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EnPro Industries Inc. (NYSE:NPO)

Q4 2008 Earnings Call

February 12, 2009 10:00 a.m. ET

Executives

Don Washington – Director, Investor Relations and Communications

William Dries – Chief Financial Officer and Sr. VP

Stephen Macadam – Chief Operating Officer

Richard L. Magee – Sr. VP, Sec. and Gen. Counsel

Analysts

Todd Vencil – Davenport & Company

Gary Farber – CL King

Joseph Mondillo – Sidoti & Company

Rob Young – Wm Smith & Co

Operator

Good morning. My name is Kevin. I will be your conference operator today. At this time I would like to welcome everyone to the fourth quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks there will be a question-and-answer session. (Operator's instructions) At this time I would like the call over to Mr. Don Washington. Mr. Washington, you may begin your conference.

Don Washington

Thank you, Kevin, and good morning, everyone. Welcome to EnPro Industry's quarterly earning conference call. This morning, Steve Macadam, our President and CEO, and Bill Dries, our Senior Vice President and CFO, will review the events of the fourth quarter and full year of 2008 and our financial results in those periods. They will also discuss the current condition of our markets and how that affects our expectations for 2009. Following their comments, we'll open the line for a question-and-answer session. In addition to Steve and Bill, Rick Magee, our general counsel, is also here to participate in that part of the call.

Before Steve and Bill make their remarks I'd like to remind you that you may hear statements during the course of this call that express the belief, expectation, or intention, as well as those that are not historical fact. These statements are forward looking and involve a number of risk and uncertainties that may cause actual events and results to differ materially from such forward looking statements. These risk and uncertainties are referenced in the safe harbor statement included in our press release and are described in more detail along with other risk and uncertainties in our filings with the SEC including the Form 10-K for the year ended December 31st, 2007, and the form 10-Q for the third quarter of 2008.

We do not undertake to update any forward looking statements made on this conference call that reflect any change in management's expectations, or any change in assumptions or circumstances of which those statements are based. This call is also being webcast on enproindustries.com and the call will be available on the website. If your questions are not answered on the call or if you have any follow-up questions, contact me after the call at 704-731-1527. And now I will turn the call over to Steve.

Stephen Macadam

Thank you, Don, and good morning, everyone. Thanks for joining us today. When we look back at 2008 and look forward to 2009, it's clear we're at a very significant juncture. For 2008 we reported record results, made a number of important accomplishments to improve our company and support our growth. But clearly in 2009 we're dealing with demand contractions in a broad segment of our markets. We expect these conditions will result in declining sales and incoming 2009.

Nevertheless, we enter the year on sound footing because of the operational improvements we've achieved over the past several years, and the current strength of our balance sheet. These factors allow us to remain focused on our long-term goals of achieving operational excellence and significant growth while exercising judicious cash management.

At the same time we're taking aggressive steps to effectively deal with the current economic environment. I'll have more to say about those steps later in the call, after Bill has given you a review of the fourth quarter, and before we open the line for your questions.

But before I turn the call over to Bill, I'll make a quick review of our results in 2008. It was our sixth consecutive year of improvement in sales and segment earnings. We got off to a very strong start in 2008 and despite sharp deceleration in demand during the fourth quarter, we recorded record results for the year.

Our sales were up 13% over 2007, organic growth was 5%. Even though our heavy-duty truck and automotive markets were under pressure throughout the year and a number of our industrial weakened sharply late in the year.

The declines in these markets were more than balanced by strong oil and gas markets, steady demand from our power generation markets, and growth in our engine business. Acquisitions contributed growth of 6%. The primary contributors were the Compressor Products International operations acquired in the third quarter of 2007, and both Kaiser engineering and Air Perfection, which we acquired in the first half of 2008.

Favorable foreign exchange rates contributed growth of about 2%. Gross margins for the year were just under 35% and almost the same as in 2007, which I think is notable given the weakening markets we encountered in the last few months of the year.

On a GAAP basis, we recorded a 33% improvement in net income and a 41% improvement in earnings per share. GAAP EPS improved to $2.54 from $1.80. About $0.11 of that improvement was a result of the share repurchases during 2008. After adjusting our results for asbestos related expenses and other selected items, income improved about 8%. On an adjusted basis, earnings per share were up 14% to $4.29 from $3.75 a share. The lower share count contributed about 22% of that improvement.

Our 2008 cash flows gave us sufficient liquidity to use about $269 million to repurchase 1.95 million shares, close nine acquisitions at a net cost of about $43 million, make $37 million of net asbestos payments, and invest $49 million on capital projects. After those expenditures, which totalled about $200 million, we ended the year with $76 million in cash, compared to 129 million at the beginning of the year.

Much of our cash was invested in our future. Our acquisitions expand product lines and introduce us to new industries and geographic markets. They generate about $45 million of annualized sales and give us a larger platform of which to grow. We closed four of these acquisitions in the fourth quarter and we've already closed one more deal in 2009.

