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Barnes Group Inc. (NYSE:B)

Q4 2008 Earnings Call

February 19, 2009 8:30 am ET

Executives

Greg Milzcik - President and Chief Executive Officer

Chris Stephens - Senior Vice President of Finance and Chief Financial Officer

Brian Koppy - Director of Investor Relations & Communications

Analysts

John Haushalter - Robert W. Baird

Fred Buonocore - CJS Securities

Christopher Wiggins - Oppenheimer

Edward Marshall - Sidoti & Company

Matt Summerville - KeyBanc Capital

Holden Lewis - BB&T Capital Markets

Yvonne Varano - Jefferies

Operator

Good day, ladies and gentlemen and welcome to Barnes Group fourth quarter 2008 earnings conference call. My name is Mary and I’ll be your coordinator today (Operator Instructions). As a reminder, ladies and gentlemen this conference is being recorded.

I’d now like to hand the call over to the host for today’s call Mr. Brian Koppy, Director of Investor Relations & Communications for Barnes Group.

Brian Koppy

Good morning, and thank you for joining Barnes Group’s fourth quarter and full-year 2008 earnings call and webcast. This is Brian Koppy, Director of Investor Relations & Communications for Barnes Group. With me this morning are Barnes Group’s President and CEO, Greg Milzcik and Senior Vice President of Finance and Chief Financial Officer, Chris Stephens.

Our press release was issued this morning and for supporting information we have provided a slide deck containing key financial data in the Investor Relations section of our website. References on today’s call regarding income, diluted earnings per share, operating profit and other company specific financial metrics relate to continuing operations of Barnes Group’s businesses, excluding adjustments unless otherwise noted.

I also want to remind everyone that certain statements we make on today’s call, both during the opening remarks and during the question-and-answer session may be forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995.

These forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those contained in the financial statements. Please consider these risks and uncertainties that are described in our periodic filings with the Securities and Exchange Commission and are available through the Investor Relations section of our corporate website at www.BGInc.com.

We’ll begin today’s call with brief opening statements by Greg, then Chris will provide some financial details and then we will open the call up to answer your questions.

Now let me turn the call over to Greg.

Greg Milzcik

Thank you and good morning. As you all know the global economy is facing severe difficulty. Today I’ll bring you up to date on Barnes Group’s position and actions we have taken to meet these challenges. While the final few months of 2008 proved difficult for our businesses, the success we achieved through the first nine months of the year provided positive full year performance for the company.

Throughout 2008, we were vigilant in controlling costs and preparing for the down cycle. However, the unanticipated precipitous decline in demand experienced in the fourth quarter necessitated swifter and deeper actions. As a result, we initiated a number of discrete actions to adjust the overall cost structure, enhance our manufacturing footprint and strengthen our global operations.

These actions are expected to yield $40 million in annualized savings in 2009 and result in a fourth quarter 2008 after tax charge of $14.3 million or $0.27 per diluted share within continuing operations and a $5.6 million loss or $0.11 per diluted share from discontinued operations.

These actions generated reduced headcount, facility closures, business exits and lower spending throughout the organization and are expected to help alleviate the effects of declining demand. While these actions are difficult, particularly for the employees and communities affected, they are necessary to maintain our long-term financial and competitive position.

We demonstrated overall solid financial performance for the full year of 2008. Key sales and operating profit for employee measures continue to improve. Our operating income from continuing operations on an adjusted basis grew to 11.8% over the reported 2007 level of 10.9%.

2008 operating activities provided $111.8 million of cash flow. We lowered our interest expense by nearly $6 million and we were able to maintain a favorable tax rate. On a full-year basis, adjusted diluted earnings per share from continuing operations for 2008 was $1.99 compared with the reported $1.80 diluted earnings per share in 2007.

Throughout 2008, Barnes Group continued to position itself for long-term success. To strengthen the benefits of our diverse end markets and geographic mix, we reorganized into two global business segments. Our new structure strengthens our focus on the needs of our customers, leverages administrative synergies and eliminates organizational redundancies.

To support our favorable long-term view of the aerospace market, we continue to invest in our Singapore and Ogden, Utah facilities. To further streamline and enhance our focus, we exited the plastic molding business and certain non-core distribution businesses within the United Kingdom.

Now let me turn to our segments and provide some color on what we are experiencing and what we expect in 2009. The distribution business of the Logistics and Manufacturing Service segment was negatively affected by weakening demand across many of its end markets, while growth in our aerospace aftermarket business continued to be negatively impacted by deferred airline maintenance and lower capacity usage.

Operation and productivity improvements in the North American distribution business, which confronted sales force disruption challenges in the first half of 2008 demonstrated measurable year-over-year progress. In addition, the positive impact of profit contributions from the stable, recurring aerospace aftermarket business bolstered margins to 12.2% on an adjusted basis.

