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The Kaman Corp. (NYSE:KAMN)

Q3 2008 Earnings Call Transcript

October 31, 2008 11:00 am ET

Executives

Eric Remington - VP of IR

Neal Keating - CEO

Bob Garneau - CFO

Analysts

Matt Duncan - Stephens, Inc.

Arnie Ursaner - CJS Securities

Steve Levenson - Stifel Nicolaus

Edward Marshall - Sidoti & Company

Robert Kirkpatrick - Cardinal Capital

Jerome Lande - Millbrook Capital

Operator

Good morning ladies and gentlemen and welcome to the Third Quarter 2008 Kaman Corporation Earnings Conference Call. My name is Francine and I will be your coordinator for today. (Operator Instructions).

I would now like to turn the presentation over to your host for today's conference, Mr. Eric Remington, Vice President of Investor Relations. Please proceed sir.

Eric Remington

Thank you, Francine and good morning everyone. This is Eric Remington of Kaman Corporation and I'd like to welcome to you the company's 2008 third quarter conference call. This call is being webcast over the Internet at www.kaman.com and an online archive of this broadcast will be available within one hour of the conclusion of the call and will be available until November 7th at this site.

Conducting the call today are Neal Keating, Chairman, President and Chief Executive Officer and Bob Garneau, Executive Vice President and Chief Financial Officer. Before we begin, let me take a moment to reference the Safe Harbor statement under the Private Securities Litigation Reform Act of 1995. This conference call may contain certain forward-looking statements that are subject to significant risks and uncertainties including the future operating and financial performance of the Company.

Although the Company believes the expectations reflected in its forward-looking statements are reasonable, we can give no assurance that such expectations or any of these forward-looking statements will prove to be correct. Important risk factors that can cause actual results to differ materially from those reflected in the company's forward-looking statements are included in our earnings release, filed yesterday and in the filings with the Securities and Exchange Commission.

In addition, the information contained in this conference call is accurate only on the date discussed. Investors should not assume that the statements made in this conference call remain operative at a later time. The company undertakes no obligation to update any information discussed on the call.

Finally, our discussions today will include certain non-GAAP measures related to the company performance. Reconciliation of this information is provided in the exhibits to this conference call and is available through the webcast section on our website.

With that, please turn to exhibit one and I'll turn the call over to Neal Keating. Neal?

Neal Keating

Thanks, Eric and good morning everyone. Given the state of the financial markets and broader economy, I would have to say that we are very pleased with Kaman's performance in the third quarter.

I'll get into the specifics behind our performance in a moment, but in brief, it reflects continued excellent performance at industrial distribution in Specialty Bearings, solid execution in other portions of our aerospace segments, and continued progress in addressing those issues at our Wichita facility that we’ve been contending with throughout the year.

Although not a third quarter event, we continue to invest in our future growth through strategic acquisitions and announce our industrial distribution segment into the Puerto Rican market with the acquisition of INRUMEC, which we completed earlier this year.

Sales for the quarter came in at $335.1 million, a gain of about 22% compared to $274.9 million last year. Reflecting a combination of both organic growth and our recent acquisitions, excluding the contributions from Brookhouse and ISC in the period, organic growth was a strong 11.5% for the quarter.

Operating income was $24.4 million in the quarter and included approximately $3.9 million in costs incurred at Wichita, as we continued to manage through those issues. Net income for the third quarter was $13.5 million or $0.53 per diluted share including a charge to unwind a hedging contract at Brookhouse, which had an after-tax impact of $0.05 per diluted share. Bob will discuss this in more in detail in just a few minutes.

Now, let's get into some details on the individual segments. I am sure you are all looking for an update on what's been going on within the Aerostructures business. So let's start there. Just as in the second quarter, our performance in Aerostructures was impacted by continued operational inefficiencies in our Wichita facility that reduced profitability by about $3.9 million. We have made and continue to make concrete progress at Wichita.

During the quarter, our efforts resulted in a key customer removing us from probationary status, allowing us to resume production on all of their programs. We also successfully passed the AS9100 audit in August. And I am pleased to be able to say that we received our re-certification in late September, actually slightly ahead of our previous schedule. While we are making progress, we are not done yet and we still expected to take the rest of the year to resolve these issues in Wichita.

Additionally, we believe it will take added base to return the facility to more acceptable performance levels. I'd like to take a minute to discuss here why Wichita is so strategically important to us. This will be a cost effective facility, located in the second largest aerospace market in the United States. The business provides us with a capability and composite structures that is critical to aircraft manufactures, as carbon fibre becomes an even more significant aspect of aircraft design and manufacturing, keeping us competitive into the future.

Finally, we believe we are making the right investments in both people and equipment to restore profitability, enhance its competitive position in the marketplace and prosper in the future. The balance in Aerostructures segment performed well, reflecting continued solid performance on BLACKHAWK program, as well as to the C-17 and 777 programs for the Boeing Company. On BLACKHAWK, we delivered 31 cockpits to Sikorsky during the quarter, up from 23 a year ago.

Today, Sikorsky has placed orders for 549 cockpits against which we have made 248 deliveries. This continues to be an excellent program for Kaman and we expect to continue delivering under the current contract through at least 2010.

On the C-17, we received an order for an additional ten ship sets during the third quarter. As a result, we now have firm orders on this program for shipments through the end of 2010. Also, during the quarter, we hosted a ceremony at our Jacksonville facility with officials from Boeing and the U.S. Air Force to launch Kaman's participation in the A-10 program. The event was a success and we think all visitors went away being impressed by our capabilities and our workforce. This is a great program for Kaman, not only does it play to the core competencies of our Aerostructures business but it will also add significantly to our backlog. Initial deliveries on the program are expected to begin in 2010 and full production rates on the A-10 contract should be reached in 2011.

