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Mine Safety Appliances Co. (NYSE:MSA)

Q3 2008 Earnings Call

October 27, 2008 10:00 am ET

Executives

Mark Deasy - Communications Director

William M. Lambert - President and Chief Executive Officer

Dennis L. Zeitler - Chief Financial Officer

Joseph A. Bigler - Vice President of NA Sales and President of MSA North America

Roberto M. Canizares - Executive Vice President and President of MSA International

Analysts

Edward Marshall - Sidoti & Company

Walt Liptak - Barrington Research

Brian Ruttenbur - Morgan Keegan

Brian Butler - Friedman, Billings, Ramsey & Co.

Richard Eastman – Robert W. Baird

Greg Halter - Great Lakes Review

Rick Ryan – Dougherty & Co.

Operator

Good morning, ladies and gentlemen and welcome to the MSA third quarter earnings conference call. At this time, all participants are in a listen-only mode. Later, we'll conduct a question-and-answer session. Please note that this conference is being recorded. I will now turn the call over to Mr. Mark Deasy.

Mark Deasy

Good morning everybody and welcome to our earnings conference call for the third quarter of 2008. I'm Mark Deasy, Communications Director, and with me today are Bill Lambert, President and Chief Executive Officer; Dennis Zeitler, Senior Vice President and Chief Financial Officer; Joe Bigler, President of MSA North America; and joining us once again from Berlin is Rob Canizares, Executive Vice President and President of MSA International.

Our third quarter earnings release was issued this morning at 8:30 and we hope everyone has had an opportunity to review it. The release is posted on the homepage of our website, www.msanet.com.

This morning, we'll begin with Bill, who will provide our commentary on our third quarter. Bill will be followed by Dennis, who will review our financials and after Dennis, we'll open up the call for questions and planned to adjourn by about 10:45 am.

Before we begin I would like to remind everyone that the matters discussed on this call, with the exception of historical information, are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 as amended and Section 21E of the Securities Exchange Act of 1934 as amended. Forward-looking statements including, without limitation, all projections and anticipated levels of future performance, involve risks, uncertainties, and other factors that may cause our actual results to differ materially from those discussed here. These risks, uncertainties and other factors are detailed from time to time in our filings with the SEC, including our most recent Form 10-Q, which was filed on July 28, 2008. We strongly urge you to review all such filings for a more detailed discussion of such risks and uncertainties. Our SEC filings can be easily obtained at no charge at www.sec.gov, our own website, and a number of other commercial websites. That concludes our forward-looking statement.

So, at this point, I will turn the call over to Bill Lambert for his comments.

William M. Lambert

Good morning everyone. Let me begin by saying thank you, again, for joining us today on this conference call and for your interest in MSA. Presumably all of you have seen our third quarter earnings release and have our financial figures with all comparisons being with the equivalent period in 2007.

I characterize our performance in this quarter as solid with sales and earnings growth in each of our three geographic segments. Consolidated sales in the quarter increased $38.0 million over third quarter 2007, or 15%, reaching a record $286.0 million in sales.

On a currency-adjusted basis consolidated sale increased nearly $30.0 million over third quarter a year ago, which is an increase of 11%.

As reported, European sales increased 24% and international sales increased 22% during the current quarter versus third quarter a year ago, and sales in North America were up 9%.

Net income increased 7% on the 15% sales increase but I think it is important to note net income in the third quarter last year was favorably impacted by the sale of land in our Cranberry Woods office park, which resulted in $6.5 million in after-tax income being recognized last year.

Excluding this non-operating gain from the sale of land last year, net income increased $7.7 million this year, or 75% over a year ago.

Looking at the segments, and also excluding currency effects, sales increased nicely over last year in all three geographic segments. North America was up 8%, Europe up 9%, and international up 18%.

Selling, general, and administrative expenses were up 9% in the quarter, about $5.5 million but when expressed as a percent of sales they were down 140 basis points from a year ago. Nearly half of the $5.5 million increase in SG&A is in currency exchange effects related to the stronger Euro and the Brazilian real versus a year ago.

North America showed good cost control this quarter, as did our European operations. Overall, we saw gross margins improve to 45.3%, up from 43.8% quarter-to-quarter, which is a 150 basis point improvement. We saw improved gross margins in all three of our segments, North America up 150 basis points, Europe up 110 basis points, and international up 230 basis points.

Project Magellan is showing gross margin improvement in the product lines which have been moved as part of this project. For example, our North American fire helmet product line gross margin is up 360 basis points year-to-date, year-over-year, which is encouraging to see and according to our plans.

Additional fire helmet margin improvement is expected to be seen in the fourth quarter as our October 1, 2008, price increase goes into effect.

Under Project Magellan, our new Querétaro, Mexico, plant continues to perform well and hit its performance milestones and our new plant in Suzhou, China, is now complete and will be ramping up production activities during the fourth quarter of this year.

Year-to-date gross margins are up for the company, increasing 110 basis points through nine months. Gross profit showed a strong 160 basis point improvement from third quarter a year ago as many factories were over-absorbed in a quarter with strong shipments.

Increased freight expenses due to rising fuel prices during the quarter and above-average warranty expenses in Europe held our gross profit percentages from improving further.

