John Stroup - President and Chief Executive Officer
Gray Benoist - Chief Financial Officer and Vice President of Finance.
Dee Johnson - Director, Investor Relations
Celeste Santangelo - Merrill Lynch
Matt McCall - BB&T Capital Markets
Jeff Beach - Stifel Nicolaus
Nat Kellogg - Next Generation Equity Research
Keith Johnson - Morgan Keegan
Alvin Metranie - Golden Lakes Asset Management
Belden Inc. (BDC) Q3 2008 Earnings Call October 23, 2008 10:30 AM ET
Ladies and gentlemen, thank you for standing by. Welcome to this morning's Belden Incorporated conference call. Just a reminder, this call is being recorded. At this time, you are in a listen-only mode. Later, we will conduct a question and answer session. (Operator instructions)
I would now like to turn the conference over to Ms. Dee Johnson, Director of Investor Relations at Belden. Please go ahead, ma'am.
Thank you, Trisha. Good morning to everyone and thank you for joining us today for the third quarter earnings conference call at Belden. With me here in St. Louis today are John Stroup, President and CEO of Belden, and Gray Benoist, Vice President of Finance and Chief Financial Officer.
We have a few slides on the web. To see those, please go to investor.belden.com and you may need to sign onto the web site there. If you need a copy of the press release, you will find that in the same location.
On slide two, there is a statement about forward-looking statements. During the call today, management will make certain forward-looking statements. I would like to remind you that any forward-looking information we provide is given in reliance upon the Safe Harbor provision of the Private Securities Litigation Reform Act of 1995. The comments we will make today are management's best judgment based on information currently available. Our actual results could differ materially from any forward looking statements that we might make. However, the Company does not intend to update this information to reflect developments after today, and disclaims any legal obligation to do so.
Please review today's press release and our annual report on Form 10-K for a more complete discussion of factors that could have an impact on the Company's actual results. This morning, John will begin with comments about the performance of the business in the third quarter, Gray will review some financial results and segment analysis, and then John will speak about our outlook for the business for the remainder of 2008, and then finally, we will open up the line for questions.
So at this time, let us turn to our President and CEO, John Stroup.
Thank you, Dee. Good morning everyone. The third quarter presented some revenue challenges as the economic weakness we experienced in the United States earlier this year has spread to Asia and Europe. Revenue was $520.5 million compared to the $561.6 million a year earlier. Excluding acquisitions, divestitures and the effect of currency translation, the organic change in revenue in the third quarter was a contraction of 10.7%. Some of this was related to channel partners closely managing their inventory in an uncertain economic environment and the anticipation of lower prices due to the recent decline in copper. The remainder of it was due to our broad base slowdown in our surf markets and geography. We will talk more about our markets in a moment.
Operating margin, adjusted for purchase accounting effects, restructuring charges and the deferred revenue impact in the wireless segment was 10.6% of revenue. For a valid year-over-year comparison, if I exclude the wireless business which we acquired during the third quarter, operating margin was 11.2% in the quarter compared with 11.3% a year earlier. We are pleased that margins remained constant year over year in an environment of declining volume. Adjusted diluted earnings per share were $0.78 in the quarter compared with $0.77 in the prior year quarter. One of the drivers of this sustained consolidated performance was developed in American segment. This is our largest segment comprising about 38% of our revenue. They generated $46.3 million of operating profit or 21% of their total revenue, a record performance on both counts.
This is primarily the result of that businesses improved manufacturing performance, the call that we went through a major restructuring of our North American manufacturing footprint in 2007. I am very proud of the team that has successfully executed our manufacturing strategy in this business over the past two years. We are solidly uncharted to achieve the plan cost reduction of $26 million despite having to overcome higher commodity and energy cost. This will be an enduring benefit for Belden's long term competitiveness.
Turning now to slide four please. We are reporting Trapeze as a separate wireless segment. This matches how we are managing the business and it also provides investors complete visibility into the strategic acquisition. For additional transparency, we have included in adjustment for the effects of deferred revenue accounting in our adjusted results. By doing so, we are able to describe the real operating performance of the business in a timely fashion. When we last gave earnings guidance, the outlook included the deferral of revenue and the related gross profit, so the results we are presenting are in a different basis than you expected. Our guidance for 2008 was $3.15 to $3.35. If we had adjustment of $0.15 to $0.20 for the gross profit impact of deferred revenue of the wireless segment, our guidance would have been $3.35 to $3.50.
As we get you an apples to apples comparison of these results versus guidance, the wireless segment actually did better than we guided. The adjusted results of operations were diluted by $0.03 whereas at the time we announced the acquisition, we thought the economic delusion might be a few cents more than that, but this network has quickly made some changes to their SG&A cost that have improved their operating results. We have aligned the sales force of Belden and Trapeze in a very short time. It is clearly too early to declare a success but we have already experienced some good examples of commercial synergy that we envisioned at the time of acquisition.
I would like to spend a few minutes discussing our revenue and the conditions of our market. In North America, revenue was down about 11% year over year but it was flat sequentially. As I mentioned earlier, channel partners are carefully managing their inventory investment. While our revenue results are negatively impacted by this inventory management, our sales through performance with North America channel partners is actually up slightly year over year and substantially more sequentially. We continued to see a pronounced shift for higher category tables and solution in the enterprise market especially in North America. High end solutions grew strong sequentially and year over year and lower category products declined as expected.
Turning to Asia, we continued our portfolio management activities in the LTK Brand bringing on new business and good margin expanding high margin business with existing customers and purging low margin business. We significantly raised our gross profit margin in that brand more than 200 basis points year over year through this action. At current volume, we have more capacity than we need but as we localize more of development brand products early next year, we will better absorb this manufacturing cost and further improve margin. We will begin moving into the newly build Suzhou plant in early November and expect to be operational for LTK production in the new location by the end of 2008 and have equipment in place for Belden production early in 2009. Please recall that this plant replaces our existing our Shanghai plant for LTK but it is new local capacity for production of Belden products.