The third quarter also marked the first full quarter of contribution from Brookhouse. While, it is still early in the integration process both sides are already seeing benefits from the combination. As Brookhouse provides an (inaudible) for Kaman into opportunities in the U.K. and Europe that we did not have before and Brookhouse as part of Kaman, is it self now able to pursue contracts that it would not have had the scale, breath or global reach to win previously.

We believe our platform diversification and waiting toward defense should buffer us some what from the challenges that may face the commercial aviation market due to the current economic crises. Including Brookhouse, about 35% of our sales in Aerostructures are to be commercial aerospace sector and these are spread across the number of platforms from Boeing, Airbus and others. Overall, while the macro-economic environment is certainly a cause for caution and concern, we believe the Aerostructures segment is well positioned given current market dynamics.

Kaman Precision Products, the former fuzing segment turned in a strong performance in the period as the third quarter saw a 47.5% increase in sales and much better margins driven by a strong performance in our legacy missile fuzing business.

In the 2008 second quarter, we saw JPF production rates meet our stated sustainable goal of 2000 fuzes per month and we actually exceeded that goal in the third quarter. While, there may still be some lumpiness in our production rates going forward, this is certainly an encouraging sign and puts us in an excellent position to be able to fill our obligations to the U.S. Military and complete some higher margin FMS sales in the fourth quarter.

As reported earlier, we still believe that our decision to re-compete the JPF for Option 6 will result in a higher price in the U.S. Government. However, we will not see that price before 2010.

In the helicopter segment, depot level maintenance and upgrade work to the Egyptian Government and our subcontract work for fuselages and mechanical assemblies for Sikorsky continue to be the primary revenue drivers for this segment in the third quarter. While, sales in this segment were lower than a year ago due to termination of the Australian program, the segment saw a substantial increase in profitability. In part, this improvement reflects the lack of charges related to the Australian program in the current period versus an $800,000 charge last year.

However, the segments results also reflect improved performance on subcontract programs. In addition, we are pleased with the progress we've made on this settlement with Australia. As part of our multi-step process, we have received the necessary approval from the U.S. Government to physically transfer the aircraft to back Kaman, and as a result we are in the process of preparing aircraft for shipping it back to the United States.

We expect to take physical delivery this quarter, at which point we will request the U.S. Government to approve the Commonwealth transfer of title to Kaman. We have also been active on the marketing front and while I will caution you that we are in the very early stages of this process, we've been pleased by the level of activity today.

For example, at the end of September, we displayed one of the Australian aircraft that the Black Sea Show in Bucharest where several nations expressed interest. We've received approvals for 38 marketing licenses and are beginning to have conversations with some of these countries regarding the aircraft. I would reiterate however, that the sale of these aircraft is a long return proposition.

Rounding up my discussion of aerospace, our Specialty Bearings segment reported another quarter of excellent performance, driven by increased shipment across several other markets that they serve. Sales in this segment were up nearly 20% compared to a year ago and slightly, better sequentially than the performance achieved in the second quarter. While, operating margins declined slightly from second quarter level as expected, the overall performance in the business continues to be very strong and our backlog remains robust.

Moving on to Industrial Distribution, this segment once again performed very well in a challenging market environment. Our total revenue growth of 14.7% was evenly divided between continued robust organic growth and the contribution from ISC, which again performed in line with our expectation and were slightly accretive in the quarter.

We believe our third quarter organic growth rate of 7.1%, following last years 8.4% is near the top of the industry and speaks to the competitive end roads we were making. Even better, operating profits grew at a faster rate indicating that we have become more efficient converting these sales into profits. From an end market prospective, the counter cyclical sectors that have been a demand driver for KIT in recent periods, including mining, energy and food continued to be strong in the third quarter. In addition, KITs performance reflects the continued success of our national accounts strategy.

We were pleased to sign a number of renewals during the quarter, including Del Monte Foods, Titan Cement, Solo Cup and the Campbell Soup Company. Clear indicators, that our commitment to service and the expansion of our distribution network is generating results. On the subject of expanding our national footprint, just after the close of the quarter, we announced the acquisition of Puerto Rico based, Industrial Rubber and Mechanics Incorporated or INRUMEC.

If you missed our press release on this, INRUMEC which had sales of $13 million in 2007, is one of the leading distributors in Puerto Rico with a rich operating history dating back to 1963. As is the case for KIT, INRUMEC is widely diversified across a number of industries including food, beverage, pharmaceuticals, cement and aggregates.

This is another great transaction for Kaman that does a number of things for our business at once. It broadens our geographic footprint, immediately giving us leading presence in the important Puerto Rican market that would have taken years to build out organically

and allowing us from day one to support our current customers and national accounts with business on the island.

I have mentioned in the past calls that a period of economic softness provides us with the opportunity to take market share from smaller players. We believe this secular trend continued in the third quarter with KIT gaining share based on our national reach, financial strength and purchasing power.

Furthermore, the recent events in our financial and credit markets have underscored just how important liquidity and access to capital are in this and every other business. Well, I can't tell you what the ultimate impact on the economy will be. I can say that we expect our scale and financial strength to enable us to take advantage of opportunities that will come from smaller less well capitalized participants. And we think we will come out of this period in a significantly enhanced competitive position.

I’ll be back in a moment to rap things up, but now I’d like to turn it over to Bob Garneau to walk you through the financials in more detail. Bob?

