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Executives

David Barta – VP and CFO

Henry Knueppel – Chairman and CEO

Mark Gliebe – President and COO

Analysts

Mike Schneider – Robert W. Baird

Andrew DeAngelis – KeyBanc Capital

Christopher Glynn – Oppenheimer

Nicole Deblase – Deutsche Bank

Holden Lewis – BB&T

Bill Dezellem – Tieton Capital Management

Sharad Patel [ph] – Jefferies & Company

Ron Elwood [ph] – Systematic Financial [ph]

Regal Beloit Corporation (RBC) Q3 2008 Earnings Call Transcript November 4, 2008 11:30 AM ET

Operator

Good morning. My name is Marcy and I’ll be your conference operator today. At this time, I would like to welcome everyone to the Regal Beloit third quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session.

(Operator instructions) Thank you. Mr. Barta, you may begin your conference.

David Barta

Thank you, Marcy, and good morning everyone and welcome to the Regal Beloit third quarter earnings conference call. Joining me today are Mark Gliebe, President and COO; and Henry Knueppel, Chairman and CEO.

Before turning the call over to Henry, I would like to remind you that the statements made in this conference call that are not historical in nature are forward-looking statements. Forward-looking statements are not guarantees since there are inherent difficulties in predicting future results and actual results could differ materially from those expressed or implied in forward-looking statements. For a list of those factors that could cause actual results to differ materially from projected results, please refer to today's earnings release and our filings with the SEC.

Now, I will turn the call over to Henry.

Henry Knueppel

Thank you Dave and welcome everyone. Thank you for your interest in Regal Beloit.

We will follow our normal agenda. I’m going to make a few opening comments. Dave will cover the financial aspects of the quarter. Mark will talk about our products and markets and operations, and then I’ll make a few comments regarding the look forward.

While we are currently operating in a turbulent environment, we are extremely pleased to announce yet another record quarter. Our teams delivered excellent growth in our power generation and industrial motors businesses as well as solid growth in our power transmission and international businesses.

We also achieved another stellar quarter of operational performance which yielded strong productivity improvements and we achieved earning accretion from the successful integration of the acquisitions we completed over the past year. We achieved these record results thanks to our strong fundamental led by our growing diversification in international markets and strong product platforms that benefit from substantial replacement opportunities and growing demand for energy efficient products.

In addition, we continue to ramp our company into a lean enterprise. While we have a long journey ahead of us, the results are now becoming clearly visible in all aspects of our company and we’re driving cost out of the business while improving our operational execution. However, like most companies, we are not immune to the economic headwinds that continue to strengthen during the quarter. The most significant headwind was commodity cost increases which totaled $29 million for the quarter. While we achieved significant price increases, the combination of timing and capture rates created a net negative impact of $13 million.

Secondly, the overall HVAC market which was down 8% continued to negatively impact our business. However, we are very pleased to report that our HVACR business which includes commercial refrigeration turned positive for the quarter, our first positive on a year-over-year basis in seven quarters. The improvement in revenue was driven by (inaudible) volume increases in July as well as a continued shift to more energy efficient products. All things considered, the third quarter was a very good quarter for us. Without the net negative impact of commodity costs, it would have been an incredible quarter.

In today’s uncertain market, investors are currently asking themselves, why would they want to own Regal Beloit or any other company for that matter? We think our investment thesis is rather simple but very compelling. It is based on three key points; strong fundamentals, accelerating growth levers, and significant unrealized value.

Our strong fundamentals include sufficient liquidity and flexibility to operate in a challenging economic environment. Our balance sheet is strong with debt-to-total cap of 37.8% and debt to EBITDA of less than 2%. Strong free cash flow in 2007 of $165 million and year-to-date in 2008 of $117 million or 109% of net income, and unused revolver of $500 million with a bank group that can and will fund. Fixed debts turned out at 7 and 10 years in October 2007 at attractive rates.

Excellent diversity in end markets, excellent and growing diversification into international markets. Strong product platforms in markets where the demand is high due to substantial replacement opportunities. And lastly an experienced management team tested under some of the most challenging environments and attuned to running a tight ship with the focus on operational excellence, cash flow optimization, and fiscally responsible spending controls.

Our levers for accelerating value growth include a global selling platform and manufacturing platform, and unmatched suite of energy efficient products that provides short cycle payback and substantive long-term benefit. Experienced management – experienced Lean Six Sigma company with valid history of demonstrating improving productivity. Recent acquisitions that open up new markets, expand our presence and market share, and provide significant cost-out opportunities, and a strong track record of putting successful integrating acquisitions given significant synergies, earnings accretion, and return on investment, while maintaining a flexible, healthy balance sheet.