The Belden product line has a relatively large number of SKUs at more volume than typical for LTK so there will be a lot of start up effort before we achieve the full benefit of local production. We are sourcing about 10% of our 2008 Belden brand Asia volume through our LTK plant and we have local suppliers that also provide an additional 25% of our need today. In our Belden brand Asia business, we got some revenue headwinds. In India, we have had some great project wins but in other cases, we have seen delays and even cancellation of IT projects by major multinational customers. Turning to Europe, we always see a seasonal decline in revenue from the second to third quarter in the segment but the business did not respond in September as it has historically.
The year over year decline in Europe segment revenue is attributable to weaker cable revenue partially offset by growth in connectivity and industrial Ethernet. Lower demand from the automotive industry was a major contributor and we saw a pronounced slowdown in the UK and Southern Europe. In addition to the effects of lower volume, we suffered margin degradation in Europe because it takes longer to adjust capacity in Europe so we could not flex costs fast enough to match revenue.
On the automation side of our European business, our industrial Ethernet and connectivity businesses grew year over year but clearly the rate of growth is impacted by the economic slowdown. Nevertheless, the businesses we have acquired continue to have a significantly better profile.
Turning to slide five. In the third quarter, we generated $39 million in free cash and free cash flow exceeded net income. That brings cash from operations for the year to $128 million and free cash flow after subtracting capital expenditure to $95 million. Cash increased to $215 million and our interest coverage ration was 8.1 time. Net of our $215 million in cash that is 25% of total capital. Besides the cash balance, our liquidity includes another $103 million of capacity to borrow under our revolving credit agreement. We feel that this is a strong, conservative balance sheet that will be an important advantage to Belden if the conditions turnout to be as difficult as we expect over the next few quarters.
To summarize, it is a challenging period and we need to be prepared for lower revenue in the next few quarters. We remain committed to our strategic plan but we are evaluating the timing and amount of investment given the current economic environment. And I am going to turn the call over to Gray for more discussion of the business result. Gray?
Thank you, John and good morning everyone and thank you for joining us this morning. I will begin my comments with a discussion of the consolidated results of operations for the third quarter then turn to the segment results, followed by cash flow, asset management liquidity, and working capital. If I could have you turn to slide six please.
Third quarter revenue of $520.5 million was 7.3% lower than a year ago. With the strengthening dollar, we realized less benefit from currency translation than in earlier quarters. The currency effect this quarter was $17.1 million or 3%. Year-over-year organic revenue growth, without the effects of currency, acquisitions and divestitures was a negative 10.7% in the quarter. Lower organic growth revenues resulted, as John noted, from market channel and portfolio activity.
Sequentially, North America volume was table whereas both the Europe and Asia experienced sequential revenue decline. Geographic mix of revenue was shown on the slide six on the left, please. Revenue in the United States was 43%, Canada 7%, Europe 25% and Asia 20%. US and Canada generated 50% of our revenue in the quarter which is contrary to our recent revenue trend and indicative that the market conditions we faced in Q3 in our Europe and Asia business. The pie chart at the top depicts revenue by vertical market. We have included the revenues of Trapeze networks, now our main wireless segment in the enterprise vertical so enterprise is expanded to 29% of revenue up from 25% of revenue a year ago. This has been the pattern all through 2008, we continue to see year on year growth in higher bandwidth enterprise structured cabling solution and a fall off in demand at the low end of enterprise product family, a good trend for us and consistent with our expectation.
Revenue in the industrial market was 42% of total revenue, sales in these vertical included cable products, industrial Ethernet and our industrial connectivity business. In North America, industrial cable revenue was stable sequentially but lower year over year. In Europe, industrial cable volume declined sequentially more than the season we expected and declined significantly year over year for reasons discussed earlier. The Europe base industrial Ethernet and connectivity businesses grew year over year and experienced a modest seasonal decline sequentially.
The video, sound and security market remains at about 12% of total revenue. The transportation and events vertical at about 4 and the consumer electronics and consumer OEM markets served by LTK was again about 13% of our revenue this quarter. If I could have you turn to slide seven please on our adjusted results.
In the third quarter, GAAP earnings per diluted share were $0.67. As mentioned in our press release, we incurred an absolute impairment charge of $753,000 related to our North America manufacturing restructuring initiative. We also have identified an adjustment of $1.2 million of one-time purchase accounting effect related to the July 16 acquisition of Trapeze Networks. In order to improve transparency and deal effectively with the complex accounting associated with SOP 972 that is for our revenue recognition, we have adjusted revenue and gross profit for the effects of all revenue deferrals of Trapeze Networks. John's earlier comments captured the current circumstances with respect to Trapeze operationally; I will add some additional color on the state of vendor specific objective evident and revenue recognition later in my remarks.
I would like to focus the remainder of my comments on adjusted results without these charges. We benefit reconciliations between GAAP and adjusted results have been provided as part of today's press release and also are available at the end of today's slide presentation.
Gross profit margin was 30.1% in the third quarter that is 210 basis points improvement year over year and just 20 basis points lower sequentially. With respect to the regional manufacturing rationalization program and our commitments to deliver $26 million in annual savings of 2008, as John said, we are on target to deliver on the commitment despite third quarter cost increases and logistics mostly early grade and in compound materials which contain significant petrochemical content. Our ability to hold gross profit margin sequentially given the abrupt decline in revenue in Europe and Asia coupled with an unfavorable commodity market is testimony to the effectiveness of the manufacturing rationalization initiative even focused on delivering these past 18 monhts.