Bob Garneau

Thanks, Neal. I’ll start today with a discussion of our performance for the quarter on a consolidated basis after which I’ll get into more depth on each of the segments. To begin, with exhibit one, as you have seen it's a recap of the sales and net earnings as reported for the third quarter of 2008. If we move on to exhibit two, there we have prepared a non-GAAP reconciliation to show the effect of the add-back of the $1 million pretax loss on the derivative contract, which equates $0.05 per share diluted to the third quarter results. On the right side of that exhibit we have shown in the 2007 figures where we add back the $800,000 Australian contract loss which equated to $0.2 per share. If we turn to exhibit three, we show the non-GAAP reconciliation for the nine months, which includes a goodwill impairment charge of 7.8 million, which is not tax deductible and equates to $0.31 per share diluted for Wichita in addition to the derivative loss. The nine months of 2007 reflects cumulative charges for the Australian program of 5.6 million, which equates to $0.14 per share diluted and it includes the $800,000 that we previously mentioned.

I would also like to point out that through the first nine months of this year; we have taken $10.1 million in charges and special costs related to the operational issues at Wichita that have not been added back to these non-GAAP analyses.

If you turn to exhibit four, I will discuss the highlights of our segment results. In the Aerostructures segment, sales growth in the period primarily reflected the contributions of Brookhouse in its first fall quarter with Kaman as well as the organic growth related to the BLACKHAWK program at Jacksonville.

Brookhouse contributed $15.2 million in sales for the quarter, was profitable and was slightly accretive from an EPS standpoint. You should note that the charge taken for the derivative contract is below the operating profit from continuing operations line and it is not in the segment number. Also, as previously pointed out, the decline in operating income reflects inefficiencies and charges in Wichita. They continued to affect the segment. Of the $3.9 million in charges taken in the quarter, 1.8 million represented inventory adjustments with the balance being programmed in overhead rate adjustments.

The inventory adjustment essentially deals with one of the two significant risks we identified in Wichita earlier in the year; the second being the final pricing on the TRP contract. In Precision Products net sales rose 47.5% in the third quarter of 2008, reflecting the strong JPF sales growth, which was driven by the continued solid production and delivery performance of this fuse.

Operating income, while up in absolute dollars, was down slightly as a percentage of sales. This was due to the fact that the higher sales for the JPF fuse went primarily to the U.S. government, which are essentially at a breakeven margin.

We do believe however, that our strong production performance puts us in an improved position to begin allocating certain of these fuzes to foreign militaries in the future, which will carry the higher operating margins. Also please remember the 2007 comparative numbers still had the 40 millimeter product line figures in then which equated to $3.9 million in sales.

In the helicopter segment, net sales were down slightly from the third quarter of last year. This sales decline reflects slower spare parts and service revenue related to the Australian program, as our activity there winds down, as well as lower sales on the Egyptian contract due to some non-recurrent work performed on this contract in 2007.

Sales to both Sikorsky and (inaudible) were higher in this quarter. Operating income in the helicopters segment improved over the year ago period, due in part to the increase sales just mentioned, but also due to the absence to 800,000 charge to the Australian program incurred in the third quarter of last year.

We again saw strong performance from Specialty Bearing segment in the quarter with the sales increasing 20% over the third quarter of last year, driven once again by strong demand across to all our markets. We indicated in the 10-Q that sales for the fourth quarter would be slightly lower than the fourth quarter of 2007. In fact, we expect the sales to be slightly higher in this period.

Operating margin was 37% of segment sales from 35.3% of net sales a year ago. Again we are very pleased with the performance of this segment. Net sales in the industrial distribution segment came in at $204.3 million compared to $178.1 million in the third quarter of last year. This strong top line growth rate of 14.7 represented another solid quarter for KIT. Of this growth about 8% resulted from the contributions of the ISC acquisition, while the remainder was organic growth generated through the success of our national accounts program and the other factors that Neal described earlier.

Operating margin improve to 10 basis points to 5.2% of sales from 5.1% of sales in the third quarter of last year. The improvement in operating margin relative to the year ago period reflects leverage from higher sales and the slower pace of Greenfield openings compared to last year. We’re also beginning to see more positive contributions from the new branches opened during 2007.

Turning to exhibit five, corporate expense declined relative to the third quarter of 2007, coming in that $7.4 million versus $9.5 million a year ago. This improvement reflects the lower the effect of lower projected incentive compensation in 2008, as well as better experience under our group health insurance over the prior period.

Last quarter, I indicated that you should expect corporate expenses to be between $9 and $10 million per quarter. While that should hold true for the longer term, lower incentive compensation and one time items for 2008 should keep the fourth quarter down in the lower $8 million range as well.

Also as you can imagine, there is a fear of downturn in stock prices and has a large downward impact on the investment in our pension plan, as it most likely as had on many such plan in existence today. We are still accessing the impact of this our plan, but this most likely will lead to higher pension expense and cash contribution in the future depending upon the timing and the extend of the market rebound. Fortunately, we’re reasonably well funded going into this market meltdown.

Let me take a minute now to walk you through some balance sheet and cash flow items highlighted in exhibit six. The business used cash of 38.5 million for operating activities through the first nine months of 2008, primarily reflecting the working capital investments necessary to fund the sales growth seen in our operating segment, along with the tax payment resulting from the gain from the sale of Music, and lump sum retirements payment made to former executives.

We used the combination of cash and bank debt to fund 111.9 million in investing activities in the first nine months of the year, primarily for our acquisition of Brookhouse and ISC along with our capital expenditures.

Overall our balance sheet remained strong, as evidence of this we closed on a 50 million term loan with our banks earlier this week. We are pleased that in a very difficult lending environment, we're able to raise this additional capital to provide us with further liquidity and allow us to continue to execute our growth strategy as we navigate through this difficult period.

At the end of the quarter we had 72.9 million available on our revolver that we can drop on. As of today we added approximately 50 million to that number.