For 2009, sales growth under the current economic conditions will be a challenge. Our ability to deliver superior customer service, improve productivity through the implementation of lean activities and improve inventory management will alleviate some of the market pressures. In addition, our continued sales focus on retaining, penetrating and adding new customers particularly in targeted end markets should establish a strong base for long term growth.

Turning to Precision Components, it was a very difficult year given the revenue impact from declines in the industrial sector, including a severe decline in the transportation end market and the impact of the Boeing strike. Declines were partially offset by year-over-year growth in the aerospace OEM business even though we experienced an impact of approximately $25 million due to the Boeing strike in the fourth quarter.

Aerospace OEM benefit from the strength of its backlog, which was $460 million at January 1, 2008. The aerospace OEM backlog at the end of 2008 was $377.3 million. Considering the significant revenue declines, we are pleased with Precision Components ability to react to the marketplace and maintain solid margins. For the full year, the adjusted operating margin was 11.1%.

2009 will continue to be challenging for Precision Components, stresses in our end markets particularly transportation and our pressures on top line growth and operating margins. Within each business, activities are focused on improving productivity, reducing cost and increasing capital efficiency. We also believe that strength of our overall financial position will provide new opportunities for our businesses.

Precision Components is highlighting to the longevity and financial strength of Barnes Group to customers in search of high quality, dependable suppliers. Looking ahead, we will remain laser focused on maintaining a strong capital position in executing the Barnes enterprise system so we can improve our competitive position while navigating difficult markets.

Our capital structure is in good shape with no significant debt payments due until September 2012 and we have adequate credit available on our revolving credit facility. We have also put in place incentives and structures to improve our cash flows and position the company for future investments.

Our Barnes enterprise system continues to allow us to standardize, align and enhance our operational activities which are critical to our long term strategy. Our enterprise wide system strengthens our ability to meet and exceed our customer’s expectations for service, quality and delivery and further derive key productivity measures.

Despite the actions we have taken internally, we cannot control our end markets. Accordingly, our forecast has no expectation of any significant end market recovery in 2009. What we will focus on in 2009 is operating our company as efficiently and effectively as possible, while identifying and funding long term growth initiatives. We’ll make investments to leverage the upside opportunity for next year and beyond.

These investments include sales recruitment and sales training programs for our logistics business, additional capital equipment for aircraft maintenance and manufacturing programs and opportunistic marketplace to secure long-term production programs. Our outlook for 2009 reflects top-line base revenue declining 10% to 15%, including continued headwinds from a strong U.S. dollar. The actions we’ve taken throughout the fourth quarter have positioned us for the expected sales volume through 2009.

Operating margin for Barnes Group is expected to be in the 9.5% to 11% range for the full year 2009. As a result, our diluted earnings per share outlook for 2009, is in the range of $1.20 to $1.50 per diluted share. The range of potential outcomes remains wide due to the volatility of our end market demand. However, we believe our solid portfolio of businesses and our strong balance sheet will provide our management team the foundation to succeed.

Investments that we’ve made over the past few years including enterprise wide training and the development of the Barnes Enterprise System will be leveraged to further improve our productivity, achieve our 2009 goals and enable the company to weather this economic storm. For 152 years, Barnes Group has weathered many such storms. Despite the economic down-cycles of the past we have continued to grow and prosper and we expect to emerge from this one as a stronger more competitive company when the markets turn.

I’d like now to turn the call over to Chris Stephens, our new CFO who will run through some of the financial details, but before I do that I’d like to say I’m very pleased to have Chris join the leadership team and I look forward to working closely with him as a key member of the senior management team. Chris.

Chris Stephens

Thank you, Greg. It is my pleasure to be here. What I would like to do this morning is walk you through a number of items that are important to note when analyzing our financial performance. I will also build upon some of the comments made by Greg as they relate to our 2009 outlook. Let me first start with revenues.

[Inaudible] worldwide economic conditions caused significant volatility in many of our served markets, which adversely impacted our top line. The reported net sales of $265.4 million in the fourth quarter of 2008, is a decrease of 25% and full year sales of $1.36 billion is a decrease of 4%. The dramatic slowdown in the global economies exerted a significant amount of pressure on our ability to generate sales growth.

Particularly, we experienced sharp declines in the North America transportation market and in the aerospace market which was adversely impacted by approximately $25 million due to the Boeing strike. It is also important to note that the sale of Spectrum Plastics earlier in 2008 resulted in reduced full year sales of $11.7 million as compared to 2007.

In addition, during the fourth quarter and for the first time this year, foreign exchange headwinds impacted total sales. International sales were negatively impacted by $10.4 million in the fourth quarter of 2008 due to a stronger U.S. dollar and we anticipate that headwind will continue in 2009.

Turning now to cash flow; we continue to generate favorable cash flow from operating activities. As a result, we regularly review our decision on how to use that cash. During the fourth quarter, we used cash to fund growth initiatives, pay dividends and repurchase shares. Operating activities provided approximately $29 million of cash flow during the quarter and approximately $112 million for the full year.