Third quarter SG&A expenses was $85.1 million or 16.1% of revenue. Excluding the results of the wireless segment, SG&A expenses were $79.9 million or 15.6% of revenue. In making comparisons to 2007, you will recall we were not identifying R&D expenses as we do today. Thus prior year SG&A includes R&D expenses of that period. In an apples to applies comparison, SG&A excluding wireless segment is $6.1 million lower than dollar term sequentially and $5.2 million lower year over year. Currency translation with respect to year-on-year strong Euro added approximately $3.8 million to SG&A year over year. Excluding this translation impact, SG&A was $9 million lower year over year. A weaker global economic environment demands continuing cost vigilance in both manufacturing and the backlog of this operation and the third quarter results were achieved by continued good cost controls in all of our operating segments.
Cost controls in the business level first facilitated the maintenance of double digit operating profit margins in the quarter and secondly, enabled investments to be made in both R&D and in our strategic initiatives, lean, talent management and our newest initiative in global sales and marketing. R&D expense was $14.4 million in the third quarter or 2.7% of revenue. Excluding the results of the wireless segment, R&D expense was $11.4 million compared with $10 million in the second quarter of 2008 and $8.5 million just one year ago. Investment in new product development in Belden automation remains a critical differentiator for our advanced product positions and an increase in R&D spending is consistent with our attention to technology development and maintaining leadership in each of our product category.
Similarly, technology investments to expand on the industry leading position we acquired with Trapeze Networks is of equal importance. Other income in the quarter which represents the income from nine consolidated manufacturing and marketing joint ventures in China was $813,000. If I could have you turn to slide to eight, please.
Interest expense for the third quarter was $8.7 million and our interest covered ratio was 8.1 times reflecting the desired state of strong EBITDA to conservative leverage which we had planned in the 2007 recapitalization of the company. I will talk about changes to the structure of our debt in a moment. Income tax expense was $12.7 million in the adjusted result or 25.6% of pretax income for the quarter. The effective tax rate on our year-to-date adjusted result was 28.4%. During the quarter, we recognized a tax benefit of $2.2 million from the release of valuation allowances on a portion of our Netherlands NOL. Despite the third quarter performance in Europe generally, we continued to manage and deliver significant improvements in the Netherlands' operating result now six consecutive quarters of positive pretax income enabling favorable accounting treatment for the NOL valuation reserve we carryon the balance sheet.
In future periods, we will continue to evaluate whether current result and operational forecast provide enough positive evidence to release additional NOL valuation allowance. With the impacts of the valuation allowance released, we are reducing our full year outlook for the effective tax rate from 30% to 29%. Net income in the adjusted results was $36.8 million with average diluted shares for the third quarter at $47.1 million. Adjusted earnings per diluted share were $0.78.
Slide nine please has our segment result. External revenue of development America segment was $202.6 million increasing 1.3% sequentially but 12.5% lower than a year ago and the divisional sales were $17.6 million. Including the inter-divisional sales, total difference of Belden Americas was $220.1 million. In addition to demand and inventory considerations, we continue to diminish our participation in the market for low end networking and certain low end industrial product that will impact current near term volume but increase profitability over the intermediate term. As the margins that can be earned on this business today are not at acceptable level nor are they expected to improve in the future. Year-over-year segment operating income was $46.3 million or 21% of revenue which represents record high profitability for the division accomplished in a very challenging quarter. The 21% adjusted operating income is an expansion of 170 basis points over the second quarter adjusted operating income for the year of $42.3 million or 19.3% and a 350 basis point expansion over the prior year.
The Specialty Product segment external revenue in the quarter was $56.5 million which is lower by 6.7% compared with the third quarter a year ago and lower by 5.2% as compared with the previous quarter. The divisions of revenues from affiliate were $15.9 million. This represents a 40% and 13% decline from the previous year and previous quarter respectively primarily due to the Connecticut site coming offline and Americas production previously sourced out of the Mohawk facilities shifting to the American site in Nogales, Mexico. Operating profits for the third quarter adjusted by $900,000 for restructuring charges were $8 million or 11.1%, down 400 basis points sequentially. As we complete the transfer of products in Nogales, operating margins for the Specialty Product segment are expected to return with historical level.
The EMEA segments external revenue was $164.4 million in the third quarter, a 4.4% decrease year over year and a 17.5% decrease sequentially. Operating income with the EMEA segment was $12.9 million or 7.6% of total revenue after a small severance adjustment. America compares with the prior year results of $15.8 million or 8.8% of revenue, a prior quarter results of $27 million or 13.2% of revenue. The EMEA segment results reflect seasonality, channel inventory, weakness in the automotive sector and deteriorating economic conditions in many European countries. Our ability to flex manufacturing cost and align more capacity to more favorable cost environment has accelerated in importance bringing an updated European footprint plan, better management's volatility into the near term planning.
Each specific segment had third quarter external revenues of $89.2 million, sequential decrease of 8.3 and an 8.5% decline from the previous year. Lower comparative revenue is driven by desired portfolio management decisions at LTK partially offset by increases in demand and new products win with China OEM customers. All of these actions benefited operating margin. However, we have delayed the benefit of these actions slightly by keeping extra production resources in place to advance our localization effort of Belden product portfolio into our new Shuzou manufacturing site. As a result, segment operating income was $8.8 million or 9.9% of revenue, down from $11.3 million in the previous quarter and $10.3 million in the previous year.
With respect to the new wireless segment, we are making transparency a high priority in our reporting and we are striving to assist our public's comprehension of the required GAAP revenue complexities. You can note in the condensed consolidated cash flow statement the inclusion of two new line items. The first, deferred revenue with an impact of $8.7 million and the second, deferred cost of sales with an impact of $3.3 million, the net benefit to cash flow of that two items added together and the corresponding deferral of gross profit or GAAP is equal to $5.4 million. This is the net impact to our GAAP result in the third quarter related to Trapeze as revenue recognition. It translates to a negative impact of around $0.06 related to DSO week that is narrower than we have originally forecasted.