I am sure many of you are wondering how we performed in our U.S. fire service segment. Sales to the U.S. fires service segment represents 10% of MSA’s consolidated sales and was up 10% in the third quarter versus a year ago. This may come as a surprise to some investors after we discussed early signs of weakening in the U.S. fire service during our last conference call.

Bear in mind, we expected to beat the comparable to third quarter year ago and we did, by $2.6 million, or the 10% increase I mentioned earlier.

To be fair, third quarter year ago was our weakest quarter within the U.S. fire service segment because last year, as you might recall, demand for SCBA’s lessened as the market awaited the introduction of our new Firehawk SCBA, which coincided with the release of revised NFPA performance standards in September.

As we discussed a few months ago in our last earnings call, we are seeing some tightening of municipal budgets due to the economic downturn. And this puts some elements of stress on our growth bowls within the U.S. fire service. But to reiterate, the U.S. fire service segment represents 10% of MSA’s consolidated sales and while important, there is the other 90% of MSA to look at for growth opportunities as well.

One of those areas, encouragingly, was overall military sales in North America, which showed very strong gains during the quarter, up 34% from a year ago, on strong shipments from SCBA under our U.S. Air Force contract and strong sales of advanced combat helmets to the U.S. Army. We expect to complete the current contract for the Air Force and those shipping requirements for SCBA by the end of this calendar year.

For industrial sales in North America, in other words, exclude all fire service and U.S. military sales for the U.S. and Canada, those core industrial sales in North American showed a 2% gain versus the third quarter a year ago. In other words, excluding all fire service and military sales in the U.S. and Canada, because those are two markets which have tended to be volatile over the past few years, and the core industrial markets which remain were up 2%.

Additionally, our industrial SCBA sales showed strong performance in the third quarter as we gained share in select oil, gas, and petro chemical production facilities, and in numerous utilities. We are adding extra emphasis in these market segments which are showing signs of strength, in order to make up for any short falls that we are seeing in the fire service.

While an economic recession is being much discussed, and many experts agree we may actually already be in one, our solid sales performance during the third quarter did not reflect a drop-off in the industrial segment as many had expected. Nor is our incoming order book showing a drop-off in business.

What is perceived to be a weakening global economy, however, cannot be ignored. And so we are taking proactive and prudent steps to better control our spending and position ourselves for maximum flexibility over the next 12 months.

Turning now our attention to Europe, MSA Europe’s sales were up 24% as externally reported and 14% on a currency-adjusted basis. This was fueled by strong shipments against a backlog that we have been working to lower. There is more work to be done in this area but I was very pleased by certain levels of improvements which were shown by our manufacturing teams in Germany and in France.

Europe showed very strong military sales during the quarter, up 41% as externally reported, which is 28% on a currency-adjusted basis, related to strong shipments of gas masks and SCBA in Germany and ballistic helmets and Paraclete body armor in France.

If we exclude military sales and fire service sales in Europe and call the 46% of the business which is left core European industrial, we see that sales were up 29% as reported and 9% on a currency-adjusted basis versus a year ago.

In Europe, and similar to our experiences in the U.S. during the third quarter, we have not witnessed any drop-off in the sales of safety equipment within this segment but we are cautious about the developing economic situation there.

International sales, as I reported earlier, were up 22% as reported and 19% on a currency-adjusted basis. We saw good, solid performance by MSA South Africa and by affiliates in Latin America, which are serving the mining industry.

Taken together, consolidated operating income for the company during the quarter was 54% ahead of last year and shows a 300 basis point improvement in operating margin on a currency-adjusted basis and excluding the sale of property and other income last year.

Through nine months our consolidated operating income is 23% ahead of last year and shows a 100 basis point improvement.

I feel this is solid improvement and I am proud of our employees’ efforts to increase performance and to show these kinds of results. There are challenges, certainly, which are emerging in the global economic outlook and MSA is taking prudent actions to adjust to these uncertain times.

Operating expense reduction is an area warranting intense scrutiny right now and we are giving it our full attention.

At this point I will now turn the call over to Dennis Zeitler who will provide a little more insight into our reported [third] quarter financial results.

Dennis L. Zeitler

I would like to give you some further insight into our third quarter performance and comments on the balance sheet and cash flow statements and additional information will be available later day when we file our Form 10-Q with the SEC.

As Bill mentioned, sales in the third quarter of 2008 were a record for the quarter at $286.0 million, 15% higher than the third quarter of 2007 and the highest third quarter sales ever.

We had sales growth in each of our three geographic segments with North America up $11.0 million, Europe up $14.0 million, and international up $13.0 million. Our global sales were also higher in each of our three market categories. The core industrial market, which is 60% of our total sales, is up 14% this quarter, with strength in gas-detection instruments, head protection, and fall-protection products.

The 23% of our sales to the fire service is up 5% and our military business is up 39% over last year with large shipments of SCBA to the U.S. Air Force and ACH helmets to both the U.S. and European forces.

As we have often discussed in the past, the two most volatile pieces of our total sales are the U.S. fire service and the U.S. military. Recent volatility in the U.S. fire service has been due to the new NFPA standard and federal funding issues and there is inherent volatility as a supplier to the U.S. military.