Our total cash balance on hand is $21 million, in line with the balance at the end of 2007. Cash flow generations, along with our credit facilities are adequate for the company’s anticipated requirements. Free cash flow, which is cash from operating activities less capital expenditures, was approximately $60 million in 2008. This was lower than our 2007 level at 70.1 million, driven primarily by lower operating performance.

Looking forward, our goal is a cash conversion equal to or greater than 100% of net income. Overall, we are pleased with our cash generation considering the significant cash outlays incurred in 2008 and it is important to note that there were a number of uses of cash in 2008 that we do not expect to repeat or at least significantly reduce in 2009, for example; aerospace aftermarket revenue sharing investments.

RSP payments during 2008 were $57.5 million and reflect final payments on our current programs. Capital expenditures; for the fourth quarter and full year capital expenditures were $9.9 million and $51.9 million respectively. We planed to reduce 2009 capital expenditures to a range of $30 million to $40 million or a reduction of approximately 30%.

Working capital; we are aggressively attacking working capital to improve cash generation and we expect to improve overall working capital levels in 2009. As noted by Greg, we have put in place incentives and structure to make this happen and lastly, stock repurchases.

We were an active buyer in the fourth quarter. We repurchased just over 2.4 million shares at an average price of $13.34 for a total cost of just over $34 million and as Greg noted we are focused on running the business for the long term and we will continue to balance the company’s cash needs and priorities with our opportunities as we move through 2009.

Regarding dividends; during the fourth quarter the company paid a cash dividend per share of $0.16 and has declared a quarterly cash dividend per share of $0.16 for the first quarter of 2009. Barnes Group has paid a cash dividend to stockholders on a continuous basis since 1934 and the company remains committed to continuing dividend payments.

Turning now to highlights on our balance sheet; our debt to capitalization ratio was 46% at the end of 2008 compared to a 40% number at the end of 2007. The change was due primarily to an increase in borrowing coupled with the decline in stockholders equity, which was related to the share repurchases and the non cash impact of accounting for pension and the effect of currency translation.

Pension adjustment reflects the change in the funded status of our pension plans. The pension plan assets declined in 2008, primarily due to the losses in the global equity markets. The impact of this is included in the $62.3 million non cash after-tax decrease in stockholders equity.

From a cash perspective, the company contributed approximately $8.7 million to its various pension plans in 2008 and at the end of the year $251.4 million was borrowed at an interest rate of less than 2% under the company’s $400 million facility, which matures in September of 2012.

The debt to EBITDA ratio on our credit facilities was 2.48 times versus our debt covenant of 4.0 times. Based on this ratio, our facilities would allow for an additional borrowing of approximately $300 million, its well in excess of the company’s unused credit facilities.

Moving forward, of the company’s long-term debt portfolio, only $15.2 million is due in each of the next two years 2009 and 2010. From the pension side, the company expects to contribute cash of approximately $16 million to its various plans in 2009. The company’s pension expense is expected to increase by approximately $900,000 from the 2008 expense level of $2.6 million.

Talk about taxes; the company reported 2008 effective tax rate from continuing operations was 23% and includes $4.1 million for the valuation reserves of certain deferred tax assets. If we exclude these valuation adjustments, the company’s effective tax rate was 19.7%. Changes in the company’s tax rate are largely dependent on earnings mix among our global operations. Our tax rate for 2009 is projected to be between 22% and 24% range.

Talk about share count; fourth quarter diluted average shares outstanding decreased nearly 10% from the prior year of $53 million, the decrease was due primarily to the diluted effect of potentially issuable shares under employee stock plans and convertible notes which are impacted by the change in the company’s stock price. In prior quarters, a significant portion of the diluted share count was impacted by the convertible notes, given an increase in stock price.

The level of dilution begins at the conversion price of $20.78, which was above the average closing stock price of the last 30 trading days of the quarter. As a result, during the fourth quarter the convertible notes were not dilutive. For 2009, the estimated diluted share count is in the range of 54 million to 56 million.

One item to mention since we are discussing convertible notes, it is important to note and I remind everyone that the accounting for convertible debt instruments changed effective January 1, 2009. Therefore, prior periods will be retrospectively adjusted beginning with the first quarter 2009 results. We currently estimate a reduction of diluted earnings per share of $0.08 in 2008 as a result of the adoption of the accounting change.

Our 2009 guidance has already taken this into consideration. In closing, we have streamlined our operations throughout 2008 and we will continue to optimize to protect against downside-risks throughout 2009. We have developed 2009 plans squarely focused on two important goals; improving cash generation and adjusting our cost structure given the impact of the global recession.

Our ability to generate profitable new business, increase productivity and reduce our cost structure will position Barnes Group for continued long term success.

Now I’d like to turn the call back to Brian.

Brian Koppy

Thank you, Chris. We will now open the call to your questions. Operator, first question please.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question is from John Haushalter - Robert W. Baird.