Much progress has been made by the wireless team in creating processes, managing documentation and establishing solid business practices to achieve DSO in a timely fashion. We will be updating our progress and the impact for 2009 guidance at our Investor's Conference in December. The wireless segment had non GAAP revenues of $16.6 million in the third quarter. The business has strong year-over-year growth with external billings increased 27% compared to the same quarter last year. Segment had an adjusted operating loss of $1.2 million for the quarter. These results reflect less than a full quarter of activity however most notably in SG&A expenses if the transaction did not close until mid July.
Free cash flow in the third quarter was $39.1 million comprised of net operating cash flow of $53.3 million less capital expenditures of $14.2 million. Free cash flow for year to date is $95.4 million. Depreciation and amortization expenses were $14.9 million in the quarter and with this reporting, we have broken out the amortization of intangibles on the face of the income statement. Since we are an inquisitive company, the identification of this element is important not only because it is significant non cash expense item impacting our operating income but also to aid an analytic comparisons of our results with others as some companies in our industry set aside this expense as a pro forma item. Amortization of intangibles in the third quarter amounted to $3.8 million.
If I could have you please turn to slide ten. We will talk about debt cash and interest. The Company had $215 million in cash at the end of the third quarter, $95 million is in depository accounts but are used in a day to day operations for business and the $120 million is in short-term investment accounts centered on government issues. We communicated earlier in the quarter, our call of all of our 4% subordinated convertible notes for redemption as of July 31, 2008. As a result of this call for redemption, holders of the note have the option to convert each $1,000 principal amount of their debentures and receive value in combination of cash and shares of our Belden common stock. All holders of the notes elected to convert their note. In August 29, 2008, we completed the conversion.
In connection with the conversion, we distributed to the note holders a $110 million in cash for the principal amount of the note and 3,343,509 shares of the Company's common stock. The issued shares had an average value of around $38. There was no delusion effect with the respect to the conversion as the shares issued had been accounted for under the fully diluted share measurements in the previous reporting. At the end of the 2008 third quarter, we had $590 million in outstanding debt, $240 million bearing interest at 4.75% under a revolving credit facility and $350 million bearing 7% interest in senior subordinated note. The Company used the amounts drawn under the revolving credit facilities to fund the acquisition of Trapeze Networks in July and to fund the cash portion of the conversion of the subordinated convertible note in August.
In addition to the cash in the balance sheet at the end of the quarter, the Company has a $103 million in additional liquidity available under its revolving credit facility. The facility is fully supported and runs through the end of 2010. If I could have you to turn to the slide eleven, please.
Given our abrupt shift in our revenue expectations for the quarter, we had setbacks in our asset turned ratios. Inventory turns in the third quarter were 5.5 down sequentially compared with six turns in the second quarter and well short at the 6.2 turns that we have experienced in the 2007 third quarter.
Absolute inventory dollars increased around $4 million sequentially. This is approximately equal to the inventory of the acquired business. Working capital turns had 5.4 turns this quarter also felt short of prior quarter and prior year as total working capital did not contract in line with revenues. Property plants equipment turns were 6.2 now this is less than the 6.8 turns with the second quarter but still an improvement from a year ago. Our asset light approach has served us very well and we expect to have several good opportunities to monetize assets in the fourth quarter.
At this time, I would like to turn it back to our CEO, John Stroup, for a few remarks about our 2008 outlook. John?
Thank you Gray. Visibility has greatly diminished but we are making a significant revision to our outlook for the remainder of 2008 based on expectations of lower revenue in the fourth quarter. We remain true to our stated long term strategy but we will accelerate or delay certain action as a result of economic condition. Several actions are under consideration for the fourth quarter that best situate the Company for the difficult environment ahead. Those will include new footprint actions in America and Europe in both cable and connectivity production and reducing our administrative resources. While continuing to invest in our go-to-market strategy, lean enterprise and the technologies that drive our success in cable, industrial automation and our wireless, we are adjusting our revenue outlook for the full year to $2.1 billion. This is a reduction from a range of $2.2 billion to $2.3 billion given earlier in the year. This implies the revenue in the fourth quarter that will be much closer to $500 million and to $600 million. Our revised outlook includes the continuing benefit of manufacturing footprint and portfolio management action we have accomplished over the past two years which are helping support gross margin but it will be difficult to overcome the impact of expected lower volume.
We do expect that our operating margins for the full year will be greater than 10%. We expect our net interest expense will be higher in the fourth quarter because of the full quarter interest at higher rate on our floating rate debt and lower rates on our invested balances and compared to the third quarter in which our effective tax rate was lower in the quarter as we adjusted to the lower expected full year tax rate, the fourth quarter tax rate will be normalized. Each of these will impact EPS by a few cents sequentially. Our 2008 outlook for adjusted diluted earnings per share is $2.95 to $3.
As I discussed earlier in the call, we have changed the basis for our guidance and this guidance is adjusted for the deferred revenue accounting in the wireless segment. Our previous guidance of $3.15 to $3.35 did not include this adjustment which we estimate it would be $0.15 to $0.20 during the second half of 2008. If we have included these adjustments, our previous guidance would have been $3.35 to $3.50. So, the new range of $2.95 to $3 should be compared to the range of $3.35 to $3.50.
As we look ahead to 2009, we envision a very challenging economic environment. We feel that our balance sheet and liquidity will work to our advantage and then as a lean Company, we could be nimble and opportunistic to satisfy demand when channel inventories are slim. We feel we have been taking the right steps to be ready for difficult times consistent with our management philosophy and historical action and we will do the best we can for our customers and our shareholders.
Thanks to all of you on the call for your interest in Belden. This concludes our prepared remarks. We now have some time for your questions. Our operator, Trisha, will remind you the procedures for asking your question.