Finally, the significant unrealized value was driven by strong cash flow generation that allows us to create sustainable shareholder value by consistently funding our dividend for 194 consecutive quarters and a high return on investment initiative such as our research and development that generates substantial profitable growth. In factoring in depth [ph] side opportunities I just discussed within the context of our current valuation which is low by historical and current industry standards, we think our investment basis is sound for the near and long-term.

Now, let me turn the call over to Dave Barta.

David Barta

Thanks Henry. Even though we’ve closed more on the end of this including more information on the release and publicly released last night, I’m going to spend less time on results by just touching on the highlights of the third and fourth quarters, and spend a little more time on debt and liquidity given recent events in the financial markets.

Approaching on the highlights of the third quarter, we have a solid third quarter from a sales perspective with volume slightly above our expectations. We saw solid results as noted in the release in almost every business unit. Overall, we’re gaining sales increase 10% partly due to price but also driven by the favorable mix of energy efficient products and volume.

On further breakdown, commercial and industrial motor sales in North America increased 9.1% which compares to 4.6% in the second quarter. Generator sales increased worldwide 25% and sales of HVACR as Henry mentioned were also positive for the first time in many quarters.

Sales in mechanical segment increased by 5.3% so that we did re-classify approximately $2.7 million sales from the electrical group – the mechanical group for the third quarter of 2007 that resulted in transfers of certain product sales in mechanical segment from the electrical segment. As mentioned in the release, our sales outside of the US were 26.8% of total sales versus 19.4% for the third quarter of 2007.

Including acquired sales, sales in Europe increased 16%, Canada 4%, and Asia 8.5%. Sales in Asia were again impacted by the loss of the business that we discussed in the second quarter. If we exclude that issue, our Asian sales would have increased 24%. High efficiency product sales increased up to 13.6% total sales which excluding the acquisitions was a 28.4% increase.

If you have any questions, we have included – we include in high efficiency category our motor mechanical products that offer an efficiency advantage. Example high efficiency HVAC motors, NEMA Premium and other high efficiency industrial motors, high efficiency commercial refrigeration motors, high efficiency generators, and high efficiency gear products.

Gross margins for the quarter were once again pressured by material cost inflation with material inflation exceeding the impact of pricing by approximately $13 million. The standard price [ph] of steel cost that continued to rise in the third quarter and will increase again in the fourth quarter and increases in copper and finished good purchases and component purchases. The GAAP also exceeded the top end of our guidance on both the price and cost items equation.

The tax rate for the quarter was 36% which was above our guidance. While we did receive the benefit of the repatriation of profits on our foreign stocks [ph] that may be included in our guidance, this benefit was offset by the distribution of income between certain foreign-based business and higher tax locations such as the US.

Turning to the forecast for the fourth quarter, our EPS guidance as presented in this morning’s release was $0.67 to $0.75 per share. Through October, the order rate was holding up well. That being said, we are certainly in interesting times.

For the fourth quarter, sales are expected to be in the range to $535 million to $550 million including the impact of the Dutchi acquisition. Because of continued increases in steel and the fact that we will not see much relief in copper prices, we’re expecting the material price gap to be in the range of $6.5 million to $8.5 million. We are using a tax rate of 36.2% for the fourth quarter which includes a continued unfavorable distribution income that was seen over the past two quarters netted against the positive benefit that we’ll receive from the federal R&D tax credit which has been extended retroactively through January 1, 2008.

We are forecasting capital spending to be approximately $10 million to $15 million in the fourth quarter, resulting in full-year CapEx of $54 million to $59 million, and we’d expect depreciation and amortization to be very similar to the $15 million recorded in the third quarter.

Overall, we continue to remain as confident as we can be in these times. We believe that our global commercial footprint portfolio of energy efficiency products, innovation capabilities will all continue to fuel the top line as markets get more difficult, as well our approach to productivity including the Lean Six Sigma, our global manufacturing footprint, and the opportunities that present and the fact that we’re already addressing avoidable expenses will be a support to margins lessening the impacts that market softness may have on the company as compared to prior slowdown for soft periods.

Finally, I'll spend a few minutes talking about our net liquidity position topics, which are certainly very important in today’s markets. We ended the quarter with $571.2 million of debt, which is only slightly above where we were at, at the end ’07 and at the end of the second quarter, and includes obviously the funding of the Hwada acquisition we completed in Q2.

Net of cash, our current debt was $457.5 million. Based on priority on the composition of the gross debt amount at the end of the quarter, we had $165 million in the term loan completed during the second quarter of this year with the floating rate notes due in 2013. We had $250 million outstanding under the private placement completed a year ago; as June trudges, $150 million due in 2014 and $100 million due in 2017. Both of these have been swapped to fixed rates. We have this $150 million in convertible notes that were issued in 2004 and are due in 2024, and we got $13 million outstanding on our $500 million revolver. That revolver we established in the spring of 2007 and is due in 2012.