John Haushalter - Robert W. Baird

If you look at the variance you are giving for the operating margin line, the 9.5% to 11%. Is that really just a function of where the volume comes in or is that something that you guys have a little bit more control over in terms of where it shakes out?

Chris Stephens

I think the way to look at this it’s probably in line with our top line forecast, given the 10% to 15% drop for the full year 2009. We are taking into consideration that considerable volume drop and the impact it’s going to have on our bottom line. So when you think about the margin assumption, that’s when we came up with that estimate.

John Haushalter - Robert W. Baird

And looking at that top-line number, just given the sharp decline you guys had in the fourth quarter, when you are saying there is no recovery in 2009, would that include kind of the fourth quarter being down comparably or just an easier comp just an easier number in 4Q, ‘09 because you are getting an easier comp?

Greg Milzcik

There are a couple of things, John. One is we anticipate that there will be some sort of inventory compression during the first quarter and that proves out. If you look at some of the data, the manufacturing alliance presents for example. The past two quarters have seen significant rise in inventories, in fact it accounts for over 2% of positive GDP in the mix in the past two quarters.

We believe that has to be bled off sometime in the first half of the year. So even if overall macroeconomic markets don’t improve, we expect that after this inventory bleeds off, we’ll recover some sales volume in the back half of the year and that’s part of the calculation. We expect the back half to be better than the first half.

John Haushalter - Robert W. Baird

I guess switching gears. If you look at the new segment reporting and you reference kind of the administrative efficiencies and redundancies that you were able to eliminate with that. Is there a way to put a number around that, just quantify for us what the benefits are internally for you guys from the new reporting system?

Chris Stephens

It’s somewhere, between $5 million and $7 million.

John Haushalter - Robert W. Baird

$7 million?

Chris Stephens

$5 million to $7 million.

Operator

Your next question comes from Fred Buonocore - CJS Securities.

Fred Buonocore - CJS Securities

Just wanted to check in as to kind of where we are for you guys with the Boeing production rate on the OEM side. Had that ramped up to close to normal relative to where we are in the world today?

Chris Stephens

It’s an interesting phenomena, when we did our internal calculation for the fourth quarter we expected somewhere around $30 million to be impacted. The actual calculation came out to $25 million, so we expect that there is some bleed over into 2009, but not that significant.

When you look at the production rate in Boeing in December, they recovered to the 40 unit per month normalized rate and we expect to see the same thing going through at least the first few months of the year. Although we had seen schedules from the OEs that are as solid as we would like to see, we expect there will be some fluctuation during the first half of the year as different customers get in line and there’s some delays and cancellations, etc.

Fred Buonocore - CJS Securities

Given the lead time that you are involved in for the 787, when would the soonest be that you would expect to start generating any sort of revenue on that given the obvious uncertainty around the program and the most recent revised schedule?

Chris Stephens

I recognize that and there are a few revised schedules, but I believe the first start flight now, our first delivery is scheduled for the first quarter of 2010. We should see production increasing throughout the back half of 2009 with orders preceding that.

Most of the work that we have in place right now has been through the development process, so most of the changes have been done and we believe that most of the production level planning has been completed as well as capital equipment expansion in place.

So we don’t expect as much disruption ramping up to the rates that they are looking at. We still have a lot of confidence that 787 is a good program with a bright future for Barnes Group and others and I think that will take off in 2010 on.

Fred Buonocore - CJS Securities

So your guidance assumes some ramp-up on 787?

Chris Stephens

Yes, it does and I think that the 787 is a great aircraft. It will eventually get on track.

Fred Buonocore - CJS Securities

Then on the spare parts side are you seeing any material impact from the deferrals and cancellations?

Greg Milzcik

Yes, it’s down some. I don’t think it has to do with deferrals or cancellations of deliveries as much as it does deferred maintenance and I will refer back last summer when there they were basically taking older fleet out of the system. That doesn’t have as much effect on us as deferred maintenance where they simply fly existing aircraft longer intervals between maintenance cycles, etc it’s still perfectly safe.

They simply deferred maintenance and it has an effect on fuel consumption and things of that nature, but this is something we’ve experienced in the past. We think it’s a temporary phenomena that eventually as capital becomes more readily available the shop visits increase.

I’d also say, not to be long winded, but when we look at the aircraft demographics associated with the CFM56 for example, we think it’s very favorable for companies like Barnes Group that have both a maintenance fare and overall activity as well as a spare parts content in that aircraft, do we’re bullish long-term even though there’s some short term impact here and there.

Fred Buonocore - CJS Securities

Then finally, on the raw materials side of things, are you seeing any benefit in any area of the business from lower commodity costs versus the year-ago period?

Greg Milzcik

There’s some, but we think that there’s a long way to go to get to the, as I tell our operating folks all the time they owe us, the commodity folks that is and we are pushing very hard.