Thank you. (Operator instructions) Your first question comes from Celeste Santangelo – Merrill Lynch.
Celeste Santangelo – Merrill Lynch
So, question, the operating margins that you talked about for '08 was above 10%. Can you just talk about relative to your prior comments of long-term target of around 15% and does that still hold or what kind of timing or margin progression should we be looking at for '09?
Well, Celeste, in December we are going to have an analyst meeting where we are going to update our thoughts and our goals going forward. So, that will be the best time for us to comment on that but clearly in the fourth quarter, we are expecting that the economic environment is not going to be good. We think that that will continue at least into the first half of 2009 and therefore that is going to have I think some impact with regards to the timing of the goals that we set for ourselves but clearly our path is the same. Our strategy is the same. Our expectations are the same. I think it is really a matter, Celeste, of what is the reasonable period of time for us to set for us to get there given the fact that the economy is in our view deteriorated quite substantially from the last time we updated those goals and those targets.
Celeste Santangelo – Merrill Lynch
Right, okay. And then just a quick question on the profit delays and cancellations that you saw in India, can you just provide maybe a little more detail what kind of projects those were and maybe the timing of it. Did that all happen the last few weeks of September?
We saw a pretty significant change in September from what we saw in July and in the second quarter. August is always a tough month for us because we got price of the world that slowed down and then of course with the Olympics at China that made it a little bit more difficult to understand what was happening but September was fairly pronounced in terms of a decline in business but as it relates to the project delays, they come across or I should say they exist in many different end markets but I would say that they are the most acute within the IT sector in the financial community. So, financial institutions that were spending fairly robustly in IT are slowing down dramatically. We saw projects get pushed out. We saw projects that get delayed. We saw projects get canceled and we think that these companies will continue to manage their cash flow very tightly, manage their IT spend very tightly and we think that that is the trend that we should prepare for.
Your next question comes from Matt McCall – BB&T Capital Markets.
Matt McCall – BB&T Capital Markets
Gray, I think you talked about some of the impact from inflation in the quarter. I guess if you looked at some of the trends at least in some of the spot that we have, you referenced logistics and compounds specifically with oil prices coming off, are you expecting any benefit to show off in Q4 and if so, is that baked into the numbers and if not, should you see some as we move in '09?
The inflation reference is really more so like commodity volatility as a better descriptor and yes, we saw significant price increases from many of our suppliers in the third quarter that affected the third quarter by about $5 million and because of our FIFO methodology, a lot of that is still on the balance sheet because of the first-in, first-out methodologies that we follow with inventories. So, we are going to still have a little headwind here in the fourth quarter. We have seen pricing easing from many of our big suppliers, their recognition that their core cost, petroleum based cost have indeed been reduced, we are starting to see the relief associated with the end prices associated with those commodities and resins here in the fourth quarter and that should be beneficial to the first quarter in 2009.
Matt McCall – BB&T Capital Markets
Okay, and then remind us that is the $5 million was a headwind for Q3. Holding everything constant, knowing what you know today, what would be the headwind for Q4 and then what would that make the total for this year?
I think, we are thinking the total is about $15 million across the entire year and I would suggest that the fourth quarter will see little degradation or little improvement if you will associate with that condition. So, for the fourth quarter right now, we are expecting the inventory position that we have established to dictate the results for the quarter and not necessarily changes in the underlying cost of the commodity.
Matt McCall – BB&T Capital Markets
Okay and does the $15 million, does that include the impact of the copper? With copper off as much of it over the past month or so, what is the impact that is going to be? I assume there was not an impact based on products so there was not an impact in Q3 but what about the impact of copper as we move forward?
The discussion we just have was around non metals based variations in our cost of goods sold. With respect to metals, the volatility in coppers that are remarkable to say the least I think was in $1.82 yesterday or at least a little while but again we are on FIFO so there is a period of time under which the third quarter purchases we need to purchase through our cost of good sold. I mean if we turn around, as we mentioned, we turn around six times so that is about two months of inventory that has to run through the cost of good sold and then in December, we will start to recognize the October level of copper purchases but that is accounting. The real economics under this circumstance is our price is holding in our markets and right now prices are holding. Prices through October had been fairly stable. There had been some pass-through as you would expect and desire pass through in order to be able to win good project business and sort of for price on the metals benefit.
But our business model and we have said previously and we will reiterate it here Matt is totally indifferent to copper where the values on copper to copper is not part of the copper. I mean our job and our responsibility every quarter is to neutralize the effect and we work obviously a lot harder during times of volatility both up and down to neutralize that impact and that is what we are seeing right now as a lot more management energy centered around the sharing that would neutralizing the impact of the underlying commodities whether they are copper by the way or conversely to minimize the impact associated with other commodity changes that we just articulated with respect to compounds and freight expenses.
Matt McCall – BB&T Capital Markets
Okay, I guess as I look at the guidance and I look at Q4, I think John you said around $500 million and I look back. I mean you have been one of these years around $511, you are $530 here but it looks like the implied margin range is in the 9% to 9.5% range and I guess I am trying to understand outside of commodities the overall volume levels do not seem to be that much lower, I am trying to understand what is causing that deterioration in such a quick fashion.
Well, Matt if you look at the revenue makeup in Q4 and you are right about the operating margin, remember the fourth quarter revenue would include the Trapeze acquisition if you were to compare for example in the first quarter where we arrive to $500 million, it did not include Trapeze. So, what we are expecting in the fourth quarter is that our legacy business is going to see deterioration from the third quarter in terms of revenue. So, I think as you do the projections, what you will see is that the projections that we have for the fourth quarter as it relates to coming out from the third. It is really volume based.
Your next question comes from Jeff Beach – Stifel Nicolaus.