Looking at this from another angle, 97% of our debt is classified as long-term and 68% of the outstanding debt at the end of the quarter will have a fixed rate of 32% and a floating rate. Our average interest rate weighted at the end of the quarter was 4.8%. From a covenant standpoint, we have two primary covenants; Debt to EBITDA and interest coverage. At the end of the quarter, our debt to EBITDA was 1.9 to 1, as compared to our covenant of 3.75 to 1; and interest coverage was 10.5 to 1 versus the covenant of 3 to 1.

And as we put on our revolver, I mentioned that we had $13 million outstanding at the end of the quarter, that leaves us $487 million available on the facility at the end of the quarter. We have a solid group of banks participating in that revolver and no significant concerns about their ability to participate in funding, although a couple may certainly have new homes after the current bank mergers are complete. So, to summarize, I feel extremely good about our debt structure, including the rates of maturities and our ability to continue to fund projects that will drive shareholder value into the future.

Now, I’ll turn the call over to Mark.

Mark Gliebe

Thanks, Dave. Good morning. During the quarter, we experienced sales growth in almost all segments. In spite of continuing difficulties in the housing segment and the overall economic uncertainty, the majority of our business delivered attractive top line growth.

During the third quarter, we experienced sales growth in our mechanical businesses, up 5% from the third quarter of 2007, and in our commercial and industrial motor businesses up 9%. Additionally, we saw a continuous drop of growth in our global generator businesses, up 25% from the same period in 2007. The robust growth in our generator business came from both China and North America.

In HVAC, our sales were also up for the third quarter, driven by two key catalysts. First, we are seeing a continued demand shift to our more energy-efficient products that we offer both in the HVAC segment, and particularly the new products we launched last year in the commercial refrigeration segment. Second, we experienced much stronger demand in our HVAC market as a result of our more focused efforts in that segment.

From the very beginning of the third quarter, we spent a considerable amount of time raising prices to offset fuel inflation that had a significant impact on our margins. By the end of the quarter, we raised prices in every segment of our business. One of our main challenges, however, was the timing of our price increases as compared to the timing of the steel inflation. The delay in our pricing increases put real pressure on overall margins. We were able to offset a portion of this margin erosion by aggressively driving productivity in all of our manufacturing facilities, and I’ll touch on that area more in a minute.

As you know, we have been working diligently to maintain and expand our leadership position in energy-related products. During the second quarter call, we talked about the increasing demand for our new generators serving the refurbished locomotive market. We continue to ship our initial orders for these new generators, and we are optimistic that the locomotive refurbishment segment will result in continued growth in 2009 and in 2010.

During the third quarter, we took our first order of yet another new product from our generator business; the new 1040 frame generator. The 1040 frame now represents our largest generator and produces up to 3.8-megawatt power. This leading edge generator marries up to a 20-cylinder diesel engine and allows the genset end-user to optimize the cost of their genset power array. The customer interest in this product has exceeded our initial expectations, and we will be showcasing the 1040 frame at the Powergen show in Orlando in December of this year.

Our new product focus continues to be around energy efficiency and energy-related technologies. We have a strong pipeline of innovative new products that will allow our customers to reduce their system costs through the use of more energy-efficient technologies. We plan to launch these new products in every quarter over the next five quarters.

From an operations perspective, we are delivering significant improvements in our factories. Both our customers and our shareholders will continue to benefit from design platform consolidations, product transitions to lower cost locations, and the implementation of Lean in every facility.

During the third quarter of 2008, we took three more critical steps to improve our operations. First, we transferred over 300 motor models from our Missouri facility to our Juarez, Mexico facility. Next, we moved the production of our transfer switches from Langley, Ontario to our Monterrey I facility. And third, at the tail-end of the third quarter, we started up our Monterrey II facility and began the transition of our smaller integral motors out of our Wisconsin facility to Monterrey II.

We will continue to deliver productivity improvements by driving the Regal Beloit operating system. This means a rigorous discipline around finding lower cost approaches every year. It means establishing a lean culture at every location, and it means having a global footprint to take advantage of low-cost regions. The result is that we will continue to provide excellent service to our customers while improving the return from our operations.

In August, we also implemented three significant IT projects that took us one step closer to our ultimate goal of putting the company on one single IT platform. First, we transitioned our Marathon Motors business from our legacy IT platform to our common Oracle ERP platform. This move gives the Marathon Motor business the necessary IT tools to better plan and manage their inventory and production. Additionally, Marathon Motors now has the capability to transact business in an online customer-friendly environment.