When you look at our globally-diversified sales that comprise 80% of our total sales this year, aside from these two specific U.S. markets, revenue grew 14% this quarter and 16% year-to-date.

Our gross profit rate for this quarter was 38%, 150 basis points better than the third quarter of 2007, and about the same as the second quarter of this year.

Selling and administrative costs in the third quarter were also 150 basis points better this quarter than 2007 and flat versus the second quarter of this year.

R&D expenses are up 25% this quarter as we continue to invest in new technology and products that will grow our organic sales in the years to come. The majority of our additional R&D this year has been in our gas-detection product line in Europe, therefore a portion of the increase in cost compared to 2007 is the higher Euro.

The resulting operating income, excluding restructuring charges and currency exchange gains, which essentially offset each other, is up more than 50% over the third quarter of 2007, representing an operating margin rate of 12% this quarter, 3% higher than the third quarter of 2007, and the same as last quarter.

Our tax rate for this quarter was 41%, the same as last year, but 4% higher than the second quarter, due primarily to our one-time audit adjustment in our German taxes. Now that the U.S. Congress renewed the R&D tax credit in October, we will see a benefit of roughly 4% in our fourth quarter tax rate.

The bottom line in the third quarter is net income of $18.0 million, $0.50 per basic share outstanding versus $0.47 per share last year. But as Bill mentioned, last year’s third quarter includes $0.18 per share from a land sale at our Cranberry Woods location.

A few comments on the balance sheet and cash flow statement. Our cash position decreased $17.0 million this quarter to $50.0 million as we had a scheduled $10.0 million amortization payment on our long-term debt in August and the translation effect of the lower Euro since the second quarter ended.

Working capital also decreased over $18.0 million this quarter as a result of the lower Euro. Our cash outflows this year are rather evenly allocated to capital equipment and dividends.

During this period of unusual market volatility, MSA has not experienced any issues with liquidity or funding of our business. We continue to have a significant amount of credit available to us in addition to our cash balances. We are, however, prudently pursuing avenues to increase both our available credit and our cash balances.

Those are my comments. At this point, Bill Lambert, Rob Canizares, Joe Bigler, and I are more than glad to answer whatever questions you may have. Please remember that MSA does not give what is referred to as guidance and that precludes most discussion relating to our expectations for future sales and earnings.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Edward Marshall - Sidoti & Company.

Edward Marshall - Sidoti & Company

You mentioned that you were looking to streamline the operations or that you are looking at that with a focus. As we enter a tougher environment here, what are you doing to streamline the operations?

William M. Lambert

I mentioned that we were prudently looking at operating expenses and reducing operating expenses. And so we have initiated, already, certain firing policies and restrictions on hiring, of adding new headcount. We have other programs that we are looking at to reduce headcount in certain areas that we feel are appropriate to do so. And just really watching the capital outlays for the company as we look at this uncertain time.

You know, we are in an interesting period here and it is very difficult for us, and I think many others in the industrial environment, to predict right now what the outlook is because as I mentioned in my comments, we did not see a drop-off in business during the third quarter. And as I also mentioned, our incoming order book in the third quarter also remained healthy.

And so while we are very much aware of the economic environment that is going on and the talk of recession, we did not see it in the third quarter and so we are aligning ourselves and our activities in such a way that gives us maximum flexibility here.

I hope that provides some clarity to you. I don’t think it is appropriate for us at this point and time to have drastic cutbacks. While there might be certain planning of certain activities that need to take place or would need to take place in the coming year, I think it’s inappropriate at this point and time, with where we see our business right now, to move forward or implement any of those kinds of activities. And so that’s why we are doing just as I indicated to you earlier.

Edward Marshall - Sidoti & Company

Is it too early to address which segments we would see these additional cuts?

William M. Lambert

I think that we have talked in the past in other conference calls about the military aspects of our business in the U.S. Military business, as I indicated in my comments to you, we will complete shipment of the U.S. Air Force SCBA contract this year. If there is any carry-over into 2009 I expect that to be fairly small. But we will see, likely, a decrease in our U.S. military business in 2009.

Now I say that with the complete understanding, and we have talked about in the past, that there are some very significant contracts which are outstanding that we have bid on, and others have bid on, with regard to the advanced-combat helmet, the next generation advanced-combat helmet, and the improved outer tactical vest, which is a multi-year, $500.0 million to $600.0 million opportunity that we, and others, are pursuing.

Those decisions have not yet been made. So those are still outstanding and there’s also a fairly significant communications contract, which is outstanding, on the chips program, which we are also pursuing.

So, our visibility, our transparency to the business, when we look out three to six months, is not that great. We have talked about that in previous earnings conference calls. We don’t have great clarity as we look out in the business, but what we do know is that the SCBA Air Force contract, will likely, we will complete all of that by the end of this year and so we will need to adjust to that decrease in sales revenue, if we see it.

Edward Marshall - Sidoti & Company

From an R&D perspective, again it was up in the quarter sequentially and year-over-year. Is that the run rate that we should anticipate going forward or should we see that come back down.

Dennis L. Zeitler

I looked at those numbers. I noticed third quarter last year was unusually low. We actually had $9.0+ million each quarter last year, probably starting in the fourth quarter last year, first quarter and second quarter this year. So I think you will see something in that $9.0+ million range in the fourth quarter, which I think is a slight increase over the fourth quarter of last year. Nothing like it was this quarter.