Jeff Beach – Stifel Nicolaus
I have three questions. One, you have talked about inventory, channel partners, it appears as though the steep decline in demand is kind of backed up in the system and it appears as though looking into the fourth quarter here as the channel partners correct inventories and then you do that you will probably do some idling of plants versus second quarter, third quarter more, fourth quarter more. I would like to know if that is the case and can you expand a little bit on this and how this is impacting the guidance. It appears as though it is going to be a meaningful impact in the fourth quarter.
Well, yes I think first of all as I mentioned, the sell-through data that we had in the third quarter was far better than our revenue comparisons which means that the products, our product going out of our distributors door to customers was a lot better than the shipments from us to our store distributors both sequentially and year-over-year. So, clearly part of the revenue decline we experienced in the third quarter is the change in the inventory manager and our channel partners which is understandable. They are preparing for a weaker economy. They are managing their working capital more closely, they are trying to figure out what to do with commodities coming down, should they wait for better prices. These are all understandable.
In the fourth quarter, what is not clear to us is whether or not there will be any change in that direction with our channel partners with the inventory. At this point, we are not expecting that we are going to see any sort of meaningful inventory increase in our channel partners in the fourth quarter and we think that the end markets could deteriorate from the third. So, as we think about how we manage through that, Jeff, what we are trying to do is really two fold. One is make certain that we are true to our long term strategy as it relates to the investments that we want to make in the Company that having the right competitive manufacturing footprint globally. So, we are evaluating whether or not there are actions we should take now that were already part of our long term strategy that perhaps should be taken sooner.
Secondly, of course, we are going to flex our cost structure in all parts of the world in a way that is appropriate with our current demand above and beyond our footprint strategy. So, we are looking today at our headcount around the world to make certain it is appropriate given what we think is going to be a recession that will be here with us for a while and make certain we are appropriately for it and have the right headcount. So for us, Jeff I think what you will see is any actions that we take will be entirely consistent with what we have laid out over the last three years as it relates to the strategic direction of the Company and I think Gray mentioned we want to make certain that we have a good regional manufacturing footprint. We want to make certain our capacity makes sense. We want to take advantage of low cost regions wherever we can and we are just going to continue doing so and some things might happen a little sooner and some things might get a little delay given the economic environment.
Jeff Beach – Stifel Nicolaus
Alright. The other two questions, I would like you to expand a little bit on Specialty products. The margin was hit pretty hard in the second quarter and I know that you were going through this shift of closing production and shifting it into Mexico and so in trying to describe the margin degradation in that area, can you address how much is meaningful at that related to plant closings and then discuss for a minute what is happening in category size cable profitability as the volume is declining there and really pressuring the margins abnormally relative to other product categories and then as to the third question, Gray had said earlier you come back and mentioned VSOE and I may have fallen asleep but I do not remember him or you going through that a little bit and the expectations or when you might achieve it. Thank you.
Yes, Jeff, let me start with the second and I will turn over to Gray with VSOE. There are really two things within Specialty going on that have really little to do with end market so let me address those numbers in market. First as Gray mentioned, there is a change in the amount of inter company revenue within that segment which has an unfavorable impact on the profitability and as you said there are cost associated with the relocation of the Connecticut factory that once those get behind us and we have our production in Nogales, Mexico that will get substantially better as well.
From an end market point of view, there are two things that we did deal within the third quarter. One is as you said margins have been pressured on the lower end category products that affect us on a lot of business. That is a real trend that we are working against and of course our manufacturing footprint is a big part of that strategy. The second issue is that within our Thermax business which supplies cable equipment to the aerospace industry for in-flight entertainment, we have seen a real weakening in demand as our domestic customers, US airline companies are delaying spend associated with upgrades of their aircraft so that business continues to be strong on the international side of the business but domestically, it has weakened somewhat and that has affected the margins very dramatically.
Let me pass it to Gray to talk about VSOE.
Thank you, John. Jeff, we got a lot of progress with respect to where we need to be on VSOE. So, there are really three elements and that is the fundamental documentation that you are collecting, the processes under which you collect that documentation and organize that documentation for review but probably most importantly, it is the behaviors and the action of the business group to put into place the standard methodologies to assure that you fit and your data fits around a certain point for clarity but defends the fact that you got an arms length third party transaction on the bundled sale. So, those are the three pieces and I am encouraged by the efforts in all three areas. Trapeze has made a remarkable progress. I will say that there was an opportunity in the quarter for us to actually declaim a subset of the revenue of this quarter much, much, much earlier than we had anticipated in our original guidance and that is because the processes inside of Trapeze are a lot more mature right than what we originally believe to be the case set when we gave the original guidance.
But there are two elements that made us decide otherwise and I would like to spend a little time on that and then when we are together in December, I will give more specifics associated with where we stand on VSOE and most importantly what that means for 2009. But the first is, we had a discussion with so many of our investors and analysts including you that suggested that we, the level of transparency that we should be providing on VSOE should be very, very high. So, management decided that we were going to pro forma all of the VSOE irrespective and therefore the need or desire to accelerate in this particular quarter or any quarter was diminished because now you can see the segment results as if VSOE has been accomplished and therefore, the transparency that the real operating performance of the business unit.
The second is with respect to the literature and the literature is enormously complex. It is subject to broad interpretations. There are many specialists that do not necessarily agree and even these levels of experts and their confidence and our certainty around their confidence was not high enough at the end of the third quarter for us to proceed with that level of confidence that you would want. So, therefore we saw no benefits of accelerating VSOE until sort of the vague reason of the expert opinions could be consolidated and we would be comfortable with great certitude like that we could take VSOE and not look backward.
Jeff Beach – Stifel Nicolaus
Just as a final, do you still expect VSOE to be achieved in 2009 so it becomes essentially a non issue?