Second, we established a data warehouse that allows us to aggregate information a number of brands. And finally, we improved our logistics operation in Indianapolis through the implementation of new warehouse management tools. This also gives us the capability to better service our customers while more effectively managing our cash assets. These projects were investments that we made for the long-term growth of our existing brands and businesses. We are now better positioned to improve our operations and to more efficiently and effectively service our customers.

In September, we were very pleased to announce the acquisition of Dutchi. Dutchi is a $70 million motor distributor located in the Netherlands. While we already have sales of $50 million in Europe today, the Dutchi acquisition gives us a Pan-European sales force that we can leverage to gain a better foothold in this important geographic region. Additionally, Dutchi has sales offices in Singapore, Malaysia and Indonesia. These various geographies hold promising growth opportunities for our businesses, and we are eager to expand our products and services to new customers in these underserved markets. We are currently in the process of integrating the business and we are very excited to have Dutchi as part of our company.

In summary, we were pleased with our execution in the third quarter which led to record results for our shareholders and our employees. For the past several years, we have been driving a performance culture around innovation and operational excellence throughout our organization. Our teams have done a great job of implementing these strategies as our record demonstrates both in this quarter and in the last several quarters. As we move into the fourth quarter, we are optimistic that it will be another opportunity for the RBC team to prove to you that we can consistently perform even in the most difficult economic environments. Back to Henry.

Henry Knueppel

Thank you, Mark. As we look at the fourth quarter, the landscape has changed and not necessarily for the better. The fact that our order rates have held up and we have great new products and new market opportunities doesn’t change the fact that we, like all businesses, will be impacted by the economy. We have clearly felt the brunt of the housing market over the last two years and we will be impacted by what happens in the North American and Asian industrial markets in the months to come.

Fortunately, the housing market limits [ph] the downturn and is likely to leave in the upturn, thus turning a recent disadvantage into a future advantage. We will face additional headwinds from materials in the fourth quarter, despite the fact that copper crises have falling, we will get little benefit due to our disciplined hedging processes.

Further, steel will not come off with a tie for us during the quarter and in fact we will suffer an additional hit from reduced scrap prices. We will on the other hand continue to gain from productivity improvement processes and from additional synergies from recent acquisitions. Of all of these puts and takes, the big swing is the general industrial economy which unfortunately offers less sturdy [ph] than at any time in the last five years. As we speak, order rates remain solid.

Our fourth quarter projection of $0.67 to $0.75 per share represents a normal seasonal sales curve in non-continued materials cost escalation offset to a significant degree by excellent operating performance. While there is not great parity in our markets, we continue to – the credit markets are beginning to free up. Additionally, we see promising growth in Asia and there is still need to improve energy efficiency in residential and industrial applications.

We have an outstanding team of people that have been delivering excellent results all year against significant headwinds and they will continue to capitalize on the opportunities in front of us. We believe that through shrewd investment – to the shrewd investor, this is the time of opportunity and we believe that we have strong fundamentals, accelerating grown levers, and great value proposition to offer. We believe that the time of need ahead offers some of the added risk but also incredible opportunities for companies and investors that are prepared. We are confident in our ability to navigate these uncertain times effectively and efficiently.

And with that, we will open up for questions.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from the line of Mike Schneider with Robert W. Baird.

Mike Schneider – Robert W. Baird

Good morning guys.

Mark Gliebe

Good morning.

Mike Schneider – Robert W. Baird

Maybe first we can just start with the order rates comments. Henry, you mentioned that they've held up, but can you give us a sense, is that inclusive of price or maybe just in clarity as to what actually unit trends have done through the quarter and through October?

Henry Knueppel

Sure. As you look at unit volumes, we would have to say that in the industrial marketplace and industrial and commercial markets that we participate in, unit volumes have been relatively flat through the last quarter and as we’re starting into the fourth quarter. Certainly, HVAC has been negative in unit volumes. NEX has been helpful and particularly commercial refrigeration has been helpful, as well as I think a very significant replacement market. Let me take a look at, power generation unit volumes are up strong.

Mike Schneider – Robert W. Baird

Okay. When you said commercial and industrial was flat, you mean flat in units or flat sequentially at the same growth rate?

Henry Knueppel

Flat in units. And then in terms of sequentially, there is a seasonal trend as you know from past years. We will see a normal seasonal trend in the fourth quarter.

Mike Schneider – Robert W. Baird

And then your guidance for Q4, specifically are you assuming those trends continue into Q4 or do you assume a deterioration in unit volumes from those levels?

