makes a lot of sense to have a high efficiency motor.

And the same is true with pumps. In high rise buildings, it requires motors and pumps to pump the water to the upper floors. There's usually multiple pumps in a large building. And some of them will run all the time to take care of drips in the faucet and water consumption that occurs around the clock.

So those two industries have been the most active. And then from a user point of view, the process industries, refineries, chemical plants that have large amounts of motors where motors make up the majority, sometimes 80% or 90% of their power bill. Many of those plants really understand energy efficiency and have adopted high efficiency motors, many of them long ago.

Eric Glover - Canaccord

Okay. Would you be willing to provide a number as to what percentage of the backlog is the premium efficient motors?

John McFarland

No, I don't know the number. I'd probably be willing to give it to you if I knew it, but I don't know it.

Eric Glover - Canaccord

Okay and then finally, I noticed the tax rate is down a little bit. Is 36% rate still fair for the year and into 2009?

John McFarland

Yes the tax rate will return to the normal rate in the fourth quarter around 36%. There should be the rate for next year. This quarter there was a couple of adjustments to some accruals and primarily a state tax accrual where we got a little bit of a benefit this quarter. It will go back to normal rate next quarter.

Eric Glover - Canaccord

Okay, thanks a lot.

John McFarland

Thank you, Eric.

Operator

We'll go next to Jon Braatz, Kansas City Capital.

Jon Braatz - Kansas City Capital

Good morning, all.

John McFarland

Hi, Jon.

Jon Braatz - Kansas City Capital

I was going to tell you your stock is up today, but it just went down $0.2 cents.

John McFarland

Stop watching. Jon, somebody said before we got on the call, somebody said, well I can't imagine with the market doing what it's doing today than anybody will be interested in motors today. And I said well, we've got a couple of hundred salesmen out there that are interested in motors each and every day.

Ron Tucker

I mean we're all interested.

John McFarland

Most probably.

Jon Braatz - Kansas City Capital

John, you talked a little bit about the timing issue with regards to the price increase and the cost increases in July. Now that they're in, does that mean that we're going to recoup some of that loss margin in the fourth quarter because we got the price increases in now?

John McFarland

Yes, we'll have more price increase revenue in the fourth quarter than we had in the third quarter.

Jon Braatz - Kansas City Capital

Okay. Okay.

John McFarland

We basically during the month of July, the cost increases on steel are calculated on some monthly indexes and so we really don't know until about 10 days or 15 days before the end of the quarter what the cost increase is going to be on steel. And so it's difficult for us to get the price increase and the cost increase aligned at the same time.

And so the price increase occurred right at the end of July whereas the price increase on the material occurred right at the beginning of July. So we lost about a month's worth of the price increase --.

Jon Braatz - Kansas City Capital

Okay.

John McFarland

For the full fourth quarter.

Jon Braatz - Kansas City Capital

Okay. I sort of keep my eye on the monthly press releases from AK Steel and their surcharges for electrical steel. And their surcharges over the last two months have come down a little bit. Is that at all reflective of what you may be seeing in your purchasing?

John McFarland

We do a little business with AK Steel and some of the Reliance plants. And I'm not really familiar with AK Steel and whether or not that has affected our cost. But most of our steel we buy from someone else, and that's at quarterly. And that's based on some indexes, scrap. And so it adjusts quarterly. And so, we would expect to see some adjustment up or down at the beginning of the year.

Right now, the scrap prices are trending down, so that if that continues through November and the December indexes, then we would hope to see some reduction.

Jon Braatz - Kansas City Capital

Okay. I was thinking of just looking at it sort of a surrogate as to what maybe the trend might be in terms of your electrical steel, not specifically related to your business with AK Steel. That's one. The other thing is SG&A costs were up a little bit more than I would have imagined. Is that more reflective of just the mix as opposed to anything else, anything unusual in the quarter in the SG&A line?

John McFarland

I wouldn't say anything unusual. The SG&A was about the same as the previous quarter. Included in SG&A at Baldor is freight expense.

Jon Braatz - Kansas City Capital

Okay.