In my comment, I actually said there was a subset that was accelerated on the, that we potentially going to be hearing in Q3 2008. So, I would say we are way ahead of schedule associated to what our expectations are except for the following. We are way ahead technically. We are way ahead process wise. We are way ahead in terms of elements that you have to do to fulfill VSOE but we are not way ahead associated with the sort of the vague reason in the interpretations and again our understanding and the opinions that you get even from experts are challenging, are complex and challenging. I am going to spend a little extra time with you and discuss some of the inputs we have received from the various experts sources so you get a better feel for it.
(Operator's instruction) Your next question comes from of Nat Kellogg – Next Generation Equity Research.
Nat Kellogg – Next Generation Equity Research
Hi, guys. Just a couple of quick questions. I think most of the stuff has been answered but John and Gray, I was wondering if you might be able to touch, I know there has some questions that are sort of the impact of falling commodity prices on margins but just curious, I mean I would assume obviously this does have a benefit for you guys of being able to sort of accelerate some of the dollars in working capital down over the next couple of quarters and I was just wondering if you guys can give any sense of just how meaningful that might be over the next six to nine months.
Well, I think Nat you are right. I mean I think on a quarterly basis on average, the amount of copper that we purchase is roughly…
Thirty million pounds.
Yes, 30 million pounds. So, the average spot price in Q3 of copper is $3.50 roughly as Gray mentioned, it is straight and it is lower to $1.85 in the last couple of days. There is obviously an enormous amount of volatility right now so it is difficult to predict with any uncertainty where it is going to be but as we manage through this cycle of purging out the older higher cost copper and we start purchasing lower cost copper, it is going to have a positive impacts of course on our turns. It could have a positive impact on our margins to be on how pricing goes. So, I guess the one good news about a slowing economy is the commodity prices fall and that can have a benefit to our income statement but a great sense we always manage the business as copper neutral and we think the value is really independent of copper and I think we have done a pretty good job of managing that in the way up and the way down in the past and I think we will do that again but going into 2009 I said that one thing right now that looks fairly good is the fact that commodity prices are easing which is positive and if it could be stable, that will be even better.
Nat Kellogg – Next Generation Equity Research
Yes, I think that would make every one, experts like you get an operating basis and also trying to look at and see what is going to happen down the road. Do you even know the fact that you guys are going to generate some cash over the next, going forward? Can you guys talk a little bit about sort of priorities on how that might get spent?
Yes, how we use our cash is always a top priority for us and I would say that for us, our priorities are unchanged. The first priority always is to make certain that we have sufficient liquidity to run our business appropriately and make certain that we have the cash on hand to make good CapEx investments in technology and organic growth initiatives, making certain that we have cash on hand to make good investments in our retail manufacturing footprint where it make sense. That is always our top priority and then following that is good strategic acquisition that can make sense and right now I would say that we are far more cautious about acquisitions than we were six months ago given the economic environment. I think as visibility improves and our confidence level improves in terms of what the economy is really doing then we would be of course anxious and interested to make high quality acquisitions, that we would make a positive addition to the Company. But right now we are just very, very cautious about that given the economic environment.
Nat Kellogg – Next Generation Equity Research
Okay and then just last question for Gray and I do not want to be the dead horse in the VSOE and I realize to some extent it is sort of accounting semantics but I think you guys had recently said that you really did not expect to achieve that until the end of the 2009 that we would see sort of things on a normal basis and 2010. It sounds like if you could pull some of the, so I guess my two questions is one, is there a chance that this is going to happen a fair amount earlier than maybe you had previously spoken and then the second question was it would be to my understanding that it was sort of an all or non thing and it sounds like maybe that might be more incremental that you could pull some of the revenues into the normal GAAP result but not all of it is sort of maybe a stair step type of thing. So, I am just wondering if you could answer those two questions for me.
Absolutely. To answer the question number one is yes, our conservatism with respect to how we guided and our knowledge around VSOE in general indicated that we wanted to be prudent with respect to what guided and we clearly are accelerated off of that schedule so the answer is yes. With item number two, this is a very interesting curiosity. The curiosity being is it an all or nothing kind of orientation associated with a single pool right of transactions or conversely do we have five pools of transactions. So that is one of the areas where the experts do not necessarily agree and when the experts do not agree, take a step backwards is our position to make sure that you have the underlying principles understood. So that when we you do argue a position you got all of the experts' opinions taken into consideration and we did not feel we were in that position at the end of third quarter to take a subset that would have been one of five subsets that has now been potentially identified for independent evaluation for VSOE.
So, management here said, "No, we are going to wait and continue at that circumstances under which a subset could be recognized, make sure that it is validated with the respect to a broad set of experts and then at that point in time if that is the case, we will begin the revenue recognition position. But basically it looks as follows. We got two from the middle of the different business models; one is OEM, the other one is direct sale. The direct sales has three regional orientations right on the diversification of the portfolio of OEMs really falls onto two categories so we have five subsets that we are looking at right now and all of them have individual or independent elements but they also have collective elements and therein lies the complications we are dealing with. I know that is a long winded answer but the fundamental is yes, we are in better condition that we thought we were and yes, subsets are possible not just aggregate.
Nat Kellogg – Next Generation Equity Research
Okay that is helpful. I realize that it is complicated so I appreciate you taking the time. Alright, that is all I got for now so thanks very much for those for taking my questions.
Your next question comes from the line of Keith Johnson – Morgan Keegan.
Keith Johnson – Morgan Keegan
Just a couple of questions, most have covered most of the subject. You talked a little bit on project delays I guess in India earlier in the call. What about North America? What do you guys think that market from project standpoint?