Edward Marshall - Sidoti & Company

So we should see that as a continuing run rate, the $9.0+ million?

Dennis L. Zeitler

Yes, something between $9.0 million and $10.0 million would be a reasonable number to expect.

Edward Marshall - Sidoti & Company

The North America core industrials and the North America fires services, do you have those numbers on a sequential basis as far as growth, quarter-over-quarter, the September quarter versus the June quarter.

William M. Lambert

I’m not sure we have those numbers. How about if we come back to that. We will see you tomorrow at your conference.

Operator

Your next question comes from Walt Liptak - Barrington Research.

Walt Liptak - Barrington Research

I want to see if I can calibrate the potential for a slow down. You didn’t see it yet. Can you talk about what your orders look like? I don’t know that you publish those.

William M. Lambert

We don’t. We don’t publish the incoming order booking and I’m giving you only a sense, as we have done in previous conference calls, and I think in this uncertain economic environment, that in the third quarter we did not see a weakening in the order book.

Walt Liptak - Barrington Research

In Europe, what does the backlog look like, at this point. It must be up year-over-year still but is it down sequentially?

Dennis L. Zeitler

It is down sequentially. I don’t have a specific number on that. It is still a significant backlog, which we will be working on during this fourth quarter.

The point we were trying to make is at least through September, you know, if you are looking at fourth quarter sales you look at September incoming and maybe the first half of October and see what it looks like. And that’s why we are saying we are not yet seeing an impact from a recession.

Walt Liptak - Barrington Research

Okay, so even in October your numbers are coming okay still?

Dennis L. Zeitler

Yes.

Walt Liptak - Barrington Research

As you were talking about cost cutting or the potential for cutting back, I have two questions. Your receivables and your inventories were both up. Are you going to have to go through lower production in the next couple of quarters to work the inventory build-down, or where did you see the inventory build?

Dennis L. Zeitler

As I think Bill mentioned, the receivables and inventory are only up because of currency. They’re basically flat from the second quarter to the third quarter on a currency-adjusted basis.

And there will be some decrease in the fourth quarter due simply to completing certain contracts, like the Air Force contract. And some of the military contracts in Europe.

But in addition to that, we are focused on our working capital going into this uncertain period of time here and issues such as rather than only looking for the lowest cost from our purchasing people is to also ask them to look at reducing our absolute dollar investment in inventory, even if the cost might be a little bit higher.

Walt Liptak - Barrington Research

Do you think of your business as being more recurring revenue after market maintenance, or let’s say that we do go into a pretty severe global slowdown, what would be the magnitude of declines that you think you would have to address with a spending cut?

Dennis L. Zeitler

That’s an impossible question. In the really big picture, you’ve got to remember that our stuff is worn by blue-collar workers. So the blue-collar guy is going to work whether he’s a soldier or a fire fighter or a utility worker or a steel worker or a miner, he has to wear safety equipment. So you can factor in whatever unemployment rate you want, and whatever population growth you want, and try to compute what the impact could be on our business, on the markets for our products, and then determine, you know, we’re obviously gaining market share in a lot of our areas, to grow in the mid-teens the way we are. You would have to factor that all together to decide just what kind of ballpark you’re in, in a recession.

Walt Liptak - Barrington Research

The body armor contracts that are out there, I thought they were supposed to get released a couple of days ago, the awards were supposed to start going out. Where is the government in the process?

Joseph A. Bigler

The big contract is the IOTB contract and as you are probably aware there was a protest on that. It was supposed to have been awarded sometime last month or the beginning of the this month, but due to that protest we now expect that to come sometime here to mid-to-late fourth quarter. It may not be awarded until December, until they get the legalities worked out.

Operator

Your next question comes from Brian Ruttenbur - Morgan Keegan.

Brian Ruttenbur - Morgan Keegan

If the dollar continues to strengthen versus the Euro then we will see continued decrease in your cash from third quarter to fourth quarter, is that the case?

Dennis L. Zeitler

In U.S. dollar terms, sure.

Brian Ruttenbur - Morgan Keegan

What kind of sensitivity do you have? I was trying to figure out some kind of way to calculate if the dollar goes to “x” how much goes, let’s say 10%, would it be an immediate 10% hit to your cash?

Dennis L. Zeitler

Roughly 2/3 of our cash is in Europe and 1/3 is in other international locations, very little of it is in North America.

Brian Ruttenbur - Morgan Keegan

In terms of 2008, how much are you planning to do in terms of DOD? You’re going to ship roughly $40.0 million or $60.0 million in DOD that you won’t see in 2009, assuming that additional contracts don’t come on board? Can you give us some kind of number?

William M. Lambert

Do you mean comparing full year?

Brian Ruttenbur - Morgan Keegan

Yes, comparing full year 2008, assuming you don’t get any additional orders and you don’t win any of the new vest contracts.

William M. Lambert

I think we’ve talked in the past about the size of the SCBA contracts and how that grew this year, nicely, as we won additional awards against that release. And so assuming that all of the SCBA business is removed, I mean, you’re in the right ballpark. What the exact number or what the exact reduction is, I’m not sure. But you are probably in the right ballpark.