Finally, I should mentioned that during the quarter we completed the purchase of the portion of Bloomfield campus leased from NAVAIR and as part of that agreement have assumed responsibility for the environmental remediation at that facility as maybe required under the Connecticut Transfer Act.

With that I will turn the call back to Neal.

Neal Keating

Thanks Bob. I'll just conclude by reiterating, that we are pleased with our performance in the third quarter, which demonstrates the continued successful execution of our operating strategy across all of our business segments. Clearly we are faced with the difficult macro-economic environment, which calls for caution, as we move forward. We do however believe that we are well positioned to navigate these difficult times and continue to grow the business by investing for the long-term.

In aerospace, apart from the macro concern of what the global economy will mean for air travel in the short-term impact of the Boeing machinist strike and commercial aerospace business. We believe that, we have a strong diversified base and that will provide key strength going forward.

Hopefully, the strike will be result tomorrow and Boeing will resume production quickly. The impact on our business was minimal in the third quarter and while we may see some revenue shift from the fourth quarter into the first quarter of 2009, it should not be significant.

At KIT, because of our participation in industries like pharmaceuticals, food and mining, we expect demand to remain fairly steady, and our focus will be to continue to build on our competitive position.

We will continue to build our geographic network, through both organic growth initiatives and strategic acquisitions. Well, at the same time, expanding our product offerings to ensure we are providing current and perspective customers, with the products they need when they need them.

At the same time, we will maintain our diligent focus on cost management to ensure, that we are maximizing leverage from our sales base and providing our customers with the most efficient customer service offerings available.

Overall, I’m very please, with the progress we have made this year. As Bob pointed out, we are in an excellent position financially and have ample liquidity with which to fund our current business and investing our future prospects, through both internal activities as well as value enhancing acquisitions.

With that, I’ll turn the call back to Eric. Eric?

Eric Remington

Thank you. Frensin, may we have first question please?

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Matt Duncan of Stephens, Inc. please proceed.

Matt Duncan - Stephens, Inc.

Good morning guys and congrats on a nice quarter.

Neal Keating

Thank you.

Bob Garneau

Thanks Matt.

Matt Duncan - Stephens, Inc.

The first question I have got, Neal. I just want to make sure we have got the numbers right on the impact from the Boeing strike. So in the 10-Q, you have guys has said that you thought it would be, the specialty Boeing sales would be down slightly from 4Q '07. I guess, now you're saying that it would actually be up slightly. So can you maybe help us with some brackets around that voice, if we just kind of think about what the right dollar number to think about is there? And then how that would impact you guys profitability wise?

Neal Keating

We -- Matt you're right. We had anticipated -- we certainly didn’t anticipate that the borrowing strike would end this as potentially quickly as it did. We had anticipated we could have as much as $3 million with the volume that would have move out of the fourth quarter and into the first quarter and frankly some of that would have been likely loss simply because they can’t ramp-up their own production rate.

So that was really, what we had intended when we look at the queue and did it. However, in reexamining it today, what the potential for this strike being ended tomorrow and back it works next week. We think that again, we'll be able to recover a significant portion of that and end up with our fourth quarter performance in '08 slightly above our '07 numbers.

Matt Duncan - Stephens, Inc.

Okay. So '07 was 29.8 million, third quarter of '08 was 36.8. So prior below 3Q, but still above 4Q, '07?

Neal Keating

Yes.

Matt Duncan - Stephens, Inc.

Okay. Fair enough. You gave us a little bit of commentary on KIT about some of the market; you see that is still pretty good. Are you seeing any end markets starting to deteriorate with the industrial company looking like its slowing down and if so how do you think that impact the KIT business going forward?

Neal Keating

You know, we -- I have been listening to calls, I anticipated that question. And we have not as of this time seen the slowing yet, do we think its, going to an adorably income net, yes, we do. However, I would put in the perspective from three ways, one we ramped-up in the fourth quarter of last year as you will remember; we had a 10% growth in the fourth quarter of '07 versus '06.

A lot of that was due to new national accounts that were added and then beginning to convert their sales to KIT. We're now a year end to that, so we expect that to slow, so as we look at slowing we see it more so from the perspective of having converted those accounts to KIT and now we will be getting incremental business from them as suppose to then join the KIT business based.

So in adorably that was slow versus the 10% that we saw, we do have now adequate contributions from both ISC and beginning in the fourth quarter (intermix), which will help us. But then again, we break it down to the individual markets that we're serving today and we have not seen a drop off in sales from them yet, but we're ready to react, when it does occur.

Matt Duncan - Stephens, Inc.

Okay. So I guess, then if we look at -- if you look at capital utilization, that you look at your mod, they both taken a free short notes out, I mean would it be reasonable to expect that, you can end up may be having small sales declines in KIT or do you feel like your end market exposures are such that you should still be able to grow that business there.

Neal Keating

While with the dynamics of that business it’s -- that is really a real time question. Right now, based on what we see, we expect that we should be able to grow that business.

Matt Duncan - Stephens, Inc.

Okay. That’s great. Looking then a Precision Products, those sales were quite a bit stronger, I think in the quarter then they were even in the one immediately prior to it. It looks like you guys are having a good success there, ramping up production of the Joint Programmable Fuze. Do you feel like this sort of 33 million type revenue run rate is a new run rate you can build off or was there anything that made shipments in this quarter particularly strong?

Bob Garneau

Well I think that, what made this quarter particularly strong, Matt, its exactly the first thing you touched down, is that we've had now two, actually three very good quarters of continued production increases in the JPF and therefore the revenues have followed that. I would expect that as we look at, at the fourth quarter that it would still be up. We will though get to the -- slower growth rate, out in the future. Simply because we are ramping up the production rates successfully, filling the orders and now we will be, we will be approaching the steady state requirement for the U.S. government and obviously the bad news there is that our ramp up rate will come down. The good news is that we will be able to more aggressively mark it JPF sales to foreign governments and be able to improve our margins in that manner.