Our capital expenditures were focused on efficiency programs that will benefit cost and productivity. The programs include the modernization of Garlock's Palmyra, New York manufacturing center, where in 2008 we opened the second of two new facilities we've built on that site.

Overall, 2008 was a good year. We continue to grow and to invest, and we believe our accomplishments during the year will serve us well in the future.

Now I'll turn the call over to Bill to cover our results in the fourth quarter. Bill?

William Dries

Thanks, Steve. Although 2008 got off to a very strong start, conditions changed dramatically late in the year as the global economic slowdown picked up steam. However, despite the slowdown, our sales in the fourth quarter still grew by 5% over the fourth quarter of 2007 with $289 million.

Before the effect of foreign exchange, sales actually grew 9% with five points of organic growth and four points of growth from acquisitions.

Gross margins were 31.1% of the fourth quarter, down from almost 33% in 2007. The weaker performance in our engineered Product segment, which I'll discuss shortly, was the primary driver behind the decline.

Total SG&A spending was flat for the fourth quarter of 2007, and as a percent of sales it dropped by 80 basis points to 21.1%. Net asbestos expenses of $14.8 million declined by half compared to 2007, when we took a significant charge as a result on adjustments to the assumptions we used to estimate the liability.

Operating income was $12 million, an improvement of over $16 million from last year. And we operated an operating loss in the fourth quarter largely because of the effect of the asbestos charge in 2007.

Our tax rate of 34.5% was in line with our expectations after the third quarter. As we mentioned last quarter, the lower rate comes from the benefit of reductions and foreign statutory tax rates, certain European countries, and the reversal of tax reserves following the settlement of an audit. The lower rate translates to an earning benefit of about $0.10 per share.

On the subject of the tax rate, recent structural and organizational changes we've made in our European operations should reduce our effective tax rate for 2009 to less than 30%. In the years that follow, the exchanges should help drive our effective rate below our historical rate of 35-37%, but the rate is not likely to go below 30% again. Of course, the actual rate will depend on a lot of factors including the level and mix of our domestic and foreign earnings.

Interest expense was the same as a year ago, but interest income declined because of lower investible cash balances in 2008. New accounting rules for convertible debt will increase our annual interest expense in 2009 by about $5 million, although our cash interest payments won't change. A full discussion of the effect of the new rules contained in our third quarter 10-Q, and will be included in our 2008 10-K when it is filed later this month.

We expect the effect of this change in accounting to reduce our 2009 earnings by about $0.15 per share.

Net earnings in the fourth quarter were about $6.1 million which translated to $0.40 per share, fully diluted. That compares to only $0.08 in 2007.

Before asbestos related expenses and other selected items, we earned about $0.80 a share in the fourth quarter, with a benefit of about 5% from our share repurchases. Earnings on this basis were down 14% from the $0.93 we've reported last year. The primary factor in the decline is lower earnings in the engineered Product segment, largely due to its exposure to the OEM markets.

We generated $98 million in cash flows from operating activities in 2008. That was about $7 million less than in 2007. Earnings before interest, taxes, depreciation, amortization, asbestos related expenses, and other selected items, improved by about 10% in 2008 to almost $190 million. The improvement was largely offset by higher working capital levels which increased on a higher revenue base and $12 million more in net asbestos outflows.

Total payments for asbestos settlements and expenses declined by about $5 million to $110 million in 2008, however insurance collections also declined, falling to $73 million from $90 million last year. As a result, net asbestos outflows increased $12 million to 37 million.

While we believe total payments will continue to decline, insurance collections will also decline. We estimate the combined effect of lower totalled payments and reduced insurance collections in 2009 will produce net outflows for asbestos about equal to those we experienced in 2008.

Now looking at the balance sheet you'll see that our shareholders' equity declined to just under $400 million at the end of the year. Besides our share repurchase, two other items significantly impacted equity. One was foreign exchange. Foreign currency has weakened considerably relative to the US dollar in the last year, particularly in the fourth quarter, and the equivalent value of our foreign net assets decreased by about $32 million.

Second item relates to pensions. It will come as no surprise to you that we've experienced a significant deterioration in the funded status of our pension plans of 2008. The combined deficit in our US plans has increased from $12 million at the beginning of the year to $74 million at the end of the year. As a result, we adjusted our balance sheet at year end to reflect the increase in the deficit of the corresponding charged equity. Net of tax, that charge amounted to $36 million. You may remember that we closed the US defined benefit plans to most new participants a couple of years ago.

Because of the decrease in the funded status of our US pension plan, we currently expect to make a cash contribution to the plan of about $6 million in 2009 and to record between $14-15 million of pension expenses for the year.

Pension expense for 2008 was $4.8 million. We expect the additional expense to reduce our earnings by about $0.30 a share in 2009.