John McFarland

And also, there was a little bit of a mix change. As you know, our motor sales force is paid strictly on commission. And so the motor business grew by 8%. And also, the Maska business is a straight commission business. And so, the growth there does add more dollars to SG&A than we would have in the other sales force where everybody is on a salary.

Jon Braatz - Kansas City Capital

Okay. One last question. I think you mentioned that your employment levels were down 3%. You're not hiring anybody. I guess there is sort of a natural attrition to everybody's business. Would you see further employee headcount reduction into 2009?

John McFarland

Yes, we would. We of course have 8,000 employees now. So with 8,000, you have a pretty large amount on a monthly basis, at least compared to what we had prior to the acquisition. You have a fairly significant amount of normal attrition from people leaving and retiring and so on and so forth. So, we expect to see further attrition each and every month.

And then in addition, we have accelerated integration activities in a couple of areas that will yield some additional attrition over and above the normal. So, I would expect that by the end of the first quarter, we would see several hundred at least more people out.

Jon Braatz - Kansas City Capital

Okay. You mentioned integration. Any update on maybe the opportunities that lie ahead in 2009 in terms of integrating the two businesses above and beyond what you had previously indicated?

John McFarland

Well, I wouldn't say above and beyond what we previously said, but the opportunities for us and the things we're working on in 2009 are the product integration on the motor side. And we have achieved a lot of the initial things that we had in our plan for integration.

We're working now on the motor integration with the target of December 2010 when the energy bill comes in to have that pretty much done. That would involve moving some products from one plant to the other, and we will be publishing a new price sheet in January. And that new price sheet will be able to take about 300 SKUs out of the price sheet related to the integration activity that would allow us to operate plants a little more efficiently on those items and keep a little less inventory.

So, there is a lot of things with respect to the product integration that's going on really on a weekly basis. And we're pushing that pretty hard.

Jon Braatz - Kansas City Capital

Right. Okay.

Ron Tucker

The goal in each of the plants is to narrow the range of [products] the plants produces, so that they are more efficient on those wide range of frames of this. And therefore, we do it. And again, as we jotted earlier, this last quarter was the absolute best manufacturing quarter we've had since the acquisition.

Jon Braatz - Kansas City Capital

Okay. Ron, thank you very much.

John McFarland

Thank you, John.

Operator

We'll go next to [Erik Valentine, Abedos].

Erik Valentine - Abedos

Hey, guys, thanks for the call. Just a couple of kind of questions on modeling for a downside scenario. I mean you guys talked about looking at kind of the 2001 timeframe and so forth. Can you just give a little more color on potential kind of margin compression and so forth what we might want to factor into our model?

And then also kind of on the debt reduction, you're saying in 2009, you can be about 125 is kind of a good number. I'm looking at the debt covenants, and I mean it doesn't look like EBITDA can hold off all that much without you guys looking at covenants if you don't have some pretty significant debt reductions. Can you just comment a little bit more on that?

John McFarland

Let me go back to the 2001, 2002 aspect of your question. First of all, we did have a big drop in income in 2001, 2002. But we were a very, very different company then. For one thing, we didn't have margins of the size we have. And so we were just a very different company. We had much more short cycle business. At that time, we were shipping more than half of our orders. We were shipping the same day we received them. We had less visibility because we did not have some of the long cycle large motors that we have. And the large motor business has continued to be real good.

And we didn't have the large generators that we have today. So our business really is a lot different than it was then. And also in those days, we didn't have any debt and the fact that we do have debts and the fact that we do have covenants and so forth would require us to move a lot faster and a lot more forcefully if necessary to make changes in our business to adjust to whatever environment we face.

And we have not seen any big change in our environment to this point. I hope we don't, but we're planning for a change and we'll be ready. So maybe a long way to say that I wouldn't expect to see the kind of reduction in EBITDA that we saw in 2001 and given today's company and today's circumstances. But we don't margins.