Henry Knueppel

Right now, based on our order rates, we would say it’s going to be a normal seasonal quarter.

Mike Schneider – Robert W. Baird

Okay. And then distributors versus OEMs, do you get a sense that distributors have de-stocked during the quarter or they will during Q4 based on your commentary?

Henry Knueppel

We saw some de-stocking early – well, late last quarter, in the second quarter, and early in the third quarter, but at this point they seem to be pretty steady.

Mike Schneider – Robert W. Baird

All right. And then on the hedging. David, you mentioned for the $13 million net impact on the trade of this quarter, did I hear you correctly that the net impact is $6.5 million to $8.5 million in Q4?

David Barta

Correct.

Mike Schneider – Robert W. Baird

Okay. So the headwind is fading. At what point do the lines cross, is it Q1 or Q2 based on current spot prices and your hedge position?

Henry Knueppel

Well, let’s make the assumption that current stock prices hold we would have to say that the fourth quarter is probably the peak, but it will not come off of that very quickly.

Mike Schneider – Robert W. Baird

So, are you – can we put some numbers around it, are you hedged for half-year copper needs in 2009 or something less than that and then steel as well?

Henry Knueppel

I think Mike, the way to think about it really is we will see – the fourth quarter actually will continue to be headwind. First quarter steel would be headwind on a year-over-year basis. Copper just start to be a small plus. And then in the second quarter, if things hold with the way they ‘re going right now, we would expect to see a tail end. And by the second half, we would be gaining full advantage of whatever the costs are.

Mike Schneider – Robert W. Baird

And have you actually seen your surcharges on steel and list prices on steel begin to decline?

Henry Knueppel

No. Unfortunately, what we are seeing is scrap prices decline so it’s more of an – it will be a bigger negative in the fourth quarter.

Mike Schneider – Robert W. Baird

Okay. And then if you could just revisit the last recession for us because investors are focused on basically what’s happened at each specific company during the last recession and I think at least there are some time to emphasize what’s new or different this time versus what occurred in 2001 and 2002 because margins at that point in electrical went from 11.5 to 7.5, call it in round numbers, so about 400 basis points decline. What was – you laid out what you’ve been doing in the past 12 months and even was currently with the business. But can you describe what may have been different in 2001 as well just about the timing or the path of that recession versus of what we have today?

Henry Knueppel

Sure, I will try at least. I’ll start and let the date Dave and Mark jump in whether they would like. But first of all, the recession in 2001 was a North American manufacturing industrial recession. We were a North American manufacturing industrial company. And arguably the capacity utilization rates in that recession were the worst they’ve been since the depression. So, I mean it was a broad side at us at time when we were pretty much single market oriented. Today, as Dave talked about, we’re nearly 30% with Dutchi and well over 30% of our sales are outside of the US, number one. Number two is the platform that we manufacture on is no longer a US platform; over 60% of what we produce is in low cost regions. And if you take a look at even the markets that we reach within North America, we’re not single market oriented, we have diversifications. I think those are big differences.

The global platform that we produced around today gives us continued opportunities to reduce cost. Mark mentioned some of the things that are going on during the quarter. This is a very active program, has been all year, has been for two or three years, and will continue. So, as you take a look at some of our lower-cost region locations. The fixed cost as a percentage of our total cost is lower, so our ability to respond to changing demands is perhaps better than it was when we were just US focused. Any other – I think the only other – no, those are the key points, Mike, that I would make.

Mike Schneider – Robert W. Baird

Okay, thank you guys.

Henry Knueppel

Thank you.

Operator

Your next question comes from the line of Andrew DeAngelis of KeyBanc Capital.

Andrew DeAngelis – KeyBanc Capital

Hi guys.

Henry Knueppel

Good morning.

Andrew DeAngelis – KeyBanc Capital

I'll hit back on this price/cost dynamic. I think coming into the quarter, you talked about that headwind being more in the range of $3 million to $5 million, and then coming in at $13 million is clearly a sizable delta versus your initial expectations. So I’m just – I guess I’m wondering where I guess that $9 million net change versus your initial assumptions came from? I know you mentioned timing on the price increases, but was it more on the pricing side or was it more in where the cost fell off?

David Barta

It was on both and on the price side as Mark mentioned. It’s a difficult environment. We’ve had repeatedly prices something that we know – let's not rush out and try to figure out how to execute price first, that's certainly is a discussion we have to have and it’s a tough discussion from our standpoint so it is from the customer. So on the price side, timing was a problem. And on the cost side, where we have good handle on steel costs and copper costs coming in for the quarter, I think we experienced more inflation on purchase product, so that there will be a complete product or components given again the pent up impact of material cost inflation on those suppliers to us. So, it's more in those areas, then again on a worldwide basis, this is something that we've seen in commodity cost increases roll through all of our businesses around the world. So a little bit of, I guess, a surprise there. And as far as the timing, more than anything on the pricing front.