Now let's take a look at segment controls, beginning with the Sealing Products segment. Before the impact of foreign exchange, sales in the segment were up 10% for the quarter. However weaker foreign exchange rates reduced that by half to give us a net increase of 5%. Segment EBITDA improved by about $3 million and EBITDA margins improved almost two full points to 17.8%.

Looking at the businesses in this segment, Garlock continued to benefit from activity in upstream oil and gas markets, primarily driven by project work, but activity was higher in other parts of Garlock as well, and the business's sales, profits, and margins, were up strongly compared to the fourth quarter of 2007. Garlock also benefited from lower restructuring expenses.

Kaiser acquisition has contributed to the increase in Stemco's sales and profits, while Stemco's core markets remain relatively weak. (Inaudible) truck and trailer builds and truck ton miles are well below recent historical levels. Having said that, we did see a small increase in Stemco's legacy sales in the fourth quarter.

Of the two smaller businesses in the segment, Garlock Rubber Technologies had a good quarter with both sales and earnings up strongly. (Inaudible) Technologies reported a weaker quarter with lower sales a slight loss, as the business dealt with the effects of a plant consolidation and soft conditions in its team market.

The weakening global economy had a dramatic effect on results in our Engineered Products segment, especially at GGB Bearing Technology, and to a lesser degree, Quincy Compressor. Acquisitions contributed a small increase to sales, but not enough to offset the effects of foreign exchange and weaker markets. Segment sales were down 4% while segment EBITDA was down 35%. As a result, EBITDA margins dropped to 11.7% from 17.3%.

GGB sales were off substantially. The automotive side of their business, which accounts for about a third of their sales, weakened considerably in November when nearly every auto plant in Europe shut down for the rest of the year and when many plants in the US were on extended holiday shutdowns. GGB's industrial business also contracted sharply in the fourth quarter.

At Quincy, sales improved because of increased volume and the addition of Air Perfection, which was acquired late in the second quarter. However, profits and margins were down from a year ago as material cost increases exceeded selling price increases.

At Compressor Products International, activity levels were about the same as last year, and with a small contribution from acquisitions, sales were up slightly before the negative effect of foreign exchange. However, CPI's markets have recently grown soft as customers take a cautious approach to spending until they get a better handle on how the economic situation will pan out. That attitude is common across many of our markets.

In the engine product and services segment, sales were 29% higher than in the fourth quarter of 2007, based on increased engine shipments and higher aftermarket parts and service sales. The engines shipped in 2008 were more profitable, and segment EBITDA was 30% higher, and EBITDA margins improved to 18.4%.

I hope you'll take note that it hasn't been that long since this segment was posting single digit margins and even losses from time to time. Fourth quarter of 2008 segment had the best EBITDA margins in the company, which is quite a turnaround.

With that, I'll turn the call back to Steve.

Stephen Macadam

Thanks, Bill. As I mentioned in my opening comments, after several years of solid stable growth, we're now facing deteriorating conditions across a number of our markets and we expect both sales and earnings to decrease in 2009. However, our businesses have long histories. They've been through these cycles before. The fact that they remain market leaders, in some cases after more than a century, proves their resilience.

Six weeks into 2009, it's too early to speculate how the year will turn out in our markets, but industry forecasts indicate that most of them will decline, some by only a few percentage points, others as much as 25 or 30%.

On a consolidated basis, we expect that will result in an 8-10% overall decline in the overall activity levels of our markets for the full year of 2009 compared to the full year of 2008. Acquisitions we completed in 2008 will provide a small contribution to our full year sales in 2009, but the larger acquisitions we made last year were included in our results for most of the year. Lower foreign exchange rates will reduce both sales and earnings as our foreign sales are translated to US dollars. About 48% of our sales last year were outside the US, mostly in Europe. The current exchange rate for the Europe is about 15% below the average rate of 2008.

In light of these circumstances, we're taking aggressive steps to adjust our cost to the current level of demand. We've reduced employment levels, shortened work weeks, frozen salaries, reduced discretionary spending, implemented an aggressive sourcing initiative to control material costs and put other productivity improvements in place.

The actions we're taking, most of which are already in place, will likely require $8-10 million of restructuring costs, primarily in the first half of the year, but by the fourth quarter of 2009 we expect to be realizing approximately $15-20 million in annualized savings from these actions.

Market conditions and other restructuring expenses should have the most dramatic effect on our 2009 results in the first half of the year, and especially in the first quarter. We expect a very weak comparison against the first two quarters of 2008, which were both two of the strongest quarters we have ever reported.

This year, facility shutdowns in a number of industries and delays in spending by many of our customers as they destock inventories and take a wait and see attitude about the economy, lead us to expect very low volumes early in the year. However, we believe our circumstances should improve as the year progresses. Activity in our markets is likely to remain low, but we expect demand for our products to increase over the course of the year as our customers begin buying in order to stabilize their inventory levels.