Brian Ruttenbur - Morgan Keegan

In past recessions, what have you felt in terms of a pull-back? Have you seen a pull-back? You have been around 100 years or right around that, you’ve been through depressions and recessions. What have you seen in the past in terms of pull-backs in terms of sales?

Dennis L. Zeitler

Bill and I were out talking to some investors a couple of weeks ago. We’re getting a lot of that question. And they would say what happened in 1991 and what happened in 1981, which were the two prior recessions. Our business is so different that it was then. We now sell indirect rather than direct as we were doing at those times. We have a much broader distribution network. The markets that we’re focused on are different. In 1991 we were big in asbestos abatement and nuclear power plants. Those two markets don’t even exist today. We didn’t have a fall-protection product line, we weren’t number one in head protection like we are today.

William M. Lambert

Our international segment is much stronger today. The part of the business that is outside of North American today is much stronger than where we were back in 1991 and going back into the 1980s, we were so dependent at that time on what has since been termed rust-belt America, that it’s really difficult for us to provide any meaningful comparison to the economic recessions that we saw back in the early 1980s or even 1991.

So that’s a tough one and I’m not sure that anything I would give you would fully explain it.

Brian Ruttenbur - Morgan Keegan

And I guess the last recession, at least technically, was early 2000 and you were experiencing rapid growth because of 9/11, is that right?

William M. Lambert

Yes, when we take a look at 2001 and what occurred there, we really did not see a slowdown. In fact, as we look at our data, I don’t think anyone is really comparing what we might be faced with here in this economic environment with 2000/2001. But if we were to look at that we could say, and as we look at our data, our industrial sales stayed about flat. We did not see a decline. And I think we have commented on that in the past. John Ryan, when he was CEO, commented on that in the past.

Now, aside from that, we did see some very steep ramp up in U.S. fire service sales and military sales at that time, post-9/11. So that more than masked whatever was happening from the core industrial side.

But our analysis of the core industrial sales at that time show that we were flat.

Operator

Your next question comes from Brian Butler - Friedman, Billings, Ramsey & Co..

Brian Butler - Friedman, Billings, Ramsey & Co.

A question on the margin. If you can, give any visibility on how much of that 12% that you reported on the operating line was really driven by the SCBAs versus if that $50.0 million had come from your core industrial, would you margins really looked a lot more like the third quarter 2007?

Dennis L. Zeitler

No, I think as Bill mentioned in his comments, that gross margin improvement was across all three geographic segments, not just North America.

Brian Butler - Friedman, Billings, Ramsey & Co.

Right, but a big piece of the SCBA sales in North America as well as I think you also had some in Germany as well.

William M. Lambert

But remember, those are both to large military contracts, which, as we’ve talked about in the past, tend to be much more aggressively bid and tend to be lower gross margins. So if anything, one could argue that those SCBA sales to the U.S. Air Force and to the German Bundesver would pull down margin performance.

Brian Butler - Friedman, Billings, Ramsey & Co.

Let me see if I can ask it the other direction then. Do you feel like you’re getting impact from the Project Magellan in the third quarter or is this really you guys running the business better along with what you have?

William M. Lambert

I tried to address that very directly in some of my commentary. I think yes, we are very much seeing Project Magellan, now again, it’s in its early stages here. We are now into its second year of this five-year plan. But Project Magellan is definitely showing gross margin improvement in those product lines which have been moved, as a part of the project.

And I indicated that our North American fire helmet product line gross margins are up 360 basis points this year. And that was one of the first product lines that moved as part of Project Magellan. Now that 360 basis point improvement in gross margins for that product line are in spite of what we have seen in significant increases in plastics and raw material prices that impact that product line. So we are seeing some good signs. 360 basis points improvement year-to-date, year-over-year, it’s encouraging. It’s according to our plans.

And now we’ve got the Querétaro plant in Mexico, which is hitting the mileposts that we had established for it. In fact, in many respects it’s ahead of some of the mileposts that we had hit for it. It’s penetrating the Mexican market and providing us with some low-cost sourcing opportunities for these lower-skilled, high-labor elements of our product line.

And I also indicated that our newest plant in Suzhou, China, was completed during the third quarter and that we will be ramping up production activities there during the fourth quarter of this year.

So, I am feeling good. I think we are seeing the results that we had anticipated seeing and now it’s a matter of continuing to drive the other elements of Project Magellan that we have so that we might realize this full benefit over the five-year period as we have talked to investors in the past about.

Brian Butler - Friedman, Billings, Ramsey & Co.

And on the fire side, can you give any update on where the upgrade kits for the new standard stand and how to think about that going forward?

Joseph A. Bigler

The upgrade kits, there was just a meeting with some of the officials of AFG and right now the upgrade kits, AFG is not really making upgrade kits a priority. There have been limited requests for AFG money for upgrades and they continue to focus on the SCBA, so we have seen some moderate activity through municipal budgets and municipal spending on upgrade kits but as we mentioned before, about 70% of our business is driven by the AFG grant program so therefore with AFG not prioritizing them and not many requests thus far for AFG in the 2008 program, we have not seen significant increases or significant pick up with the upgrade kits.