Andrew DeAngelis – KeyBanc Capital

Got you. And then, I guess, how comfortable do you feel with your estimate at this point of 6.5 to 8.5 through the fourth quarter? Do you feel that you have the pricing in place in terms of meeting that range or –?

David Barta

Yes, we do. Obviously, when you have a number that you’d put out in guidance and you’re not there, you spend a little more time with it. So, at this point, with the visibility we have and the variables, we’re comfortable with that guidance.

Andrew DeAngelis – KeyBanc Capital

Okay. And I guess, overall, just looking through the release, hearing you guys on the call today, things sound relatively more positive versus maybe some of your other motor competitors. Just wondering what you’re seeing out there in the way of competitive dynamics, particularly with some of your competitors more highly levered.

Henry Knueppel

Well, I think from a competitive standpoint, North America has a pretty large set of competitors. They’re all good quality companies and good competitors in every sense. You really have a more diversified set of end-users, which may give us a little bit more comfort; but I would be hard pressed I think to come up with a lot of other reasons why there’d be big differences.

Andrew DeAngelis – KeyBanc Capital

Okay. And then, I guess this last question for me, any changes in terms of the acquisition landscape and your intentions with respect to acquisitions here in the near term?

Henry Knueppel

Well, we continue to have our head up and looking at what the opportunities are. We are not in a hurry. Certainly in the environment we’re in, we want to be cautious, frankly, from our cash standpoint and leverage standpoint. But we do think that there will be some pretty good opportunities that will become available during the course of this cycle. And certainly, we have a pipeline that has some good opportunities in it. So we’re going to continue to watch that very, very closely and we’re going to be cautious but not closed for business.

Andrew DeAngelis – KeyBanc Capital

Super. Thanks guys.

Henry Knueppel

Thank you.

Operator

(Operator instructions) Your next question comes from the line of Christopher Glynn with Oppenheimer.

Christopher Glynn – Oppenheimer

Thanks, good afternoon.

Henry Knueppel

Good afternoon.

Christopher Glynn – Oppenheimer

Just looking at the volume a little bit more closely, did you notice any buying ahead of price increases or not at all?

Mark Gliebe

Difficult, since I would say that as we were increasing price, we always give our normal 30 or 60 day lead time, and I would say there was some activity in the July time frame where we saw some of that behavior.

Christopher Glynn – Oppenheimer

Okay. That probably came back within the quarter then.

Mark Gliebe

That would be correct.

Christopher Glynn – Oppenheimer

Okay. And then the energy efficiency really seems to accelerate versus 2Q. Just in terms of understanding the dynamics around that, was that just a good season or did your share gains accelerate there?

Henry Knueppel

Well, I think Dave talked a little bit about growth rate in energy efficient products. We have a tremendous array of energy efficient products. We’ve been pouring R&E dollars into that for the last few years and our teams have really done a great job of understanding what the markets require and how we can add real value. So, we’re very positive about where we’re headed with that. And we believe that frankly, almost regardless of what the economy does, the need to reduce cost through better efficiency of energy usage is going to continue to be a critical component. So, we’re pretty bullish on what those opportunities are and they are growing and they’re growing strong double digit rates.

Christopher Glynn – Oppenheimer

And then just on the operating expenses from the acquisitions, the detail on the gross margin differential in the press release, can we get the overall operating dollars or performance of the acquired sales?

David Barta

It is not in the release, but I believe all the acquisition payment around probably about one a day [ph] 7% op margins plus or minus a little bit.

Christopher Glynn – Oppenheimer

Great. Thanks a lot.

Henry Knueppel

Thank you.

Operator

Your next question comes from the line of Nigel Coe with Deutsche Bank.

Nicole Deblase – Deutsche Bank

Hi guys, good morning. This is actually Nicole Deblase asking questions on Nigel’s behalf.

David Barta

Good morning, Nicole.

Nicole Deblase – Deutsche Bank

A couple for you. It looks like your inventory levels spiked a little bit in the third quarter. Is that just normal seasonality, is there anything else we need to worry about there?

David Barta

No. The inventory level did come up a little bit in the third quarter but nothing out of the ordinary.

Nicole Deblase – Deutsche Bank

Okay, and was there a favorable impact to gross margins on the back of that?

David Barta

I guess nothing significant. It was again more normal productions, so nothing significant.

Nicole Deblase – Deutsche Bank

Okay. Okay, got it. And then was there any impact on third quarter power demand due to hurricanes?