We also expect to realize savings from our restructuring programs and cost controls as the year progresses. Our actions and modest growth in demand in 2009 should allow us to maintain gross margins in a rate similar to what we've reported in recent years, although they will likely be below the levels of 2007 and 2008 as a result of the competitive intensity we're experiencing in the market.

As I mentioned in my opening comments, we're fortunate to be standing on solid ground as we deal with the current environment. Our new product programs, and the businesses we've acquired in the past couple of years, should benefit us. We believe our balance sheet will allow us to take advantage of acquisition opportunities that are likely to occur in the current economy.

Our aftermarket sales are less likely to be impacted to the same degree by the economic downturn than our OEM sales. Although our customers may delay or postpone some activities, we believe they will continue to maintain and repair their facilities and equipment.

Our oil and gas and power generation markets have been important contributors in recent quarters, and activity in those markets remains relatively stable. The outlook is good for our engine business where the backlog is driven by defense spending rather than the general economic activity.

We have strong brand names, good market shares, and we expect there will be opportunities to gain share as markets soften and the competitive landscape changes.

Finally and perhaps most importantly, we have a strong balance sheet and liquidity sufficient to pursue opportunities to grow and improve our company in 2009. There's no doubt these are sobering times, but we're confident that we're on track to deal with them and deliver solid performance in 2009.

Thank you for your attention, now we'll open the lines for your questions.

Question-and-Answer Session

Operator

(Operator's instructions) And your first question comes from the line of Todd Vencil from Davenport. Your line is open.

Todd Vencil – Davenport & Company

Hey. Good morning, guys.

Don Washington

Good morning, Todd.

Stephen Macadam

Good morning, Todd.

Todd Vencil – Davenport & Company

So, the big thing I guess that surprised us in this quarter was the margin in engineered Products, and you talked a bit about in general the fact is they were behind and that's certainly on the demand side, also on the raw material side — can you give us a little more color on what's going on with raw materials and the price-cost balance and how you see that playing out going forward?

Stephen Macadam

Yes. I think late last year and certainly early this year we've seen a number of our raw materials turn south and start to fall in price, some of them significantly. In the engineered Products segment in the case of GGB, we actually had some contracts that were in place that played out through the year and into early 2009 that required us to pay higher prices that were bought ahead a couple of months. But other then that we've got pretty aggressive sourcing activities under way, and we expect our input material costs to be going down throughout the year.

Todd Vencil – Davenport & Company

And how's pricing working out? I mean, are you — I know that you had raised some prices there late last year, have you lost price or are you just having trouble kind of getting prices in, or how do you think that's looking?

Stephen Macadam

Well, we did get — we were pretty aggressive in the second half of last year in pricing in the market and we, for the most part, have been able to hold those levels. Obviously they're under a lot of pressure with the competitive intensity that's going on today, but our expectation is, as I said in the prepared remarks, that our gross margin levels — we'll be able to hold those this year through the combination of pricing discipline and some declining material costs.

Todd Vencil – Davenport & Company

Okay. And if you think about the operating margin there in that business, would it fall into the 6%-ish level from what's kind of a generally mid-teens kind of number. How much of that is what we've just been talking about which is price versus cost, and how much of it is maybe under utilization of plant do you think, Steve?

Stephen Macadam

Yes. It's tough to say. I mean, the engineered Products segment is composed of GGB Bearing Technology and Quincy Compressor, and of all the businesses we have, GGB is predominantly OEM. There is very little after market to that business, and that's a business that has 71 or 72% of its activity in Western Europe. And as I think everyone, it takes a little bit longer and it's a lot harder to adjust your cost structure in Western Europe than it is in the United States, and so that business, because of its exposure to the OEM markets and also, by the way, a third of its sales are going into the automotive industry worldwide.

So, because of its automotive exposure, because of its OEM exposure and because of the Western European manufacturing base, that's one where we've suffered the most on the operating margin line, and we've been working hard to get those costs in line, and quite frankly that's where we've seen also probably the highest level of destocking in our customers as well because that's obviously polymer metal bearings and typically our customers there can and have maintained a reasonable level of inventory. So, for them to take that down is not that big of a struggle for them. Now, there's a limit to what they can do, and we're hoping that that will stabilize as we go forward in the year.

Bill, do you want to add anything to that?

William Dries

Sure. Let me just add, Todd. Again, to give you some perspective, in the case of Quincy, we actually saw unit volume increases year-over-year in the quarter. Again, the issue there is primarily the price cost, and as Steve indicated, we generally will lock in most of our components a quarter to two quarters ahead. And so, when we saw the precipitous drop in the fourth quarter, we were not able to take advantage.

Having said that, now we're in for the new year, we are beginning to see fairly significant benefits on the costing side as we've repriced and readjusted based on the new commodity prices.

On the GGB side, it was a combination of both lower volumes as well as the price cost issue, and there in that case — Steve said in his earlier remarks, about a third of GGB's business is automotive sales wide, but more than 50% of their production in terms of unit volume.