While some of our businesses are somewhat insulated to commodity prices, and I’d mentioned the vast majority of our work in aerospace OE is pass through work, in other words the material whether it goes up or down its simply pass through during a contractual issue, but much of our industrial business is still susceptible to material fluctuations and that’s where we are expecting to see some improvement.

Operator

Your next question comes from Christopher Wiggins - Oppenheimer.

Christopher Wiggins – Oppenheimer

Just a couple really quick ones here; first, what was the cash component of the restructuring actions that you did in the quarter?

Greg Milzcik

That’s a great question.

Brian Koppy

It wasn’t a whole lot. Chris, this is Brian. The amount of the cash that was encored as part of the restructuring wasn’t that significant. I don’t have the exact number, but I don’t think it was that great of a number.

Greg Milzcik

It was primarily a P&L impact on paper, but we can probably get that information out.

Christopher Wiggins – Oppenheimer

I may have missed it when you were talking about the cash flow earlier, but did you mention what the working capital contribution was for 2008 and can you provide any color on what you think you can squeeze out of that for 2009, especially assuming that you will probably be adjusting the inventories lower I would assume and --?

Chris Stephens

Let me just comment. I think when we look at cash flow generation from operations over the year we actually did see another increase in cash usage on working capital, but let me just comment.

As you look at the cash outlays, we had some major onetime items in 2008 that we don’t expect or at least significantly reduce as I mentioned in my opening comments such as the RSP payments, we repurchased shares, we were active in the market as well as capital expenditures are going to be coming down. So the focus on working capital is to make that a cash generator versus a user that we have seen in 2008.

Christopher Wiggins – Oppenheimer

So you that that’s the goal, then.

Chris Stephens

Yes, that’s the goal.

Christopher Wiggins – Oppenheimer

Last one then on the cost savings actions, the $40 million that you are looking at, I think if I’m correct, you are looking at about $25 million in savings in Precision Components and the rest in Logistics? Can you talk a little bit about just the timing and the pace of when you expect to see the benefits really start to flow through?

Chris Stephens

We expect it to be the back half of the year because some of the restructuring costs are not allowed to be reserved for simply because of the accounting rules. So there’s some cost associated with the ongoing restructuring that we’ll be impacted in the first half of the year, but the numbers we gave were full-year numbers.

Christopher Wiggins – Oppenheimer

So you’d expect the $40 million for the full year or that should be a run rate?

Chris Stephens

Yes, that’s the full year.

Operator

(Operator Instructions) Your nest question is from Edward Marshall - Sidoti & Company.

Edward Marshall - Sidoti & Company

The decline in revenue in the revenue guidance of 10% to 15%, we’ve discussed what the distribution and the second half ramp-up, but can you kind of talk to the other segments, what you expect aerospace and kind of industrials to do?

Greg Milzcik

In aerospace, my personal opinion is you are going to see flat year-over-year production levels and that’s slightly lower than what the current forecast is for both Boeing and Airbus and I say that for a couple reasons. One is there’s bound to be some deferrals and cancellations and second is you’re seeing that significant drop-off in business jets. Well we don’t have a lot of work in business jets, but does have a minor effect. So I think that it’s still fairly stable, but we are anticipating some level of effect.

On the service side of the business, it’s much more of a short-cycle business, the LMS whether it’s our distribution business in aircraft parts or distribution business in vendor manage inventory. It’s much more of hand-to-mouth and you have a much shorter time horizon to forecast to. So what we usually look at is some of the manufacturing alliance which is made by economic reports on industrial production forecasts by quarter and that’s part of our anticipation in the back half of the year being better than the first half as inventory compression takes effect.

We also use that same data to look at industrial production as a whole and including doing some estimates based on geographic end markets. In other words, we may have a domestic producer of our industrial component, but it may be distributed globally and therefore we take that into account when we make some of our estimates.

Edward Marshall - Sidoti & Company

I understand hearing from some of the base metal guys that the channel seems to be stuck here on the engine side for aerospace. Have you been seeing that, have orders been as strong? Can you kind of talk to that a little bit?

Greg Milzcik

I think that there are some fluctuations and I think the Boeing strike certainly threw ripples throughout the industry and it threw ripples in our business in particular because we have a variety of customers. We don’t do that much work directly with Boeing, we do primarily with peers to Boeing, such as the engine manufacturers or the cell manufacturers, etc. So each of these customers have had different levels of inventory and different philosophies on how to deal with the Boeing strike.

So we’ve seen orders volatile and in that sense I wouldn’t take any short term view of the orders rate as a good indicator of anything. I would take more of the macroeconomic view and that still looks favorable for the full year in comparison to the other industries.

Edward Marshall - Sidoti & Company

Circling back to the first question, you had mentioned that you expect flat production levels in 2009. Does that mean you anticipate a drop-off in 2010?

Greg Milzcik

Here’s where it gets complicated. If you are heavy in the 787 as we are and your platform mix is right, you should be okay in 2010, but I think there may be a decline in the overall production rates. A good part of our workload is 777 currently with the GE90-115 and that engine and that airframe is a hot seller and it looks like the production levels are pretty secure through 2010.