Mark Gliebe

I would say that there was a limited improvement in our business because of the hurricanes that we had a little bit. With the hurricanes, if you have the product in inventory, you’re going to sell it at the time that the hurricane hits. It’s come in two flavors; one, to provide backup power or emergency power; and then two, some people buy them after the hurricane comes because they feel a little naked. So, we did see a little bit, but I wouldn’t say it was a significant driver.

Nicole Deblase – Deutsche Bank

Okay, got it. And then one last one for you. On the mechanical side, mechanical power transition was obviously very strong. How much of that was pricing?

Henry Knueppel

We would say unit volume was relatively flat.

Nicole Deblase – Deutsche Bank

Okay, great. Thanks.

Operator

Your next question comes from the line of Holden Lewis with BB&T.

Mark Gliebe

Hi, Holden.

Holden Lewis – BB&T

Good morning or good afternoon now. Thank you. I just want to get a little bit more color on the revenue. I mean, if you looked at your organic trends, preceding Q3, the six prior quarters, you really have been putting low single digits and then in Q3, it really pops up into the low double digits. And then you’re looking at low to mid-single digits again in Q4. I was sort of wondering also if there was some hurricane effect, I guess, also HVAC proving the way it did. I mean, does that look durable as it appears? And maybe there are some units being built up ahead of new refrigerant rules or – it just seems odd to have gone from so flat to such a big number, and then assuming it goes back to its trend again. I'm trying to get a feel for the moving pieces there.

Mark Gliebe

Well, primarily on the HVAC side, I mean, there is – we don’t believe there’s any buildup going on, so there is no near-term legislation that would affect a buildup going on there. In terms of our products, as we commented, there was a shift to a better mix of energy efficient products both in the HVAC segment and in the commercial refrigeration segment. On the commercial refrigeration segment, that's a new product that we launched last year that’s gaining some traction supported by energy legislation in California and the rest of the US. And then, and we also saw some lift in the aftermarket during the quarter, most likely as a result of people tending to repair HVAC systems as opposed to replacing them.

David Barta

I got another comment on the HVAC. If you recall, we left the second quarter with a pretty strong HVAC market, driven primarily by weather – finally getting hot. And as we said in our call for the second quarter, that continued into July. So I think there was a little bit of favorable weather impact late second quarter, early third quarter as well. But just like the others, as Mark said, very efficient customers and very efficient distribution channel where they won’t hold, assets or inventory is not needed.

Holden Lewis – BB&T

Okay. And the reason you see it coming off in Q4, the growth rate is just because of the absence of the weather or is there anything else that contributes to that?

Mark Gliebe

No. I mean, as you'd probably know, fourth quarter is normally our seasonal low in HVAC segment, so it’s nothing different from what we’ve experienced in the past.

David Barta

Certainly beyond the HVAC piece, the rest of the story, and I think generators had just an outstanding quarter, up 25% worldwide, and it’s at the higher end of what we’ve seen to go back. Certainly, that’s recorded above but our normal view is that business is probably more of a plus 10% to 20%, so they had an outstanding quarter and I don’t see quite that strength repeating in the fourth. And on the commercial and industrial side, our view again beyond the seasonality is that whether a recession is there, whether we talk ourselves into it, it’s probably going to be a little more cautious market conditions starting in the fourth quarter and moving forward.

Holden Lewis – BB&T

Okay. And then you talked a little bit about some of the organic metrics but do you have a sense of what the acquisition wound up contributing at the bottom line?

Dave Barta

I did bring it in [ph] sales numbers out in the gross margins. And again, I think the opportunity margin is around 7%, so (inaudible) EPS calculation.

Holden Lewis – BB&T

Okay, thank you.

Mark Gliebe

Thank you.

Operator

(Operator instructions) Your next question comes from the line of Bill Dezellem with Tieton Capital Management.

Bill Dezellem – Tieton Capital Management

Thank you. Circling back to the fourth quarter, you may have already addressed this, but let me try this from a little different angle. To what degree do you have visibility into the sales for the fourth quarter versus really a need to step back and make an assumption about how difficult the economic environment will be and then apply that to your business?

Henry Knueppel

Well, we don’t have fantastic visibility, about 70% of what we ship in a month, we book in a month, and booked that same month. So we don’t work off along eight times a big backlog. That said, October is pretty much done, so we continue – our current order rates are continuing to be what we would have expected in the fourth quarter, but we don’t have a crystal ball that will look that far forward.

Bill Dezellem – Tieton Capital Management

Thank you.

Operator

Your next question comes from the line of Sharad Patel [ph] with Jefferies & Company.