So, when the automotive side slows down as it did, it has a fairly dramatic impact, and you see that in terms of the overhead and the absorption on that side of the business. So again, our anticipation is that that will start to recover as the year progresses, but in view of what's happened in the automotive industry, at this point we're down.

Todd Vencil – Davenport & Company

Okay. And so looking at that margin recovering through the year, do you think it's possible to get back to kind of a double-digit margin for the year? Is that in the outlook or is that asking you to look closely into the crystal ball?

William Dries

I'll give you my own view. I would hope to be able to get back into double digits, it is just that a lot depends, as you can well imagine, on the recovery and how quick or soon we're able to realize that. But I would hope that we should be able to get back to double digits.

Todd Vencil – Davenport & Company

And is the first quarter do you think, going to be more or less a repeat of the fourth quarter, or are you seeing enough price cost there to kind of help you out with that because the first quarter looks a bit better marginal wise?

William Dries

For engineered Products?

Todd Vencil – Davenport & Company

Yes.

William Dries

It's going to be a tough quarter, yes. Volume levels are down. Most of those automotive plants shut down in the middle of November and continued right on into 2009. So, it'll be a tough quarter.

Todd Vencil – Davenport & Company

Okay. And then final question for me, switching gears to the Garlock business. You mentioned that most of the strength, or a lot of the strength that you are seeing in that business is in the project side? Can you kind of give some color? Are you talking about new construction of plants there and where are you seeing that?

William Dries

Well, we have one product line within Garlock that we do quite well with that is selling gaskets into new oil field development around the world. And that was particularly robust in 2008, so we benefited from that. We expect that that will have some carryover because it's not easy to shut those projects down. They don't. They finish them. They just delay starting new ones and so that will probably exist through at least the early part of 2009, and then beyond that we really don't have visibility to make an accurate forecast.

Todd Vencil – Davenport & Company

Right. Thanks for that.

William Dries

Um-hum.

Operator

And your next question comes from the line of Gary Farber from CL King. Your line is open.

Gary Farber – CL King

Okay. Thanks. I just want to confirm a couple of things throughout on the call. Are you saying as far as gross margins for fiscal '09 that they will be less than fiscal '08, but probably better than fiscal '06, which would put you sort of in the 34% range?

William Dries

We didn't say that, but that's a reasonable conclusion, Gary.

Gary Farber – CL King

Okay. And then on cash asbestos, are you saying that roughly $37 million is going to be the cash outlay for fiscal '09?

Stephen Macadam

Yes. You got that right. That is about what we saw, because as we drive our total expenditure number down, we have, as I think everybody knows, a declining insurance program going forward and so we've tried to marry those up so that we can maintain that cash outflows in the same ballpark.

Gary Farber – CL King

And does that mean that the expenses amount on the income statement will likely mirror what happened in fiscal '08?

Stephen Macadam

Yes, Gary, when we adopted the change in the way we accounted for the asbestos liability, one of the benefits we saw was bringing more stability in removing some of the volatility in the year-to-year. So, the short answer is yes, we expect our expenses to be roughly in the same (interposing).

Gary Farber – CL King

Okay. And then can you quantify the aggregate amount of foreign currency dollar business that you felt in fiscal '08?

Stephen Macadam

Yes. It improved our sales by somewhere in the neighborhood of about somewhere between 50-60 million. The Euro was, on average for the year, up about 7%.

Gary Farber – CL King

Right. And you are saying a tax rate of 30% for fiscal '09?

Stephen Macadam

We should be a little bit below 30. We'll have some benefits associated with the change in the European tax structure and organization, so we should be a little bit below 30.

Gary Farber – CL King

Okay. And then just so I understand, pricing for your company as a whole — I don't know if you want to do it by operating segment. On a net basis, as you see fiscal '09, pricing will be a headwind or sort of neutral to your overall company?

William Dries

Our planning assumptions, Gary, going in — and again obviously it's a crap shoot, but our planning assumptions are that we will be able to offset any inflationary cost increases with price increases. So, we kind of don't plan a plus or a minus. We plan that we should be able to at least neutralize it. We hope to do better than that, but for planning purposes we assume that will be neutral.

We also, as Steve alluded to, we've instituted a number of programs and actions already, so we anticipate some actual cost reductions as we go through the year. So, on that basis we would anticipate that the price-cost ratio would be positive.

Gary Farber – CL King

And you're quantifying the net savings as $15-20 million in operating expenses in Q4?

William Dries

No. That's on an annualized basis.

Gary Farber – CL King

Okay. Annualized, okay.

William Dries

An annualized savings — by the time we get to Q4, that's what the annualized savings ought to be.

Gary Farber – CL King

Okay. And then just lastly on oil and gas, you're saying that that business sounds relatively stable. Is that a greater than 10% of revenue business for you?

Stephen Macadam

It's oil and gas about 12-13%.

William Dries

Yes. In aggregate, it cuts across a number of our businesses selling into that industry.

Stephen Macadam

12 or 13?

William Dries

Yes.