And having said that, though, I want to reiterate again that we modeled that scenario, that kind of drop in EBITDA even though we don't expect it to happen and we won't let it happen. We modeled that drop. We looked at the cash flow that came out during that same period of time and what the cash flow would be now and we're really confident even given that scenario, we're confident we'll be in compliance with debt covenants. So yes, we're not going to let that kind of drop happen, but we've modeled it and we're okay.

Erik Valentine - Abedos

Okay. Okay, that's fair and what about kind of other levers I mean on your CapEx? How much is your maintenance CapEx?

Ron Tucker

It's less than $15 million.

Erik Valentine - Abedos

Okay.

Ron Tucker

As we said in the press release, we are planning a small increase in our CapEx next year. It's related primarily to additional motor lamination manufacturing that we need at the end of 2010 when the energy bill comes in and it's also somewhat related to our efforts to get into the motor business in China.

But we review our CapEx, most of it usually comes in the back half of the year. We review it very carefully. I mean, it's something that we look at and carefully monitor and something that we will adjust as necessary based on the circumstances that we encounter next year.

Erik Valentine - Abedos

Okay. Great, thanks, guys.

John McFarland

Thank you, Eric.

Operator

Our next question is from Mike Schneider, Robert W. Baird.

Mike Schneider - Robert W. Baird

Good morning.

John McFarland

Hello, Mike.

Ron Tucker

Hi, Mike.

Mike Schneider - Robert W. Baird

I am wondering, John you mentioned you have seen 4 or 5 cycles. So you've got a unique perspective. Can you address what pricing did, even say, in the early '70s during a down cycle and in the deflationary period for motors and for gears?

John McFarland

I think I'm getting that odd look from everybody in the room because I did work at Baldor in the 1974 recession. But to be honest with you, I don't remember what happened with prices. In those days, we were a small company and after the recession, we resumed some pretty rapid growth.

In the 2001 recession, which was more recent, it might be more applicable. Our pricing slid by about 1%, 1.5% overall and I can remember at the time, I went through the '74 and then the early '80s and then late '80s and the early '90s and then the 2001. And I can remember at the time and we talked about this at the time about how surprised we were that it didn't slip further, but we've got a very good sales organization.

We've got a very fair strategy for selling our product and at the end of the day, I think, each company prices their product. The market doesn't price your products. You make the decision as to what price you're going to sell your product at. And so we want to be fair, but fair to everybody. And that includes the shareholders.

Mike Schneider - Robert W. Baird

Okay. And then on this deflation topic, scrap prices have fallen significantly and I suspect even during the quarter, scrap was probably below what you're paying for your electrical steel. Given that, can you just frame for us if you were to see a commensurate drop in sheet and electrical steel as we've seen in scrap? Just what amount of savings in dollars, cents per share, percentages, however you would see in 2009?

John McFarland

Well, we obviously we would see some savings. But I don't know what the amount would be. Let me just say that steel is our largest purchase. So a change in the price of steel has more impact on our cost than anything else, but I don't know the answer to your question and would take a fair amount of research to produce it. So sorry, I can't answer that.

Mike Schneider - Robert W. Baird

But presumably that's a cushion in 2009 if indeed new steel catches up to scrap?

John McFarland

It would be a positive, yes.

Mike Schneider - Robert W. Baird

Okay and the 2010 legislation. I know the legislation springs in late 2010, what are your updated thoughts and could you just refresh us what's happened to your business when there has been new efficiency regulations?

John McFarland

That's a very good question. In 1997, the Energy Policy Act of 1992, I believe it was, went into effect. And because we have maybe a little bit different manufacturing strategy than a lot of people; we manufacture a lot of custom motors. It's about half of our business. And so, shifting from one design to another design or shifting from a non-EPAct motor to an EPAct motor in that case was not a big deal for us.

I think the law became effective on October 24th. And on October 23rd, we made non-EPAct motors. And on October 24th, we made EPAct motors. So, in that case, we had done a fair amount of engineering work that we don't really have to do this time. And from a manufacturing point of view, other than needing some additional motor laminations, which we just talked about, we don't have to make any changes in our manufacturing.