With our upswing in 787 work in 2010 we are relatively optimistic, but we will wait until later in the year before we start giving some more color to the outlook for 2010, but we do expect narrow body production to be down in 2010.

Edward Marshall - Sidoti & Company

Then opportunities; it looks like the OEM, GE needs some cash here. Does it make sense that RSP agreements or further RSP agreements with GE is possible?

Greg Milzcik

We’ll continue to do RSPs as long as it makes financial sense for both parties and it’s also more than financial sense. It has to be a strategic partnership that works long term for each player and as I mentioned in previous press conferences we’ve done RSP like agreements with Smith on the pistons and cylinders and with Goodridge on the cells for the 787 and A320 I believe.

So we’ve done RSP like agreements with other companies as well where it secures long term production at with some shared capital risk. So we’ll continue to explore it with a variety of customers and I think given the current environment, the pay to play environment is appealing for many of our OE customers.

Edward Marshall - Sidoti & Company

You mentioned in the past though, about the RSP agreements. Have you exhausted the kind of what you can get out of them, the lucrative RSP agreements in kind of the GE engine area?

Greg Milzcik

I don’t think so. I think that what we have seen is we have a mix of about 120 part numbers, somewhere in that neighborhood maybe 130 and the mix we targeted that makes sense for us. I think as it goes forward, we’ll enter into other types of agreements and it doesn’t have to be in the same particular model of the past RSP agreements, its kind of what I was emphasizing when I was talking about alternative customers and alternative models. It doesn’t have to be completely mirrored on the historical ones.

Edward Marshall - Sidoti & Company

Final question; the reversal of the deferred tax asset, can we talk about that? Where did that come from and how much was it in the quarter?

Chris Stephens

The deferred tax asset, the provision we put on was primarily in Europe as it relates to the discontinued operations we had in the UK, as well as we took a harder look at our distribution business in France as well and that’s where it came from.

Operator

Your next question comes from Matt Summerville - KeyBanc Capital.

Matt Summerville - KeyBanc Capital

Good morning, couple of questions. First; just back on aerospace. Fourth quarter, can you give a little more color on what the performance was in the OE side of the business versus aftermarket and then in the context of your guidance for ‘09, for the full year what are your expectations out of those two buckets, if you will?

Greg Milzcik

First of all, the reason I’m hesitant on fourth quarter OE performance is simply because we take $25 million out of it. We also didn’t do what you’d normally do if you saw a step function decline in sales and that is, we didn’t have a steep reduction in force which means that your contribution ratios will be different than they would be normally.

So from that perspective, overall I think the OE performance was up slightly year-over-year on a full-year basis, including the fourth quarter it was what you would expect. We had downside incrementals that are consistent with that type of operation and if I recall it still maintained profitability throughout the quarter despite the strike, and with that said I could go into the aftermarket.

Aftermarket, we did see some volatility in the quarter, but some of that is associated with the maintenance schedules that you usually see and the last quarter of the year around the holiday period, it’s also the peak ordering time because that’s when price increases go into effect from the OEs to the airlines for aircraft spare parts, but in general our aftermarket business was up year-over-year on a full-year basis.

As I mentioned before, the demographics favor us even though there’s a lot of volatility in the marketplace. On a long-term basis, the demographics combined with continued air traffic increases really favor around the CFM56 in particular.

Matt Summerville - KeyBanc Capital

Do you think the OE and aftermarket business has grown 2010 versus 2009 for the full year?

Greg Milzcik

I’d have to wait for that one. The reason I’m saying that is you need to know what’s going on with the 787 before you can make a commitment of that sort. If I base the aftermarket on demographics I’d say yes, but it’s still too early to say on that since it’s such a short cycle business.

Matt Summerville - KeyBanc Capital

So its suffice to say, the way we should be thinking about modeling this even though you don’t explicitly give quarterly guidance is, aerospace is still going to be down in the early part of the year against tough comps.

Greg Milzcik

Yes, I think in general the first quarter and the second quarter will be very difficult comps year over year. We expect that inventory compression whether it’s residual from the Boeing strike or industrial operations etc. We are not expecting a lot out of Q1 or Q2, but we do expect that to improve as the year goes on.

Matt Summerville - KeyBanc Capital

How many points of FX headwind do you have modeled into your total sales decline forecast of 10% to 15%?

Chris Stephens

Matt, the way I would look at that is around 2% to 4% is what we’ve got take into consideration assuming that the dollar is strengthening and will continuing in 2009.

Matt Summerville - KeyBanc Capital

So in Q4, your total sales were down 25, organically down low 20, sequentially as we move into the year and maybe speaking in the context of your own inventories, distributor inventories are bloated, end user inventories are probably bloated.

Is there any reason the year-over-year compare in your core business improved sequentially in Q1 and perhaps even in Q2? I’m just trying to get comfortable with this 10% to 15% down forecast, because I can kind of see something that’s higher than that.