Stephen Macadam

It's about 12 or 13% of our total revenue.

William Dries

If you go to the investor presentation that we have consistently used with all the meetings with you guys and conferences we do and whatnot, the pie chart in there that indicates the end use markets that we sell into is relatively stable and accurate year-to-year. It doesn't move that much. So, our expectation for '09 will look a lot like it did in '08, so that's out there, Gary, if you want to —

Gary Farber – CL King

Right. Okay. And then just lastly, organic growth in first half of last year would have been in the 5-6% range?

Stephen Macadam

Actually, it probably was a little higher than that. I think overall for the year we were in the 5-6% range. We were obviously stronger in the first half of the year than the second half, so it's probably a little higher than that.

Gary Farber – CL King

Right. Okay. All right, thanks again.

Stephen Macadam

Just a little higher than that.

Gary Farber – CL King

Okay. All right. Thank you.

Stephen Macadam

You're welcome.

Operator

(Operator's instructions) Your next question comes from the line of Joe Mondillo from Sidoti & Company. Your line is open.

Joseph Mondillo – Sidoti & Company

Hi, guys. How are you doing?

William Dries

Good, Joe.

Stephen Macadam

Hey, Joe.

Joseph Mondillo – Sidoti & Company

First off, can you give us a little more color in terms of how the fourth quarter played out through the three months and then going into the first quarter. A lot of your products are short lead times, and with the severe downturn, I was expecting a little more for you guys to see a little more of the downturn faster. How is that playing out into the first quarter and how did you see it play out in the fourth quarter?

Stephen Macadam

Well, I think the best way to answer is that is just — first of all you got to look at it by aftermarket and OEM. If you remember that our company is about 50-50 OEM and aftermarket, and then there's a slide of the OEM piece that's the engines. Now, the engine segment also has an aftermarket component to it which did quite well in the fourth quarter and continues to do just fine.

So, if you take the half of the company that's OEM and you take the engine piece out of that, that's the part of the business that we felt the brunt of the economic downturn. Now, you got to remember, a small part of that OEM sales is also from our Stemco business which sells seals into the commercial truck industry, and that sector has been extremely weak from an OEM perspective for now going on a year and a half. It did weaken further in the fourth quarter, but we've already been dealing with extremely weak markets there.

So, I think as you think about the whole company, that's kind of how you got to remember. We've got this pretty strong moderating force that's the aftermarket and while that can and has weakened a little bit, it's nowhere near what we see in the automotive industry and other industrial segments that we're selling to OEM customers.

Joseph Mondillo – Sidoti & Company

Do you see that aftermarket business weakening further sequentially, or is that holding up?

Stephen Macadam

With the exception of what Bill indicated earlier, because we had a very strange period of time, I think, broadly in the industrial economy both in the US and in Europe where over the holiday period of time we had many, many of our industrial customers and us — we took extended down time. A lot of the auto guys, they literally shut down in late November, early December, and many of them didn't come back up until mid-January. Usually they come up right after the holidays, and we saw other equipment manufacturers and other industrial OEM customers that weren't quite as extreme as the auto guys, but they took a fair bit of down time over the holidays.

And so, it's just too early in the year, Joe. I mean, we're going to have to kind of wait and see how demand shakes out, because during that time period it was just a really difficult time. There was a lot of uncertainty. Destocking was happening, folks were just kind of on the sidelines waiting to see what to expect from others.

So, I think it was a bit, for us anyway, a hard time to try to make any forecasts or views on what the first half of the year is going to look like. I'm sorry I can't give you a better answer, but that's just what we were dealing with.

Joseph Mondillo – Sidoti & Company

Sure. No problem. Secondly, how's your backlog looking in the engineered Products and services segment?

William Dries

It's solid for the year.

Joseph Mondillo – Sidoti & Company

Do you continue to expect growth in '09 for that segment?

William Dries

I think part of it depends on what the aftermarket ends up doing. So far the aftermarket has held in there relatively well. Our backlog going into the year is 160 million bucks which is about 20 million higher than it was a year ago —

Joseph Mondillo – Sidoti & Company

For that segment?

William Dries

Yes.

Joseph Mondillo – Sidoti & Company

All right. And then lastly just one more question. The $0.30 per share of pension expense, do you expect that to be spread evenly over '09, or how is that going to look?

Bill

Yes.

Joseph Mondillo – Sidoti & Company

All right. Thanks a lot, guys.

Operator

(Operator's instructions) Your next question comes from the line of Rob Young from Wm Smith. Your line is open.

Rob Young – Wm Smith & Co

Hi. Good morning, guys.

Stephen Macadam

Hey, Rob.

Rob Young – Wm Smith & Co

I was hoping that you could just talk a little bit about the oil and gas market. I know that it's been talked about for a couple of questions, but how reliant that is on the spot commodity prices?

Stephen Macadam

I'm sorry, Rob. Can you say that again a little louder?