I believe in '97, I think we had a really good increase in market share as a result of the way we handled the lack of problems that we caused for our customers as opposed to some of our competitors at the time who did have problems. And so we're working hard this time to make sure that we handle it as effectively as we did in '97. But we did a very good job in '97, and I think we gained some customers and some market share as a result of that.

Mike Schneider - Robert W. Baird

And do I recall correctly that you saw about a 10% boost of sales in that '97 period as a result of legislation both to the pricing and volumes?

John McFarland

Yes, that's correct. That was on motors. And of course, this law affects only motors. It doesn't affect all our sales. But on motors, I believe we had about a 9.5% price increase. And so this time, the price increase on motors would be a little bit larger, because the EPAct motors go to the NEMA Premium. And currently, there is a 20% to 30% price difference for those. And the non-EPAct motors go to EPAct. And I think that would be about a 9% or 10% increase. So it'll come in somewhere I think around 12% on our motor business.

Mike Schneider - Robert W. Baird

And is there a commensurate increase in your costs or do margins expand on those higher efficiency motors?

John McFarland

The margins on the high efficiency motors are just a tad bit better than the standard motors.

Mike Schneider - Robert W. Baird

Okay. And then, Ron, just on the cash payments, you mentioned about prepaying copper here in Q4. I'm curious; so this is just a timing issue so that if you were to take a six-month view, you've not changed your debt reduction plans?

Ron Tucker

That's correct. It is just a timing difference on the debt repayment.

Mike Schneider - Robert W. Baird

Okay. And that is all. Thank you.

John McFarland

Thanks, Mike.

Ron Tucker

Thank you, Mike.

Operator

We'll go next to Kristine Kubacki, Avondale Partners.

Kristine Kubacki - Avondale Partners

Good morning, everybody.

John McFarland

Hello.

Kristine Kubacki - Avondale Partners

You haven't talked about drives and generators. I was wondering if you could give us an update on those kind of business trends, where you see that going into next year.

John McFarland

Because drives and generators combined only are about 6% of our total business, we quit reporting on them a couple of press releases ago. But we had a poor quarter on drives, and we had a really positive quarter on generators. And the two combined overall showed a little bit of growth.

Kristine Kubacki - Avondale Partners

Okay. Do you see generators continuing or was that kind of a one-time pop due to the hurricanes that hit?

John McFarland

We did get some orders as a result of the hurricanes. But our generator business appears to be improving. We're not trying to build a business around hurricane season. We're building the business. We're adding the new distributors. We've got some really good new opportunities that we're working on. And I think our generator business will show much better results over the next few years than it has in the last few years, whether there is a hurricane or not.

Kristine Kubacki - Avondale Partners

Okay. Can you talk a little about the increase in backlog? Is there any particular industries that are showing more strength than others and kind of where that came from, where it's derived from?

John McFarland

Yeah, I looked at some of the industries this morning and the industries that are showing the greatest growth, the agriculture business for us continues to be good. The pump business and especially it seems to be in larger, larger pumps, larger motors for larger pumps, continues to be good. The oil and gas business feels real good, but in looking at the numbers this morning, it looks like the oil and gas business has kind of leveled out. It's leveled out at a real good level, pretty high level. But the growth rate has leveled there.

The mining business seemed to be real strong. So we've got some good, strong, fortunately, pumps. When you think about the use for motors, pumps are the biggest use there is. And so, the pump business is strong. The mining industry is strong. Agriculture is strong. Oil and gas has weakened. So.

Kristine Kubacki - Avondale Partners

Do you have any concerns, because we're hearing from our industrials about either stalling in kind of projects or maybe pulling back in CapEx. Is there any concern that you could see, some pushback in either terms of timing on deliveries or cancellations altogether?

John McFarland

Well, we looked at that. And obviously, we'd be concerned if that were happening. We haven't seen it happen. I mean, we've seen no cancellations out of the ordinary cancellations and to this point, I don't know of a single order that's been pushed off, pushed out to later periods. So I haven’t seen it. If it happens we'll have to adjust to it. But at this point, we haven't seen it.