Greg Milzcik

Here’s what I could tell you. If we look at November to December to January, sequentially each one of those were up. Dramatically up, no but we saw an improvement in each one of those months on a broad base, so it was across the board. The data I have in front of me and we’ve scrubbed it in a variety of different ways and you could get economic reports from a variety of different sources, but I found that the manufacturing alliance provides pretty solid data.

So when we modeled it based on aerospace being flattish to slightly down and then using the made by data for the balance of it, that was a range that was appropriate. I know some industrial-based companies are looking at closer to 20%, but I think that our mix of aerospace combined with industrial benefits us slightly.

Matt Summerville - KeyBanc Capital

As far as the profitability with just looking at Barnes Distribution, it sounds like the European operations even when excluding the discontinued opp, continued to lose money in the quarter. How did performance in North America fare in Q4?

Greg Milzcik

I think Q4 is just a bad example in the sense through the third quarter, we had stated that that business had produced double digit ROS, which was along the lines of historical numbers, but a significant retraction during the quarter. BD North America for example, for a full year basis was up year over year. December profits actually went up year over year, but I wouldn’t use that as a good comp going into the first part of the year and I’m basing that more on gut feeling than I am on data that I can share with you.

In general, the distribution business, vendor managed inventory of North America has been a success story throughout 2008. We expect that we are going to invest heavily in that platform going into 2009 and I think it will really flourish next year.

Matt Summerville - KeyBanc Capital

You provided some components of cash flow guidance for 2009. I did not hear you talk about operating cash flow. Can you give a little color on what your expectations are there?

Chris Stephens

Yes, I think as you look that, Matt when we think about operating cash flow. Our ability to generate cash at a working capital reductions and looking that going into next year is to have that increase, putting a specific number on it would be difficult to do, but we are looking at a lot of programs and incentives and structure around showing some cash improvement out of working capital reductions going into ‘09.

Matt Summerville - KeyBanc Capital

So you think, just at the operating cash level, I understand CapEx is coming down. You believe your operating cash flow performance will improve in ‘09 versus ‘08?

Chris Stephens

That’s the goal, that’s the objective.

Matt Summerville - KeyBanc Capital

One last question, the magnitude of extended shutdowns you’ve seen with your customers. Are we through that yet; are your facilities that were impacted by the shutdowns back up and running? Just maybe a couple words on fixed cost absorption and how that’s going to trend.

Greg Milzcik

I can comment on that directly. It’s been extremely painful for both the folks out in the field. It’s been difficult for our OE customers as well as for our plants. We’ve found the OEs, being primarily transportation end markets have an excess inventory that they have to bleed off before they can get to a normalized run rate.

We expect that to continue through most of the first quarter. Some of the OEs that we are seeing think that they’ve hit bottom on production or sales levels which ultimately will lead to production levels and we kind of subscribe to that same thing. So we think that we will still have impacts throughout the first quarter. It absolutely does impact, when you start getting down to looking at fixed costs and how that affects our overall profitability, but that’s another one of the reasons why we don’t have high expectations for Q1 and Q2.

Operator

Your next question comes from Holden Lewis - BB&T Capital Markets.

Holden Lewis - BB&T Capital Markets

A couple more specifics on the balance sheet during the quarter, it looks like very little progress was made in terms of inventories and the payables dropped pretty sharply. Can you just comment a little bit about the trends there and how you expect those to play out as you go forward in 2009?

Chris Stephens

Sure, Holden. I think the way to look at that is the drop in AP, if you will obviously we had the final RSP payments as I mentioned before. That’s a significant decrease, as well as the receivables coming down just given the top-line pressure. What we haven’t had a chance to really move the needle on is inventory.

So that gets into taking a look at 2009 and adjusting our production schedules, our inventory builds to the slowness in the market and that’s where we expect to get cash generation from working capital improvements year over year.

Holden Lewis - BB&T Capital Markets

So you just got caught a little bit with the rapidity of the decline on the inventories?

Chris Stephens

You got it, just so quickly in the last part of the third quarter and obviously most of the fourth quarter.

Holden Lewis - BB&T Capital Markets

And you’ve seen a number of OEMs, you perhaps have a unique perspective on this given that you are in both distribution and manufacturing, but as we have gone through the various transcripts you’ve seen or you’ve heard from a lot of OEMs talking about, it’s distribution that has been winnowing its inventories and I think when you look back at past cycles and its been so typical for OEMs to be able to get inventory of there balance sheet by handing it the distributors that sort of discounted rates.

It seems like this is a little bit different, is the fact that distributors are cutting inventory this cycle so quickly and dramatically and not taking discounted product, does that mean really that manufacturers haven’t even really begun the process of cutting their inventory levels and therefore it’s going to drag out longer than normal, just some perspective on that?