Rob Young – Wm Smith & Co

Oh definitely. I was hoping that you could comment on the oil and gas market in relation to the spot price for those commodities.

Stephen Macadam

In other words, how our demand varies on price of oil?

Rob Young – Wm Smith & Co

Correct. I mean, I think last call you spoke about 40 bucks as kind of a breakpoint in terms of when you actually expect that demand to possibly decline. Is that something that you're still seeing or at that current price are you still seeing some sufficient demand?

Stephen Macadam

Well, I didn't mean to imply that it kind of made it — there was any kind of discontinuity at the $40 level.

Rob Young – Wm Smith & Co

Okay.

Stephen Macadam

What I meant to communicate was what we hear from our customers is that in that $40 range number is when new project development starts to lose some economics and so obviously if it dips under $40 for a short period of time it doesn't, but if it stays — what is it today, 35 bucks or something? If it stays in that range for an extended period of time, then I think it's only natural to assume that exploration and upstream project development will flow and we serve that market, so we would feel that.

But again, a big part of our ceiling products business is aftermarket in both upstream and downstream oil and gas. So, it's not like we see it dry up completely.

Rob Young – Wm Smith & Co

Right. Do you actually have the specific numbers on that on how much there is aftermarket in that particular sector?

Stephen Macadam

In just oil and gas?

Rob Young – Wm Smith & Co

Yes.

Stephen Macadam

No. We don't.

Rob Young – Wm Smith & Co

Okay.

Stephen Macadam

But, in sealing products, sealing products in total was about 70 to 30 at the market — or actually larger than that, probably 80-20.

Rob Young – Wm Smith & Co

Okay. Great.

Stephen Macadam

That is sealing product overall.

William Dries

Sealing products, right.

Rob Young – Wm Smith & Co

Perfect. And then in terms of the engine sales segment, how do you see that evolving throughout fiscal '09? I know that the typical lumpy business — is that expected to continue or are the aftermarket sales in that segment as well tend to smooth it out over the longer period?

Stephen Macadam

Well, let's be clear. The reason it's lumpy is because of new engine sales and deliveries, and that's a very difficult for us to predict quarter-to-quarter, as we've mentioned in previous calls, because it is not uncommon, literally a month before engine delivery is scheduled for a customer to call and say move that two weeks later or two weeks early — which would put it out of the quarter. It's not like they come back and say we want to delay it six months, but it could easily push it from late one quarter into early the next quarter. That is why the business is lumpy. The aftermarket is relatively stable throughout the year.

William Dries

Right. The aftermarket is stable and on the engine, a pattern seems to have developed over the course of the last two or three years. We've been shipping, on average, 15, 16 engines a year. For the last two or three years, about half of those have happened in the fourth quarter. That's just the way the (inaudible) has setup their schedule and it can move quarter to quarter, but that seems to have been the pattern that's developed.

Rob Young – Wm Smith & Co

Okay. So, relative to last quarter in Q3 when I believe there were actually no physical engine sales, and I think you came in at around 21 million in revenue for that segment, is that a reasonable run rate for the aftermarket portion?

William Dries

Yes. Generally speaking — well, you can see the numbers. That's about $150 million business in total and generally speaking in a normal year, annualized over the year, it's about 50-50 parts and service and engines. So, if you divide that in half you get 75-80 million which is four times 20, so the answer is yes.

Rob Young – Wm Smith & Co

Okay. Great. And then just a couple more relative to the cost reductions that you had. You detailed that on your prepared remarks and I was just hoping if you could talk about just the morale of the employees as a result of your cost cutting initiatives.

Stephen Macadam

Well, we have — the good news is we've got most of what we are planning to do, done. It' sonly where we have to negotiate different arrangements primarily in Europe, that we're still working on some of that, and of course in Europe we've gone to short work in a number of locations. So, I think our employee base, for the most part, has seen what's happened. And I think quite frankly, guys when — I mean, you live in the same world we do, you're watching the news and reading the paper and everything else. I think the people that are still working in our facilities, quite frankly, feel good about having a job.

And so, we're okay. There is obviously some unrest in these times in any employee base, but overall, I think at most of our locations, I think our employees understand that we've gotten certainly the vast majority, the lion's share, of our personnel eliminations behind us, and we're moving on to try to figure out how we can take share and continue to improve the company and do the things that have made us successful over the last few years. That's really what we're focused on at this point. We've got a strong enough balance sheet. We don't have a lot of cash commitments for the company so we're still a strong generator of cash flow, and it's our intention to continue to invest in strategic deals that we find.

We've already done one, as I mentioned, this year. It's our intent to continue to invest in new product development where it makes sense in geographic expansion. Obviously we've got to protect our liquidity, but we're fine. I mean, we've got our cost structure in the right position for the demand and I'm pretty optimistic we're going to be able to take some market share because a lot of our competitors are a lot weaker than we are.