Kristine Kubacki - Avondale Partners

Okay. Thank you very much.

John McFarland

Thank you, Kristine.

Operator

We'll go next to Fla Lewis, Weybosset

Fla Lewis - Weybosset

I think Jon Braatz asked my first question, but what's included in the other income line, please and why the big increase?

John McFarland

It's the currency and just normal other income royalty things like that in there. The amount that we had in this quarter was a little less than last quarter. So it is a normal amount. There was nothing unusual in there.

Fla Lewis - Weybosset

I'm sorry, so that's currency?

John McFarland

A part of it is currency. Some other miscellaneous items, some royalties et cetera,

There's just a variety of things in this. It's a normal type amount that you saw this quarter.

Fla Lewis - Weybosset

Okay. Thank you.

John McFarland

Nothing unusual.

Operator

And our next question comes from Bob Franklin, Prudential Financial.

Bob Franklin - Prudential Financial

Hi. In your experience how long do the OEMs tend to keep producing beyond the turn?

John McFarland

That's a difficult question, Bob. Just go back to '01, '02, '03 time period and typically in every downturn there's always some industries that are doing well and the only real exception to that has been the '01, '02, '03 time period when of the 160 or so SICs that we track, there were hardly any of them that were showing any positive growth.

I mean they were virtually all down back in those days. Today we've got a mixed bag. Even I would say that looking at the SICs and looking through them this morning, more than half of them are showing growth this year. So I don't really know how to answer your question except to say that in a typical recession if there's such a thing, usually there's some because we have such a broad product line, usually there's some industries that do well. A good example would be medical equipment. I would not expect we do quite a few motors for medical equipment, both here and abroad and then that's the kind of product that typically you would see continue to do well even in a downturn.

John McFarland

And also our current experience says that agriculture seems to be doing well and might do well in a downturn, even with some lower commodity prices, they are still pretty high.

Bob Franklin - Prudential Financial

So with companies or industries that do enter a recession, do you find that somebody says, yes I should have stopped buying this last quarter or two quarters ago? Do they tend to overbuild until they realize it's caught up with them?

John McFarland

That's a good question. I think that in the past people have tended to let their inventories get out of control. We've been guilty of that as well. When you see a downturn, you think that, well, it's really not real and so your inventories get up a little bit more than they should be.

And but today, we have so much better capability to monitor inventories, our computer system and our customers' computer systems are so much better. And both of us try to operate on a so much less inventory than we used to. We have a lot of OEM customers in particular where we deliver to them daily or deliver to them a week's worth of motors at a time, whereas if you go back 15 years or 20 years, we would deliver to them a month's worth at a time. And so I think it seems to be, at least this is my feel that this is a little less of an issue today than it was in times past.

Bob Franklin - Prudential Financial

Okay. On the copper payments, what's the dollar amount of those and were they in the third quarter as well or is it third quarter and the fourth quarter.

John McFarland

Really wasn't. there was a little of it in the, was there any in the third quarter? I don’t think there was much in the third quarter.

Ron Tucker

Not much. It was very little in the third quarter. But most in the fourth.

Bob Franklin - Prudential Financial

And what's the dollar amount in the fourth?

John McFarland

It's a little in excess of $10 million. It's a significant amount of money, but again it's like a prepayment for the copper. So, you move it from the current period to the future period.

Bob Franklin - Prudential Financial

Okay. And can you remind us what your covenants are?

John McFarland

Well, there's an overall leverage covenant and there is fixed charge covenants. The overall leverage covenant is 5.5 times. And as the other one, during the Q, the fixed charge is--

Tracy Long

And that started again, I think.

John McFarland

Yes, the fixed charge is about total leverage is 5.5 and the thing that's secure is 3.5 and then the fixed charge is 1.15.

Bob Franklin - Prudential Financial

Okay. When do those start going down? When do the leverage ratios go down?

John McFarland

They moved out at the end of the year.

Bob Franklin - Prudential Financial

End of '08?

John McFarland

Yes.