We are seeing the same thing. We are seeing project delays in North America as well and that is actually I would say the amount of delay has increased here recently. We actually had a pretty good third quarter in our enterprise business because we I think, we did better job in managing our project business than we did in Q2 a year ago. So, we might have been a bit of outlier in Q3 in our enterprise business but in the fourth quarter, we are seeing delays, push outs, cancellations. We are also seeing a lot of push outs and cancellations in the Middle East right now. We are seeing it in Europe as well, so yes I had a comment about India but I would say it is very global in nature right now. IT spending is really coming down significantly. We do not know how long that is going to last but we think it is going to be with us for a while.
Keith Johnson – Morgan Keegan
Okay. So these projects you are talking about being delayed or canceled fully, I was just to try to make in my mind and I am thinking about them correctly, we are talking about projects that potentially a company takes the conservative stand and says we are not going to do anything in the fourth quarter, see where this plays out and by the time we get to first quarter of '09 maybe it sounded bad as we think it is going to be those projects are right back on for these very large scale projects that once you pull them off the ground board to get them cranked back up again you are talking about a six months delay?
Well I think that the projects themselves in most cases have good economic returns. I think the matter is whether or not they are affordable for the customer and so I think the customer can turn it back on as soon as they have a sense of confidence. The question that we all have of course is when are they going to get a sense of confidence and we do not know that.
Keith Johnson – Morgan Keegan
Of course, when you talk about, I think you made a comment about looking a recessionary type position, what is the kind of entered into 2009 a little bit earlier? If you kind of look at what you are thinking in relation to your fourth quarter guidance, how does that backup against the recessionary environment under your model today versus where you guys were in early in 2000?
Well I think there are a lot of things that substantially different about our Company today than the last time Belden went to a recession and I think you already see that in the result. First of all, our Company is a lot more diversified geographically, a lot more diversified from an end market point of view and lot more diversified from a product point of view. We have mentioned a number of times in the last recession we had an enormous telecom exposure for example that we do not have today. So, I feel very good about the Company's ability to manage through a recession. I think that the revenue decline we saw in the third quarter compared to a year ago and the fact that we are able to maintain our operating margins in that kind of environment, I think that speaks to a fact that this business is far better positioned to deal with economic shocks that it has ever been. So I feel actually quite optimistic about our ability to navigate through any sort of difficulties. I think we have a good portfolio businesses. I think we are greatly diversified from the end markets in geographies. I think we have a much better handle on our cost structure than we ever had before. I think we already have a plan going forward on our footprint, now it is just a matter of executing perhaps fashion on them otherwise. So, the balance sheet is incredibly strong. None of us likes this sort of environment of course but these are great opportunities for companies like Belden and I think to differentiate itself as a clear leader and that is the way we are thinking about it.
Keith Johnson – Morgan Keegan
I guess just one last question. Talking about inventory management within the different channel, to some extent North America has been slowing earlier than Asia and Europe or customers are already adjusting inventory balances coming to the summer in North America and to staying a little bit more paced or was it a significant adjustments you came through September quarter?
Well we have seen some amounts of inventory management throughout the year and we talked about that earlier but we saw a much, much greater attention to it in the third quarter and especially September. September was a dramatic change from what we have seen earlier in the year.
Keith Johnson – Morgan Keegan
Do you think a lot of that is related to more credit issues or more underlying market demand?
I think it is three things; I think there is credit concerns that our customers and our channel partners that they have to be mindful of their working capital. I think that they are clearly preparing for a slowdown and I think thirdly, with commodities so volatile they are wondering whether or not their inventory position is overpriced given what might be happening in the future and therefore they are being cautious.
Your next question comes from the line of Alvin Metranie - Golden Lakes Asset Management.
Alvin Metranie - Golden Lakes Asset Management
Just a quick question. Thank you for all the color you have given. You have not really told us what your competitors are doing in this environment and how some of the smaller companies that you compete with them thinking more of the enterprise cabling business and some of the other areas are doing. Can you just talk about what the competitive response has been whether it is competing with price they are trying to or cutting inventories or doing something and also maybe talk about some larger competitors and how do you expect that to play out?
Well I think it varies by region. We have already seen some of our larger competitors in Europe come out and say that their demand is weakening. Some of those companies are not blessed with the same balance sheet that we have and therefore they may not be able to do all the things that they would want to do some of the things we are going to be able to do. I think what we should expect around the world is that the environment was going to be competitive. That people are going to be looking very, very carefully at any opportunity that exists. I like our position obviously a lot better than theirs. I like the fact that we have got outstanding channel relationships that we can build upon. I like the fact that we have got an improving sales organization that creates end user demand and creates real hard specs and I like the fact that we have got a strong footprint to be able to take advantage of a cost structure and therefore be aggressive when we need to be on business. So, in the third quarter I would not say we saw an enormous change in the competitive environment. I would say that we are looking probably even more closely now than we ever have been in terms of how we go after projects and making sure that we are smart about our project business. Clearly as I mentioned, our LTK business continue to do great things in the third quarter on purging low margin business. We will continue to attend to that so I think the environment might get a little bit more competitive here going forward but it really is not a great concern of ours because I think we are well positioned to deal with it.
Alvin Metranie - Golden Lakes Asset Management
Okay great and then also just to add, I may have missed it, could you give us an update as to what you think cap spending will be for 2008 and where you can see it leveling at in '09 and in 2010?
Well I think our cap guidance for 2008 is unchanged. We have a project that is $60 million. We have projects committed to the new factory in Shuzou for example that we are going to finish of course and then we have not really updated our CapEx for 2009 and going forward. We will do that in December when we are all together but we are going to look at everything including CapEx to make certain it is appropriate with the new environment.
We are overtime. We need to cut out now. Trisha, I think we will have to stop here. Thank you very much everybody for good questions. If we did not get you please give us a call this afternoon. Thanks again for joining us on the Belden earnings conference call. We sincerely appreciate your interest and we will be happy to entertain your call for follow up questions. This concludes our call.
Thank you, ladies and gentlemen. This concludes our call for today. You may disconnect from the call and thank you again for participating.
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