Now hopefully that will change as we go into the 2009 program.

Brian Butler - Friedman, Billings, Ramsey & Co.

What’s the AFG logic on that, if you have any visibility on it?

Joseph A. Bigler

Their logic at this time is they’re responding to the requests that were made at the beginning of the 2008 program. What they are saying is based on the requests that we have, the requests continue to be primarily for SCBA versus upgrade kits. So therefore there’s not really a focus on giving grants or prioritizing them in any way.

William M. Lambert

The other thing that I think the AFG did this year, the administrators did year, was to institute a policy for the FY 2008 monies, which did not permit any monies to be spent on upgrade kits unless the SCBA was at least two-revisions-old. And when you go back two revisions to the NFPA standard, the number of changes required to the SCBA are just so significant that it becomes economically impossible to justify why you would essentially build this SCBA part-by-part as opposed to buying a brand new SCBA.

So they made the hurdle, for both municipalities and fire departments, and for manufacturers, so high that, as Joe said, the amount of impact we have seen from upgrade kits this year is very slight.

Brian Butler - Friedman, Billings, Ramsey & Co.

That policy lapses going into 2009 so that is another potential opportunity where some demand could show up, especially when you think about a tougher economic environment for the municipalities.

William M. Lambert

That’s right. I think when the FY 2009 monies get put together and the program policies get established, which they will, and they can change on an annual basis and we certainly have seen these AFG program policies and decision logics change over the past few years, you know, something else could emerge next year which doesn’t make that hurdle quite so high and as the AFG administrators look to spread more money to more municipalities, we have always believed that it is in the best interest of everyone to remove that kind of a hurdle and allow upgrade kits to be an option.

So those who purchased and SCBA just a year or two ago would have the capability in a very cost-efficient way to secure federal funding to upgrade their SCBA to meet the latest standards.

Operator

Your next question comes from Richard Eastman – Robert W. Baird.

Richard Eastman – Robert W. Baird

Could you just address pricing policy here, real time, for the overall business.

William M. Lambert

I’ll let Joe Bigler comment on what we did in North America and then Rob can mention what he’s doing outside the U.S.

Joseph A. Bigler

Really two things that we’re taking a close look at. First of all we have moved up our price increase. We were looking at a price increase effective January 1. In light of the economic environment we really accelerated that because of the rising costs that we saw, so our price increase for North America went into effect October 1, 2008.

The second thing that we take a look at is certainly special pricing on contracts and special pricing in the industrial environment. That is something we are getting much more stringent on and much less flexible in terms of pricing discounts on a special basis.

So those are two actions that we expect to have some positive impact in the fourth quarter and obviously going into 2009.

Roberto M. Canizares

In international we have done similar things. We actually went through a thorough price review about a month ago and we also announced price increases that become effective December 1, 2008. And again they are on the upper end of the envelope because of the anticipated pressure, especially on the plastics and components that use materials derived from petroleum. We made those announcements, they are public, they are working through the system right now.

And we’re also continuing to take advantage of our diversity, if you want, of manufacturing in order to optimize the product offering in different parts of the world so that instead of having only European products sold in Europe, only Asian products sold in Asia, etc. we are working through our product portfolios to optimize that and achieve better margins overall and more competitiveness.

Richard Eastman – Robert W. Baird

Do you feel that overall, both North America and international, when we get out to the first quarter and we look back year-over-year, can we get 3% or 5% net price increases?

William M. Lambert

That sounds a bit aggressive to me.

Richard Eastman – Robert W. Baird

At what point would you expect in North America that the industrial piece of the business may be subject to distributor inventory adjustments? Would you expect that in the fourth quarter?

Joseph A. Bigler

Quite honestly, I think we have seen quite a bit of that already occur in the third quarter. And I think there will be some effect in the fourth quarter but I would say 65% to 70% of drawing down inventories, really we have already seen that at the end of the second quarter and particularly through the third quarter. So although it will have some impact, I think most of that impact in draining down inventories, at the distributor level within North America, we have seen the bulk of that in Q3.

Richard Eastman – Robert W. Baird

Also, Joe, in North America, if I look at the sales delta year-over-year in the third quarter, it was about $11.0 million. If I identify the SCBAs and the HCHs were up, gas masks down, comm devices down. Something else was down in there, was it head protection or ballistic protection?

Joseph A. Bigler

It wouldn’t be either one of those.

Richard Eastman – Robert W. Baird

Just trying to circle up something that might have been lower.

Joseph A. Bigler

We can follow up. I believe you will see that in head protection and fall protection we showed some nice increases. I believe it primarily is in the gas mask business. We had some specialty business in the third quarter of last year in gas masks that we shipped and I believe if you compare Q3 to Q3, there was a decline in our industrial gas mask sales.

We can double check that and get back to you.

William M. Lambert

That is correct.

Joseph A. Bigler

That is correct. It’s primarily the gas masks. We had some good Homeland Security business in the third quarter of last year and that was all shipped during the third quarter and as you know, the Homeland Security business is really something that is not a significant factor, certainly this year.

William M. Lambert

The other thing that I think it was also related to were military communication systems. Last year in the third quarter we had about $2.5 million more in military communication systems than we had in the third quarter this year.