Matt Duncan - Stephens, Inc.

Okay. So, you should be able to grow quarterly sales should go up again in the fourth quarter from this level from this 32.5, 33 million level.

Bob Garneau

We expect that they will.

Matt Duncan - Stephens, Inc.

Okay. That's great. Couple more things, then I’ll jump back in queue. Just from a modeling perspective if I look at the operating margins at KIT, clearly you are showing some improvement there. But just to make sure we understand this is a sequential move of margin if I look back the last two years. You seen your operating margin declined about a 100 basis points in the fourth quarter from the third quarter, is there anything materially different about the KIT business now that you made a couple of acquisitions and then that business is grown, they should keep a similar drop from happening in 2008.

Bob Garneau

We, Mat, I do not expect that we will -- we have broken that model because that is based primarily on the seasonal decline in sales. So I can't tell you that we've broken that model however, there's two aspects. One, our volume is higher, so we should expect that we would get some contribution from that because of the fixed cost based. And in addition, we have two additional business days in the fourth quarter for KIT in 2008 versus 2007, so that should have an incremental positive impact done as well.

Matt Duncan - Stephens, Inc.

Okay. That's very helpful. And last thing here on foreign exchange, dollar is obviously strengthening quite a bit recently, how would you expect that to impact your various businesses now that you got breakout, I know part of Specialty Bearings is a German based business, just a commentary on how foreign exchange may impact you guys going forward to strengthening dollar?

Neal Keating

Matt, in all of our businesses, one of the things that will do will be to tend it to reduce the numbers a little bit with the strengthening of the dollar and we haven't disclose the size of those businesses, but I mean that could have an effect of $1 million, $2 million some like that on our aerospace businesses.

Matt Duncan - Stephens, Inc.

Okay. Thanks, guys and congrats again on the nice quarter.

Neal Keating

Thank you.

Operator

Our next question comes from the line of Arnie Ursaner of CJS Securities. Please proceed.

Arnie Ursaner - CJS Securities

Good morning. I will try to max give you ten or twelve questions if I can. My first comment if I can is regarding is Wichita. Wichita, obviously continues to be problematic, you quantified in a general sense, if you mentioned the $1.8 million was in inventory related charge which I assume should be one time in the way you already think about it?

Bob Garneau

That’s correct.

Arnie Ursaner - CJS Securities

But I want to focus on the balance of your business and begin to think about margin and opportunity there, you mentioned you moved from probation in the AS9100 certification in August and these have been incredibly costly items that have impacted your margin there. So can you comment on that, but also you mentioned the final pricing on the TRP seems to be an issue, but I guess I am concerned about it is, we're entering a period similar to the helicopter where you have a long-term contract to produce a product that will loss indefinitely and if so, Neal, how do you intent to attack that?

Neal Keating

Well, let's start with your last question and to put in context, I hope that we've been pretty clear in articulating the two outstanding risk items in which outside of the normal operating inefficiencies that we have had there, Arnie. And they were number one in inventory adjustment as we went through and evaluated material in working process. And the second was a final negotiation for pricing with Sikorsky and the TRP. We believe that we -- the charge that we've taken of $1.8 million in this quarter should enable us to put the inventory issue behind us. So, we're not down to the Sikorsky TRP. To begin with, that is not an indefinite contract. That's a contract for 30 units and we have now, as of last weekend, shipped the third of those 30.

So it's not indefinite. And what I think we've represented is that through the life of that program, there have been a significant number of changes that have impacted the cost. We are going into a negotiation with Sikorsky to be able to recover those costs. We feel we have a sound basis for recovering those costs, but it will take a negotiation for us with the end customer to determine what the final outcome is. But again, not indefinite, we are already 10% of the way to that program. So I just need to make sure we're clear on that.

Bob Garneau

It's clearly not an Australian type of situation.

Neal Keating

Yeah.

Arnie Ursaner - CJS Securities

But to clarify, you just said 10%. You meant 10 units at a 30 or a third, is that correct?

Bob Garneau

No. we've shipped three units so far of the 30 that are required. So, 10%.

Arnie Ursaner - CJS Securities

Got, it. Thank you. A very quick question, foreign sales as a percent of JPF sales, what where they please?

Bob Garneau

We've got that. They were very small in this quarter.

Arnie Ursaner - CJS Securities

And still had a pretty sizeable impact on margin?

Neal Keating

No.

Neal Keating

No. The improvement was predominately driven, Arnie by the legacy missile fusing business from Middletown, while we had strong shipments of the JPF, 90% was to the U.S. Government and only 10% was outside of U.S. Government.

Arnie Ursaner - CJS Securities

So the real margin improvement is yet to come as we are able to increase the percent to foreign governments?

Bob Garneau

Yes. I think that they did a great job this quarter in the legacy fusing business. They did a very good job in the ramp up of the JPF. But we've got the margin improvement yet ahead of us both on mix of sales and re-negotiation for option 6 pricing.

Arnie Ursaner - CJS Securities

Okay. Can you disclose the number of branches you opened in industrial distribution in Q3? How many you hope to open in Q4 and the impact of the branch openings on margin if you could?

Neal Keating

We can do that, Arnie. We can handle at least the few of those. We opened one branch in the third quarter of this year. I think that between branches, distribution centers and service centers we've opened four this year. And I think in the last five quarters that number has been 13. So, we haven’t characterized how that may have degraded our performance in prior periods. But what we have said is that we do expect that they are in investment the first year, that they breakeven the second and they turn profitable and get to KIT average margins in the third year. So that’s really how I would model it.

Arnie Ursaner - CJS Securities

Thank you very much.