Sharad Patel – Jefferies & Company

Hi. I wanted to cover just operations real quickly and just a few questions (inaudible) from that? Can you quantify the amount that you might have (inaudible) from the commission [ph] throughout this year and what the expectation you have for the full year?

David Barta

We haven’t broken out separately and I think it’s one or two probably won't [ph]. I think the one bigger part maybe we have given just our lean six sigma is that over the first couple of years, it was a $30 million benefit as far as cost taken out across the board, but beyond that, haven't discussed any gross numbers on productivity.

Sharad Patel – Jefferies & Company

Okay. And then on the acquisitions, we’ve discussed the operating – the gross margins below the rest of the business. What’s your expectation for where you can get that up to and over what time period?

Mark Gliebe

When we completed the major ones last year, we said that we thought over a three-year period, we can get them up to our company average. And at that time, our company average was in the 11% to 12% area, and we got a piece of that in year one which we did get and we met or exceeded what we said we would do, the remainder has to do with platform consolidations and those take longer.

Sharad Patel – Jefferies & Company

Thanks, guys. I appreciate the color.

Mark Gliebe

The schedule over the next two year is to hit the members that we talked about.

Sharad Patel – Jefferies & Company

Thanks a lot.

Operator

And your next question comes from the line Ron Elwood [ph] with Systematic Financial [ph].

Ron Elwood – Systematic Financial

This question is for Henry, Dave or Mark. You mentioned that the credit markets are fleeing out. Just wondering what you’re hearings from your customers with respect to that? (inaudible).

Mark Gliebe

El, I don’t think we’ve been hearing a lot from customers per se. We didn’t see customers get locked up in general, but I think it's more coming from our discussions with other companies and in the general marketplace, whereas a month ago, I would say it was reasonably frightening to have someone of the discussion about what was going on and what banks were doing and not doing. I would say today that things are starting – what we see and what we hear and what we hear out of our banks and our discussion with them, and what we hear off other people is that, credit is certainly more expensive but it’s available and banks are lending.

David Barta

We have met with the majority of our banks, it is obviously self interest, but certainly understanding how that impacts our business, although people generally aren’t financing any of our particular products, they obviously will be financing what our products go into, whether it's a large people capital equipment or a home HVAC system. I think it’s gone from a period of what I would describe, I guess, from our view point a complete chaos, we’re really – even as the lender didn’t even have an idea what their cost of funds are going to be and how to price things, what kind of credits they could look at to where I think there’s been some stability reenter as far as from availability and pricing perspective, and I think certainly they’re taking a hard look still at the credit quality of the borrower. At least a couple of the variables I think are starting to stabilize a bit and we've been positive as far as our customers' ability or the end-user's ability to finance a purchase of our product.

Ron Elwood – Systematic Financial

That’s great. Thank you.

Henry Knueppel

We'll take one more question.

Operator

Your last question comes from the line of Andrew DeAngelis with KeyBanc Capital.

Andrew DeAngelis – KeyBanc Capital

Hey guys, I just want to follow up real quick on the scraps deal issue. I was wondered, did you see any negative impact from that in the third quarter and what is implied within that 6.5 to 8.5, that headwind in terms of scraps deal in the fourth quarter?

Henry Knueppel

We did in the third quarter – obviously, the scrap market seemed to move on the front end of what (inaudible) so the scrap market started declining during the third quarter and I don’t have a specific number on that. But going on to the fourth quarter, that is going to be a couple of million dollars roughly hit to the company just because again the scrap prices are down. There are loss [ph] purchase costs so –

Andrew DeAngelis – KeyBanc Capital

Is that some thing that you look at on kind of a net basis after looking that your steel purchases or is that something that you breakout separately?

David Barta

It’s a different line to the P&L if you will. The scrap cost obviously net of recoveries is reflected as scrap at the manufacturing location and the purchases are inventory (inaudible) price variance. So it’s something that's somewhat separated in our financials.

Andrew DeAngelis – KeyBanc Capital

Got you. Thanks for that color.

Henry Knueppel

Okay. I thank everyone for joining the call (inaudible) Regal Beloit. As you know, we are in the midst of turbulent market conditions and economic uncertainty. Yet, in spite of the challenges we face in the short term, we remain confident in our ability to deliver strong results in a difficult environment.

Our great market diversity, continuing focus on innovation, and expanding global footprint have us excited about the future. We will continue to take steps necessary to remain the market leader in our industry and provide great value for our customers and shareholders. We appreciate your continued interest in our company and we look forward to talking to you again at the end of the year. Have a great day.

Operator

And this concludes today’s conference call. You may now disconnect.

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Source: Regal Beloit Corporation Q3 2008 Earnings Call Transcript
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