Joseph A. Bigler

That was mentioned in the release.

Richard Eastman – Robert W. Baird

Europe’s operating margin, can I just ask again, I know it’s better year-over-year, it’s still low. We’ve been shipping out of backlog. Are there any inefficiencies there or raw materials that have hurt us or should we think that what remains in backlog if still coming out at kind of a 2% net margin?

Roberto M. Canizares

Two parts to the question. First, on the short term, we had a significant amount of shipments of military products in the third quarter. And we will have also a significant amount of military orders in the fourth quarter. So those, as Joe indicated, tend to have lower margins, our big contracts are a little more competitive.

In the longer term, we have had two issues with our productivity in our Berlin plant and we’re working through those and we’re putting in play [inaudible] manufacturing and getting really good improvements and efficiency. But this is a longer term program that probably will not be measureable in the next quarter.

But we are addressing a lot of those. We have added quality engineers, we have added manufacturing engineers, that are really now working all these processes to get this operation where we really want it to be.

So there are some fundamental improvements going on but I don’t think you will see them in the next quarter as you are looking for.

Richard Eastman – Robert W. Baird

In terms of military sales in the U.S., again, my math suggests that we’re going to have a fairly substantial Air Force SCBA quarter in Q4, like $40.0 million to $45.0 million perhaps. Does that sound right?

Joseph A. Bigler

No, that sounds too heavy.

Dennis L. Zeitler

The contract we announced was $25.0 million.

Richard Eastman – Robert W. Baird

But the original contract was $36.0 million. Wasn’t the $25.0 million an extension of that or was that?

Joseph A. Bigler

Right.

Richard Eastman – Robert W. Baird

So you’re at $36.0 million plus the $25.0 million. You’re at $61.0 million and I think the second quarter and third quarter were both $13.0 million quarters, I think. So maybe you’re at more like $35.0 million for the fourth.

Joseph A. Bigler

You would be in the ballpark. Let’s just say it will be a very strong fourth quarter in terms of the Air Force SCBA shipments and what we intend to get out for all of our U.S. military business.

I think what we said in going into 2008 is certainly that our military sales in 2008 would exceed our 2007 military sales and I can tell you that we are well double-digit ahead of our plan. So the fourth quarter will be strong in terms of military sales, is certainly what our plan is.

Richard Eastman – Robert W. Baird

And is the ACH backlog, how does that look heading into the fourth quarter and 2009?

Joseph A. Bigler

The current contracts that we have on the books right now will take us approximately through the middle of December. There then are two other contracts that we are waiting to hear from. There is a contract for what they call a bridge buy for approximately 90,000 more ACHs. We would hope to hear something about where we stand on that versus our competition, hopefully over the next three or four weeks. That contract we hope would take us through the first quarter if we get our fair portion, which we’re confident we will. That would take us through the first quarter until about March or April.

And then there is a second contract for an improved ACH coming out of DSCP that will kick in probably sometime during the second quarter. That is going to be a fairly large contract. What we are told is that it will come down to two contracts to issue. One will be for 200,000 improved, upgraded ACHs over a two-year period and the other contract would be 300,000 for a two-year period. So there will be two awards on that and hopefully that will kick in sometime in that May time frame.

Operator

Your next question comes from Greg Halter - Great Lakes Review.

Greg Halter - Great Lakes Review

I know you talked about the European backlog but do you work off of a significant backlog in North American or the international businesses?

William M. Lambert

The only area we that really work off any significant backlog is in the military segments of the business where the contracts have fixed deliveries that go out. Sometimes up to a year we would know that, but certainly over the months or the quarters we would know that. We tend to announce those significant military contracts so that the market sees that. And if we know the shipping schedules we would release that as well.

Outside of the military area, whether that’s for the German Bundesver or whether it’s for the French military or whether it’s for the U.S. Air Force or Army, we really don’t work off of a large, extended backlog. So when I commented earlier in this call that our visibility is very limited here and that is why it is important for us to maintain the maximum amount of flexibility that we can to respond to the orders that do come into MSA.

Greg Halter - Great Lakes Review

Relative to the AFG funding, it seems like it has slowed, unless they have changed the way they make announcement, it looks like the last round was round 10 on September 5, providing $70.0 million so far that has been allot assertion?

Joseph A. Bigler

Really, the last award I believe was the week of September 12 and so far year-to-date under the 2008 program that began about July 4 of this year, the total grants that they have given is about $71.0 million versus about $174.0 million at this time last year. So they are literally about $104.0 million behind in issuing grants.

The reason they claim for that is their system was down during the summer. They had some real difficulties getting into their system. That was one reason. The second reason was a reorganization of grant management within the program delayed some things. And their final reason was they are going through the process of reconciling 2007 with 2008 and that’s a process that is taking them longer than expected.

So for those three reasons they are really behind the eight ball in terms of the grants. And that certainly translates into the personal protective equipment awards. That really is down as well. This time last year, in the PPE side, probably about $63.0 million and so far this year there’s about $18.0 million so there is a big difference in obviously the total awards as well as the amount that’s going to PPE.