Neal Keating

Thank you.

Operator

Our next question comes from the line of Steve Levenson of Stifel Nicolaus. Please proceed.

Steve Levenson - Stifel Nicolaus

Thanks. Good morning, Neal, Bob and Eric.

Bob Garneau

Good morning.

Neal Keating

Hi Steve.

Eric Remington

Good morning.

Steve Levenson - Stifel Nicolaus

Nice to the see the continued progress you're making. In terms of the fuse contract you said it won't really change much until 2010.

Neal Keating

Right.

Steve Levenson - Stifel Nicolaus

Do you expect to see any revenue in 2009? I guess the award is pending?

Neal Keating

Sure. I am sorry, if wasn't clear on that. But we will continue shipping option 5 fuses through likely early 2010, based on current productions schedules and demand. So we will not have a decline. We will continue to fulfill under the option 6 contract, excuse me option five contract.

The option 6 contract will be negotiated hopefully, end of this year. Early next year we'll come to a conclusion. And we would expect to begin providing product on that option and therefore at better pricing in late first quarter 2010, perhaps early second quarter 2010. What we also have said is that and it has been released by the U.S. government is that we do in option 5 have a higher percentage of foreign military sales. So, we should have some marginal uptick in margin for that product in 2009.

Steve Levenson - Stifel Nicolaus

Okay. Thanks and I think that there is no further development needed on the product?

Neal Keating

Well, we've actually done a new development it's in test right now, flight test and other things with the U.S. government. So, we're ready to make that transition and are going through all of the inventory balancing and other things as you would expect with that.

We do anticipate that there will be some further quality improvements and producibility improvements in the design. But frankly I don’t want to over state it. We've done so well with production ramp up of the current design that we don’t mind if the new design moves out a little bit.

Steve Levenson - Stifel Nicolaus

Great, thanks. On the Bearing side of the business, are there other interested opportunities that you see coming up. I know bearings don’t directly affect fuel consumption, but has anything come up where people are asking you to come up with new designs for existing aircraft?

Neal Keating

I can’t say that they have. I think more so, what we continued to encounter on a number of the new aircraft programs, as they go through their testing and they find out that -- that some of the bearings that they have specified don’t meet the requirement in actual fact that the Specialty Bearings group continues to be broad end and increase their content in those new platforms. But, I can not tell you right now or point to you any retrofit applications, any additional retrofit applications or news since we have talk about them before.

Steve Levenson - Stifel Nicolaus

Okay. And on Bearings, are you still quoting with the similar lead-time as you have in the past?

Neal Keating.

Yes. We are.

Steve Levenson - Stifel Nicolaus

And, will that require any further expansion for that new bay that you built?

Neal Keating

We don’t believe that it will right now, for the next, and I don’t know if it’s 18 or 24 for a months and I said before I think that everybody in this room and probably a number of people out there will be very happy when we have to expand that business again. But if you were here for example, we had a group from United Technologies and their companies such as Pratt & Whitney and Sikorsky here earlier this week, and they presented a Specialty Bearings business with the UTC gold recognition. It is extraordinary, I believe there’s only 19 companies in the world that have got their award and as they toured the facility, what they were interested in was the number of machines that were actually being moved around, and how we continued to relay out the value streams in that facility to improve both our operating performance in terms of lead time and handling time but also clearly for all of us how that helps improve our margin performance in that business as well.

So, they have got an ongoing program of improving efficiency. We’ve added capital in there with new higher speed, more sophisticated machines, robotic loading and unloading. So, we can continue to invest in that business within the existing footprint that we have and increase our output as well.

Steve Levenson - Stifel Nicolaus

Great. Thanks. In terms of your new bank arrangement, are there any restrictions on acquisitions there and in relation to acquisitions, what are you seeing in your pipeline both on the aerospace side and KIT and how are the people in there or are you seeing prices coming down or any greater willingness to sale?

Bob Garneau

Steve actually on the new bank arrangement, the terms modeled what's in our other agreements. So, if there are any restrictions that you mentioned, it’s pretty much as we can use as we could use our existing once. In terms of what’s available out there, in this market hopefully more of things will come on the market and prices will be lower. And therefore more opportunistic, but of course you do need to worry about financing because as of yet the credit markets aren’t providing for great liquidity and so we’re happy that we did what we did. And then it will be on an opportunity as presented going forward.

Steve Levenson - Stifel Nicolaus

Okay. Thanks. And last on the hedge, did you cancel that are there any other instruments like that or it was just a one-time?

Neal Keating

That was a one-time.

Steve Levenson - Stifel Nicolaus

Okay. Thank you very much. Last question, I’m sorry, one another things, with Brookhouse and the work you doing in composites, are you at all about expanding into wind power, seems to be a lot of demand for blades? And some of the people who make them are having problems with them using the older technology?

Neal Keating

I can’t tell you right now, that we are looking at that. In fact, Kaman many years ago did some composite wind blades. We may actually still have one around here somewhere. But at this point in time, we have not and we certainly are looking at ways in which we can move into adjacent markets, whether it's in our bearings business to support wind power or another alternative energy investments right now. But I don’t believe that at this point in time, we’ll be in a position to look at our wholesale shift of some of our composites work for wind applications.

Steve Levenson - Stifel Nicolaus

Thanks again. Have a good weekend.

Neal Keating

Thank, Steve.

Operator

Our next question comes from the line of Edward Marshall from Sidoti & Company. Please proceed.

Edward Marshall - Sidoti & Company

Good morning everyone.

Neal Keating

Good morning, Edward.

Edward Marshall - Sidoti & Company

The first question is on the Aerostructures, actually both of my questions are on the Aerostructures. Backlog was up year-over-year nicely, but more importantly sequentially up 11% I didn’t catch if you said what was driving that?