Greg Milzcik

There are a couple comments. One is; it’s almost a misnomer to say that we are in the distribution business as much as a service business. Our vendor managed inventory model is much more service oriented with different criteria, different margins. So it’s hard to compare us to distribution when you are reflecting on OEs shifting inventory to us.

We have a very tight inventory level based on our distribution centers. However, I will say that this cycle is different from the people I have talked to in the various industries and associations I’m involved in the speed and the breadth of the impact and I say the speed because it was very rapid, but the thing that compounds it was that it hit so many industries at one time and I do think that Europe and Asia are lagging behind, but they are certainly catching up quickly.

I do think that over the first half of the year, they will be able to adjust inventories, but I partly share your sentiment that they haven’t gone to the point where we could say that by next month or next couple months, that inventory will be normalized.

Holden Lewis - BB&T Capital Markets

Then I guess when I’m thinking about your guidance of $1.20 to $1.50, my assumption is that includes about $0.60 in savings since you seem to be maintaining the $40 million in savings to be realized in 2009, which means that stripping out those savings you’re kind of talking about base earnings if you had done nothing between $0.60 and $0.90 and in 2008, I think you were looking at $1.99 or something like that, if add back in all the charges that you took

It just seems like $1.99 down to a range of $0.60 to $0.90, that’s a pretty dramatic drop particularly considering you are looking for flattish performance I guess out of the aerospace business, which represents third year revenues and half of your operating profit at least as of the previous quarter. Can you just provide some color around that? Because that just seems like you’re talking about just a disaster in the industrial and the distribution business to get there.

Chris Stephens

Holden let me make a few comments on that. I think as you look at our 2008 performance and what we are projecting for 2009. Clearly, volume decline obviously is a big negative. We’re going to get the restructuring savings that we talked about before, but the other thing I also want to note is we have also put into this guidance that change in accounting on convertible debt. We estimate in 2008 that retrospective adjustment to be comparable in 2009. So that’s also another piece of that element, if you will.

Operator

Your final question comes from Yvonne Varano - Jefferies.

Yvonne Varano - Jefferies

I know that Barnes Distribution in Europe has been under performing for quite a while now. I’m sure that the markets are slowing down, a turnaround there, but when do you think we could see some better performance out of that business?

Greg Milzcik

Good morning, Yvonne. First I’d like to comment that during the third quarter conference call I made a comment that we are looking for a step function improvement in the distribution business in Europe. I think part of that, the planning and execution came out about with the discontinued operations, that’s part of the step function change.

The balance of the change comes with the organizational structure and the channels to market etc. I’d be happier if the markets in Europe were better, but I think we are already going to see a step function change and improvement, that’s part of that $40 million savings.

I think that we have to see how things unfold in Europe over the next quarter or two to see if there is any other changes we have to make, but I think right now with the management team we have in place, the plan we have in place that we should see improvement by midyear.

Yvonne Varano - Jefferies

So this is a business that at this point you still feel committed to and something you want to hold onto or have your views changed in regard to operating distribution in Europe?

Greg Milzcik

I think what we looked at in Europe is the channels to market that we were going to were too varied and that with the eliminating of some of the UK operations we didn’t exit UK, we still have our businesses in UK and look at consolidating the way we go to market is very helpful. So we feel bullish for the time being, but that’s part of the investment going into 2010.

Yvonne Varano - Jefferies

I was actually a little surprised that you think the manufacturing inventories are still high and it’s going take us through the first half of the year to bring them down and recognize auto is a tough market, but in general, could you comment on that area more specifically what you’re seeing for end markets for nitrogen gas spring?

Greg Milzcik

There are several components to this Yvonne. First of all, the auto is a big part of it. Auto is going to take longer than the rest of the businesses, simply because the cycle and the volume of inventory that’s out there. The second thing we are seeing is a geographic delay.

In other words, if everything was North America, I’d say that it’s probably flush through probably by the end of the first quarter, but because we are seeing our business of course geographically diverse, we are going to see some inventory reductions in Europe and Asia. I think if you saw the industrial production numbers coming out of Asia whether Japan or China that certainly will have some ripple effect in inventories.

Yvonne Varano - Jefferies

So I guess that comment is taking into account, those European and Asian markets that are likely to just take longer.

Greg Milzcik

I might add in some cases we haven’t seen anything out of Asia yet, but you can’t stick your head in the ground and expect nothing will happen. So we’re just anticipating some of this will happen and trying to be as proactive as possible.

Operator

Thank you. I would now like to hand the call over to Brian Koppy for closing remarks.

Brian Koppy

Thank you very much and as always, if there are any additional questions about any of the matters discussed this morning please feel free to contact me. I would also like to remind everyone that in addition to our earnings press release that we put out across the wires today, we did also post an earnings supplement on our website that will provide some additional information regarding our results. Once again, thank you for joining us today.

Operator

Thank you for your participation in today’s conference. This concludes the presentation and you may now disconnect. Have a great day.

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Source: Barnes Group Inc. Q4 2008 Earnings Call Transcript
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