Bob Franklin - Prudential Financial

And so can you give us what those are in '09?

Ron Tucker

4.25 and 2.75 and 1.25. And these are all outlined in the credit agreements if you want to go out and look and get more details about that.

Bob Franklin - Prudential Financial

Yes. Okay. Thank you.

John McFarland

You're welcome. Thank you, Bob.

Operator

We'll go to Tom Lamb Weybosset.

Tom Lamb - Weybosset

Hi. Good morning, gentlemen.

John McFarland

Hi, Tom.

Tom Lamb - Weybosset

I guess my questions are pretty much answered I think, but you mentioned your visibility from the OEMs and that you had no change in the near term. What's the near term? Is it a month, is it two months?

John McFarland

Well I don't know that there will be no change in the near term., but what I said was that we've watched, we looked at the third quarter pretty carefully to see if there was a difference in buying habits at the end of the third quarter, was there a difference in the first couple of weeks of October compared to earlier in the quarter. And we focused on primarily August and September. And our feeling has been that as all this bad news gets out there, which just seems to be never ending. But as all this bad news gets out there that this causes people to kind of pull back.

Tom Lamb - Weybosset

Sure.

John McFarland

And in our customer base, about half of our business is distributors. And so the distributors naturally would pull back first because they're buying for their inventories. And we did in fact see that, so that for the last two months of the quarter and into October, the distributor business has been roughly flat with last year. Whereas the OEM business has not been affected.

And so I would assume OEMs, they're buying for specific orders that they have and they have customers and orders to take care of and they are buying the products they need to do that.

Tom Lamb - Weybosset

Sure, do you have some visibility into their production schedules?

John McFarland

We do have some visibility into certain customers' production schedules.

Tom Lamb - Weybosset

And how far out would that visibility go?

John McFarland

Well most of the visibility will come from simply talking to the customer and having the customer say, in the first quarter actually we're going to reduce our schedule by this amount and it's kind of hard to say. We have about 4000 to 5000 OEM customers. Companywide and big ones, small ones in all kinds of industries. And so it's kind of difficult to answer your question.

Tom Lamb - Weybosset

Sure, sure, okay.

John McFarland

We've seen a few customers that have changed their schedules, reduced their schedules. But by and large overall, if we look at the total in aggregate, there has not yet been any big change.

Tom Lamb - Weybosset

Okay, okay. Great. Thank you very much.

John McFarland

Thank you, Tom.

Operator

And we'll take our final question from Yilma Abebe, JPMorgan.

Yilma Abebe - JPMorgan

Thank you. I think you alluded to the fact that it will come off some. Next year you'll be able to pay out more debts from working capital and the benefits. Can you quantify that if the sales do come off next year, should we expect a significant source of working capital?

John McFarland

Well there is a source from working capital and I won't get into all of the details of what we have modeled, but I'll just give you one example. We at least initially can pay off more debt if sales decline slightly than if they increase slightly. And so if you look at the current growth rate for the year, say on a year-to-date basis, that actually consumes more cash than a slight decrease in sales. And a decrease in sales throws off a lot of cash from inventory receivables, payables that we would use for debt reduction.

Yilma Abebe - JPMorgan

That's it for me. Thank you.

John McFarland

Thank you, Yilma.

Operator

And that does conclude the question and answer session today. At this time, I'll turn the call back over to management for closing remarks.

John McFarland

Okay. Well, thank you very much for joining thus morning and as I said earlier while we haven't seen clearly an indication that our business is going to be much weaker next year than this year, we feel that it might be and so we're taking steps today to adjust to that and just like our strategy is with the customer that has a problem, and that is to try to overreact rather than under react. So, we recognize that we have debt and we have a different company today than we had in 2001 and that we need to be very proactive in our approach to a downturn and that's exactly what we're doing. And as I said and with the conclusion of my previous comments, our intention is to overreact, not under react.

So with that, I'd like to say thank you for joining us this morning. And we appreciate the confidence you have in Baldor Electric Company.

Operator

That does conclude today's conference. Thank you for your participation. You may disconnect at this time.

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