Neal Keating

Well, I can tell you that. We don’t have A-10 in there yet. We have a little bit of A-10 in there. So it’s predominately the additional ship sets on C-17.

Bob Garneau

In Brookhouse.

Neal Keating

In Brookhouse of course, we've added that, as we've added Brookhouse we've added their backlog.

Edward Marshall - Sidoti & Company

But that was from last quarter as well, there was about $250 million backlog last quarter, I think that jump from year-over-year was due to Brookhouse or was I incorrect on that?

Neal Keating

I think it’s predominantly we had the Sikorsky multi-year that is probably multi-year Sikorsky order and the A-10, so…

Edward Marshall - Sidoti & Company

Okay. When does the A-10 start to hit the backlog?

Neal Keating

No, A-10, we’ve got a very small backlog on that right now. But, since we begin producing in 2010, I would expect it would be dependent on how Boeing issues orders on it frankly and how we put it in, but we’ve talked about it being the potential for a $100 million program, so…

Edward Marshall - Sidoti & Company

Sure.

Neal Keating

And it is…

Edward Marshall - Sidoti & Company

Yes.

Neal Keating

Something that they're going ahead with.

Bob Garneau

It’s the big change in the third quarter versus C-17.

Edward Marshall - Sidoti & Company

Okay. And could we quantify the effect that Boeing had in the quarter to either the Aerostructure segment with the 777 and 767 or as well as with the Bearing segment?

Neal Keating

Very small.

Edward Marshall - Sidoti & Company

Small in both and both?

Neal Keating

Small in both. Yes.

Edward Marshall - Sidoti & Company

Okay. And I just want to see, if I’m looking at this rate, looking at the business is going to be hitting in 2010. I mean you're going to still have the firm base Sikorsky and the C-17, but you have additional A-10 business coming on and the joint program over fuse I guess option six at that point, hopefully we get a higher price. I mean, am I right in assuming that 2010 looks like a pretty good year for you guys? And not to put guidance or anything in your mind, but just as a kind of a hard set of question to you?

Neal Keating

I like our business for now and I think I’ll like it a lot in 2010.

Edward Marshall - Sidoti & Company

Yeah.

Neal Keating

I think that, and I don’t mean to be tried. I think that, those are the things that the people in each of the businesses have been working really hard. And whether it’s the Precision Products group and all of the work that they've invested not only in middle town with the work for the missile fusing but, an awful lot of hard work to get up to where they are in Orlando today on JPF. And to work with the U.S. government, to be able to get a higher pricing, a four option six, is going to make a huge difference for that business and they worked really hard for it. When you go to the Aerostructures business and whether it is Jacksonville or here, obviously our Bloomfield Helicopters business is actually one of our big suppliers and to Jacksonville and the A-10. They worked very hard to position and win the A-10 program. They have performed well as a sub supplier in the entire chain on C-17 to position Boeing to continue to get orders so, there are a number of things that are coming together pretty nicely now, we expect that should continue based on those things and feel pretty good about it.

Edward Marshall - Sidoti & Company

Good. Thank you so much for the commentary. Have a good day guys.

Neal Keating

Yeah. Thank you, Ed.

Operator

(Operator Instructions). Our next question comes from the line Robert Kirkpatrick from Cardinal Capital. Please proceed.

Robert Kirkpatrick - Cardinal Capital

Neal. Let me add my congratulation as well.

Neal Keating

Thanks Rob.

Robert Kirkpatrick - Cardinal Capital

You have mentioned, I think that there were 35 or 38 marketing approvals that you had received from the U.S. government to talk to different countries about the SH-2. Was there any that you applied for, that were rejected?

Neal Keating

Not that I am aware off.

Robert Kirkpatrick - Cardinal Capital

Okay. And maybe a longer, again of a longer term question for you Neal. The company has burnt through a fair amount of cash this year on an operating basis, if you look at the cash flow statements for the nine months, and I realize that, there are something something's this year that make it perhaps a little bit more unique, but as you look forward over the next several years is there a more normal pattern that you would expect, or would you expect command to continue to end up burning few cash on operating basis?

Bob Garneau

Rob. This is Bob Just as we get into the more profitable businesses that, the cash flow comes with it and I think that, going forward as we do think so the business to improve it, and as we increase sales and profits. I think you'll see that there will be good cash flow generated.

Robert Kirkpatrick - Cardinal Capital

Okay. That certainly would be our expectation as well. Thank you very much gentlemen.

Neal Keating

Thanks Rob.

Operator

And our next question comes from the line of Jerome Lande from Millbrook Capital. Please proceed.

Jerome Lande - Millbrook Capital

Good morning. And great quarter guys.

Neal Keating

Thank you, Jerome.

Jerome Lande - Millbrook Capital

First of all, speaking on KIT first for a second here, what about understanding that you’ve got a sort of basket of counter cyclical or off-cycle industries. What about mining which I know has been a huge win for you especially as we see commodity prices coming down, do you have any more color on that specific segment?

Neal Keating

You know, Jerome, its one of the ones that, you listen to the announcement now a number of months that [Terex] made what’s happened with KIT and others and you see inevitably that capital programs would be reduced. Do I think that we're going may remain immune to that? I don’t think that we will.

At the same time, our business into those markets consists really of two components and it is supporting new capital programs and supporting the operation of the facility itself. I don’t think that we've heard about people shutting down mining operations and closing them down. They may run them at a lower rate, but shutdown and restart is an expensive proposition for them.

So we will continue to be able to provide product. If it turns it burns and we work to help them maintain the operating efficiency. So do I think it will come down in mining based on commodity prices? Yes. But I can't tell you today as we sit here, that we have seen that yet.