Don Washington

Let me throw in — Steve, that's a very good point. We're not shutting down. Commissions may be softening up, but we still see a lot of opportunity out there. To Steve's point, these businesses still remain very good cash generators and we will continue to invest in to grow the business, we will continue to look for opportunities that will arise out there in the acquisition front, so we don't plan on just stopping business. We see a lot of opportunity there.

Rob Young – Wm Smith & Co

Okay. I appreciate that. That's helpful. And then just lastly really quick; did you comment at all on your CapEx expectations as well as your working capital for fiscal year '09?

Stephen Macadam

Yes. We would expect our capital spending to come down. As we've said in the past we've had a number of projects ongoing over the last two or three years which has increased our spending into the mid to high 40 range. We would expect next year to drop down to a more normal range in the kind of mid thirties or so. And we would also expect our working capital levels to come down as well. Partly in response obviously to the drop off in activity, but we would expect to see some liquidation of working capital levels through minor, but some working capital levels will come down as well.

Rob Young – Wm Smith & Co

Okay. Perfect. Thank you very much.

Stephen Macadam

You're welcome.

Operator

And your next question comes from the line of Todd Vencil from Davenport. Your line is open.

Todd Vencil – Davenport & Company

Hey, guys. The prior questions actually caught a lot of my questions. DD&A, Bill, do you think pretty similar to the fourth quarter? Is that a good rhetoric for next year?

William Dries

Yes. We'll be up a little bit, Todd, just based on some of the projects that we put in place by the end of the year, but it should be generally in the same neighborhood, yes.

Todd Vencil – Davenport & Company

Okay. And now to beat a dead horse on the engines, but do you guys have just for the first quarter, any comments on that relative to last year relative to maybe a third of the — I guess you said you shipped 15 or 16 a year with half of them coming in the fourth quarter and I mean, is it pencilling out reasonably to be kind of a third of the rest of that in the first quarter (interposing) schedules?

Don Washington

Todd, in our relationship together, before it's all said and done, I'm going to get you to think outside of one quarter in the future. All right, buddy (laughter).

Todd Vencil – Davenport & Company

Absolutely. That's fine.

Don Washington

I would rather not make a prediction on the first quarter of the engine business. I think we've laid it out throughout the year, because honestly, we really don't know on these engine deliveries. So, I would rather just let you work with that.

Todd Vencil – Davenport & Company

Fair enough. Thanks a lot.

Don Washington

All right.

Operator

(Operator's instructions) Your next question comes from the line of Joe Mondillo from Sidoti & Company. Your line is open.

Joseph Mondillo – Sidoti & Company

Hey, guys. Just a couple of follow-up questions. First off, the restructuring charges that you're going to take in the first half, is that mostly severance payments?

William Dries

Yes.

Joseph Mondillo – Sidoti & Company

Yes? Okay. And then the Palmyra restructuring, are you going to see any benefit from that in '09 or is that a capacity thing?

Stephen Macadam

You're talking about the Palmyra modernization program —

Joseph Mondillo – Sidoti & Company

My second question, yes.

Stephen Macadam

Yes. Bill really hinted at that. We've invested a lot of capital in Palmyra —

Joseph Mondillo – Sidoti & Company

Right.

Stephen Macadam

— really going now back three years, maybe a little more than three years, and this year we completed our second and final new facility on that site. We did a lot of demolition. There's still some demolition to happen and some internal moves to existing facilities, but the capital burn rate will go down substantially because we've gotten the lion's share of that done. Now, that has been basically phased in over time. So, I don't think there will be any kind of step change noticeable financial — I mean, that's kind of been feathered in since we started this project, quite frankly. And we opened that new facility kind of just past midyear of last year.

Joseph Mondillo – Sidoti & Company

All right. And then use of cash; last conference call you guys were saying that you were going to use that mostly for acquisitions and it looked like you did. Is that still the same case going forward?

Stephen Macadam

Yes.

Joseph Mondillo – Sidoti & Company

And then finally, competitors or businesses that you said are faltering that you expect to take market share from, what businesses of yours will be taking market share, or what competitors I guess?

Don Washington

Well, I think that was a general statement. I mean, I think it quite frankly is across a number of segments. We're going into this period of time pretty strong relative to a lot of folks and so those that might come for sale I think we'll be able to buy them and take over all market share.

Joseph Mondillo – Sidoti & Company

Okay.

Stephen Macadam

I'm not sure we want to be telling you right now which specific customers we plan to —

Joseph Mondillo – Sidoti & Company

Yes, right. True. All right, thanks a lot, guys.

Operator

Gentlemen, there are no further questions in queue. We are ready for any closing comments.

Stephen Macadam

Okay. Well thanks, everyone, for dialing in, and we'll talk to you next quarter.

Stephen Macadam

Take care, everyone. If you, as I said earlier, if you have questions give me a call, 704-731-1527 and maybe I'll still have a voice. Thank a lot.

Operator

Ladies and gentlemen, this concludes today's conference call. You may now all disconnect.

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