I think that’s some reason for optimism as we move ahead. They should be getting back, at least we’re told, they should be getting back to issuing awards here, hopefully as early as this Friday and that will continue on with the 2008 program and certainly might be a catalyst for us in the fourth quarter and going into 2009, of some of this pent-up money that they have not released yet.

William M. Lambert

Let me also add that as Joe pointed out there very accurately, it is down quite significantly from where we were this time last year. And even though the awards started to flow in early July and we were very encouraged by that, we have been very disappointed by, and I think the municipalities very disappointed by, the pace at which the federal government is awarding this money to municipalities.

I think that it is important for us to keep the overall SCBA and U.S. fire service in context for MSA overall. So in spite of these challenges that we have seen here, and I think our performance in the third quarter was quite solid, and as Joe said, maybe there is opportunity here for us to be optimistic and as we look into the fourth quarter and into early next year.

These monies must be spent. Legally the government cannot withhold this money once approved by Congress in this respect. We know that from past practices even though the monies were delayed in previous years by significant amounts, it eventually all was released and doled out and awarded to municipalities.

Greg Halter - Great Lakes Review

That sound very good that you have done so well without this, just to reiterate, you said the U.S. fire service is 10% of MSA’s total revenues.

William M. Lambert

That’s right.

Greg Halter - Great Lakes Review

And I think you indicated that 70% of that is coming from outside of the AFGs.

Joseph A. Bigler

About 70% of the U.S. fire service dollars we estimate is really coming from AFG grants and 30% of the municipal is coming from the municipal budgets. I believe the 10% number you are talking about are global sales overall. So that number of 70/30 is strictly for the U.S. fire service.

Greg Halter - Great Lakes Review

And a lot of concern these days over the quality of receivables. I just wondered if you could comment on that.

Dennis L. Zeitler

Actually, over the last 12 months our receivables have gone down in terms of days sales outstanding. We are talking to our people, in fact I have a meeting this afternoon with our global finance team from around the world to talk about receivables and our customer credit limits and making sure that everybody recognizes the difficulties that we are faced with right now.

So at this point we have seen nothing in the way of increase in receivables and we have not seen any bad debt issues yet.

Greg Halter - Great Lakes Review

Did you provide a figure for cash flow from operations, either for nine months or the quarter?

Dennis L. Zeitler

I didn’t but I could. Cash flow from operating activities for the nine months was $21.0 million.

Greg Halter - Great Lakes Review

And what would your capital spending be for this year under current budgets and any early estimates for 2009 yet?

Dennis L. Zeitler

As you will see in the 10-Q we spent $31.0 million through nine months. That includes most of finishing up the Chinese factory but we still have got to put production lines in. So I would say we would probably be in the midi-30s, a $35.0 million or $36.0 million number for the year. And it should be something significantly less than that next year since we won’t have any new factories being built next year.

Greg Halter - Great Lakes Review

Any shares repurchased in the quarter?

Dennis L. Zeitler

Given the financial markets, we have decided not to be repurchasing shares.

Greg Halter - Great Lakes Review

And I presume that continues for a while here?

Dennis L. Zeitler

I think that continues until things settle down a lot.

Greg Halter - Great Lakes Review

I think your debt was up about $27.0 million in the quarter on a sequential basis. Any comment there? Is that currency or what’s happening?

Dennis L. Zeitler

That would not be currency. The short-term debt was up, the long-term debt was down $10.0 million, because we had to pay off a $10.0 million amortization payment.

Greg Halter - Great Lakes Review

I have you at $174.0 million June 30 and $200.0 million now.

Dennis L. Zeitler

You also have a chunk of that going into our insurance receivables, during the third quarter? It shows up under other long-term assets.

Nothing special. We didn’t buy anything. We did have a big capital expenditure quarter.

Greg Halter - Great Lakes Review

I actually picked up the wrong number. It’s actually $168.0 million so it was actually down about $5.0 million or $6.0 million. Sorry about that.

Operator

Your final question comes from Rick Ryan – Dougherty & Co.

Rick Ryan – Dougherty & Co.

Rob, can you give us some general comments on the mining sector with commodity prices declining as significantly as they have here. Any general comments on the mining sector that you might be picking up?

Roberto M. Canizares

I wish I could give you some real clarity about it. Our business has been strong and it continues strong so far. But you are right, the commodities are plummeting in pricing and it’s likely to at least make people revisit some of the capital expenditure programs.

On the long-term, however, the expected demand by all these companies is relatively strong and as you know, the lead time for these investments is pretty long. So it is very difficult for us to tell how much are they going to delay things. But at this stage, our contacts with the companies don’t really give us a lot of clarity as to what they will do for the next 12 months. We are trying to get that information, we are trying to talk to our customers, but we really don’t have any clear picture at this point as to whether it will actually stop projects or that the things that already started will continue.

That’s the way it looks at this point, the things that they started are continuing and whether things that were on the drawing board will start or not, that’s still not clear to us.

Operator

There are no further questions.

Mark Deasy

I would like to again thank everybody for joining us today. Also I would like to remind everybody that an audio replay of today’s call will be available on the MSA website for the next 30 days so if you missed anything, feel free to check back on that site. On behalf of Bill, Dennis, Joe, and Rob, again, we thank you for joining us today.

Operator

This concludes today’s conference call.

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