Jerome Lande - Millbrook Capital

Got it. You started to get into the area of my second question which is my understanding has always been that KIT, if you were to look at the sort of end users for what KIT sells mostly MRO. But do you have any analysis that says how much of KIT sales are maintenance repair versus how much is original equipment or capacity expansion at your customers?

Neal Keating

We do break it down actually between MRO and OEM. And I am working from memory and it’s about, I believe it’s about 80-20. But wait a second I have a smart person giving me a chart. How about 75% MRO and 25% OEM.

Jerome Lande - Millbrook Capital

Okay, I'll take it. Thanks, and with regard to helicopters for a second. Understand that Sikorsky continues to ramp and that’s a good program for you. And you just holding up and then I guess whoever you sell these next draft of sea spreads too will the service contracts probably come in with that, which will be good. Are there any other new opportunities out there that you are bidding? Should we expect to see you expanding service breath in helicopters and then my recollection that you have got a lot of space, you also I think so have a pretty big pool of labor you could pull from there in Connecticut. So what’s the sort of outlook for product breath if you will?

Neal Keating

I would look at it from two perspectives. Number one, we're really focused on performing on the on the Sikorsky program. And actually if you were to come up here this week you'd see that our building 30 is pretty much full of both Sikorsky helicopters as well as some of the blade erosion coating that we're doing. So I think that they might contend that we don’t have a lot a space right now.

But if we look forward, reselling the Australian helicopters are very important to us for the very reasons that you said and what Rob touched on earlier. Great cash generation opportunity, profit adds to our service base. MDHI helicopter continues to be a good customer for us as well in this period. We're also looking at together with DRS and announced in [Mechanica] a reset for the Kiowa now that the ARH has been cancelled and that would provide us some upside opportunity as well.

And finally, we have talked in the past about a very opportunistic and I would emphasize very opportunistic program that we're working on in conjunction with Lockheed Martin right now called the Burrow Program, which essentially takes our K-MAX heavy lift helicopter and reconfigures it for unmanned re-supply using the Lockheed Martin Mission Management System. That is a longer term program, but it is an opportunistic one that we are looking at that could provide dividends, especially when you're looking at the environment for UAVs today, a 6,000 pound lift capability, which is very different than anything that is out there today and a strong partner like Lockheed Martin.

Jerome Lande - Millbrook Capital

And the Burrow Program would be retrofitting K-MAX helicopters that are already out there in the filed or helicopters you have grounded somewhere or Lockheed has, where were the actual choppers themselves come from?

Neal Keating

They would be new aircraft.

Jerome Lande - Millbrook Capital

The new aircraft that Kaman would build.

Neal Keating

Yes. Between Lockheed Martin and ourselves today we have acquired three K-MAX helicopters and that’s what we are using for our initial testing, demonstration et cetera. But if in the future, one of the services were to establish a requirement that the Burrow would meet, we would be looking at producing new aircraft.

Jerome Lande - Millbrook Capital

Okay. Lastly moving onto the term loan that you got finished just couple days ago?

Bob Garneau

Yeah.

Jerome Lande - Millbrook Capital

What is the rate on that?

Bob Garneau

Well, it’s a market rate. The keys of the LIBOR and probably around 5 and 5.5% all out something like that.

Jerome Lande - Millbrook Capital

Okay. And why was that done now, I mean it's impressive enough to get it done and that's sounds like a pretty decent [range]. But you are replacing from I've read here you are replacing existing revolver borrowings which had a little ways to go, what sort of the financing structure rational?

Bob Garneau

I mean, we wanted to number one replenish part of what we'd use to deal with the Brookhouse acquisition and we're just starting this market; it was good to have the available cash resources and credit.

Jerome Lande - Millbrook Capital

Okay. And it's nice that it gives you more power for acquisition out in the M&A environment people you to speak to I'm sure, you've got your [contract] potential acquisition, you talked different from time-to-time. Are you getting any sense of different pricing out there and or more seller desperation from properties that you might be looking at?

Neal Keating

You know, Jerorme, what I think might provided the best indication for the industrial distributions area to begin with is that there is an analysis that MDM, Modern Distribution Management does, that is an analysis of acquisitions and what the valuations have been. In the third quarter of this year, the average valuation came down by 100 basis points. So I think that's indicative of just doing the financial models.

So I think that pricing will be -- valuations will be lower in the industrial distribution market and that's a data point that tell us that. In aerospace, it's still difficult. The valuations are still high and there is probably a hike in the level of uncertainty probably not 2009 or 10 perhaps but pass that. So I don't think that we would comment that we've seen desperation. We've got a few that we wouldn't mind having being desperate. But I can't say that we've gotten people to that level yet.

Jerome Lande - Millbrook Capital

That MDM figure you quoted, that was 100 basis points, in order works one multiple point lower or…

Neal Keating

Yes.

Jerome Lande - Millbrook Capital

1% change?

Neal Keating

No, one multiple point lower. I don’t remember exactly. It's on their website. I'll get the hard copy, Jerome, but I think it went from 7.5 times to 6.5 times, but I would double check that.

Jerome Lande - Millbrook Capital

Great. Well, thank you very much. Thanks a lot.

Neal Keating

Okay. Thank you, Jerome.

Bob Garneau

Thanks, Jerome.

Operator

Ladies and gentlemen, I am showing we have no further questions in the queue. I would now like to turn the call over to Mr. Eric Remington for closing remarks.

Eric Remington

Thanks for joining us for today's conference call. We look forward to speaking to you again when we report fourth quarter and year end results next year. Thank you.

Operator

Thank you for your participation in toady's conference. This concludes the presentation. You may now disconnect. Have a good day.

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Source: The Kaman Corp. Q3 2008 Earnings Call Transcript
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