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Sauer-Danfoss Inc (NYSE:SHS)

Q3 2009 Earnings Call

November 10, 2009 10:00 am ET

Executives

Sven Ruder - President and CEO

Jesper Christiansen - EVP and CFO

Ken McCuskey - VP and CAO

Analysts

Alex Blanton - Ingalls & Snyder

Joe Mantello - Sidoti & Company

David Lieberman - Southpoint Capital

John Emrich - Iron Works Capital

Cory Armand - Rice Voelker

Alex Blanton - Ingalls & Snyder

Operator

Welcome everyone to the Sauer-Danfoss' Third Quarter 2009 Results Conference Call. (Operator Instructions) Thank you.

I will now turn the conference over to Mr. Sven Ruder, President and CEO of Sauer-Danfoss. Sir, you may begin.

Sven Ruder

Good morning, good afternoon ladies and gentlemen. Welcome to Sauer-Danfoss' conference call review of our third quarter 2009 results. Today I have with me Jesper Christiansen, Executive Vice President and CFO of Sauer-Danfoss and Ken McCuskey, Vice President and Chief Accounting Officer of our company.

Before I begin, I'd like to inform you that this conference call contains forward-looking statements that involve risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. The company's reports on file with the Securities and Exchange Commission provide a more detailed description of these risks and uncertainties.

As the results of the quarter came in as expected and consistent with last quarter. Our sales in the quarter continues to be hit by the downturn basically every market and region we serve, as well as by the impacts of our customers working down the inventory levels, which is being ongoing since the fourth quarter of last year.

The reported loss comes as a result of the drop in sales. The upfront costs of our cost reduction action and the significant non-cash deferred tax asset evaluations around the charge. However, we are encouraged by the signs that we have reached the bottom of the downturn and we expect to slowly start seeing an upturn.

Let me begin with comments on the sales by market and by region as well as about the status of the new orders that we receive from our customers and the current backlog. Jesper then will review the details of our overall financial results and I'll follow up with comments on our outlook for 2009. Following that then we'll open up for questions.

Our sales for the third quarter declined 48% and excluding the impacts of currency, sales were down 47% compared to last year's third quarter. This is slightly less than the decline that we reported in the last quarter. I would also like to point out that we are still comparing figures this quarter to record sales results of last year.

Sales in the America's were down 48% over last year's third quarter served into the material handling and specialty vehicle market. Still our weakest markets were down 74% led by an extremely weak [Ag] market.

This drop continues to be driven by reduced non-residential construction, sharply lower machinery exports and lower capital expenditures from [metal] companies.

Construction and road building sales were down 58%. Any new projects that have been started perhaps from stimulus funds are not yet resulting in machinery sales. In addition, state government budget problems are also affecting the road building sector.

However, this is a segment where we're hearing positive sounds from our customers that the market is trying to pick up. Sales into the agricultural sector and turf care markets, which continue to weaken are now down 28% compared to last year's third quarter.

Agricultural customers are particular pessimistic as we have posted a year end and 2010 with Ag commodity prices also on a slightly downward trend. The decline in consumer spending continues to be a drag on the turf care market.

In Europe our third quarter sales declined 52% year-on-year excluding the effects of currency, sales into the construction and road building markets in Europe were down 62% and sales into the material handling and specialty vehicle market were down 54%. The decline in both markets are less than reported last quarter. The recession in Europe and customers reducing their inventory levels continued to contribute to this sharp drop in sales.

Sales into the Ag markets were down 43% compared to the third quarter of last year. This is a further decline compared to what we reported last quarter, again driven by the general economic environment and increased pessimism of our customers in this market.

If we look at Asia Pacific, sales in that region were down 23% for the quarter, though a smaller decline in what we reported last quarter. Our largest market in the region is the construction and road building market and sales into this segment were down 34% driven by a drop of export sales and by customer inventory reduction.

However, domestic infrastructure investment by the Chinese government is helping our business and this somewhat mitigates the full effect of the downturn. In addition, we're getting market share in the [transient] mix of market.

Sales to other markets were primarily down with one bright spot remaining being China where government investment programs have kept the market relatively stable compared to last year.

The Japanese market is particularly hard hit because of their dependence on exports to North America and Europe.

If we take a look at our order book, orders were down 21% from last year's third quarter and the backlog is down 49% compared to a year ago. These declines are also less than what we reported last quarter and we believe that our customer's orders are also in these uncertain times is significantly shorter than a year ago.

Therefore, part of the decline in our backlog from a year ago is due to the fact that our customers are only ordering a few months out today compared to a year ago when it was not uncommon for customers to have orders in our system for a year or more. We are of course optimistic that we're going to see a pickup in our backlog as we move into 2010.

With that overview, I'll turn over the conference to Jesper so he can comment on the company's financial results.

Jesper Christensen

Thank you, Sven. As we reported, we incurred a loss of $70.8 million or $1.46 per share. The loss continues to driven by the sharp decline in sales, restructuring and workforce reduction costs as we aggressively size our company to the new market levels and the need to record non-cash charges relating to deferred tax assets.

We incurred restructuring and workforce reduction or severance cost of $13.2 million in the quarter or $0.25 per share. A significant portion of this is severance cost as we continue to reduce headcount in-line with the declining sales.

We announced the closing of our Lawrence Kansas plant and the sales of the unprofitable steering column business based in Kolding in Denmark.

The operations in Lawrence are being relocated to our Ames, Iowa and Freeport, Illinois plants. We also still incurred some final cost of actions we started in the first quarter, the closing of our Hillsboro, Oregon valve plant and the sale of the AC electric drive business relating to the material handling market and the exiting from the remaining electric drive business. These three restructuring actions are now completed.

Finally, we just recently announced the closing of our former executive offices in Chicago, Illinois. The cost associated with this will not be significant and will be incurred over the next three to four quarters.

As we highlighted last quarter, we will require to record an additional $28.5 million or $0.59 per share of non-cash deferred tax asset valuation allowances. This relates to tax benefits from operating losses generated in the US and in Denmark. These losses result in a deferred tax assets on our balance sheet, which is basically a receivable from the government as an offset to future taxes that would be payable on future income.

With the current level of losses and the uncertain economic times, accounting rules require that we set out an allowance against the assets thereby assuming we will not have future income to allow utilization of the assets.

The good news is that this is non-cash and when we do return to profitability we will be allow to reverse these allowance and record income. In the mean time though, we will have some various strange-looking tax expense and effective tax rate.

Our aggressive cost reduction actions have resulted in a reduction of $47 million or 21% of fixed production over any expenses for the quarter compared to last year.

We've not seen the full benefit of our actions we're taking yet, since in many of the European countries there are extended employee reduction notice periods. This means that some employees are still on the payroll until later this year. In addition, our restructuring actions that we've just recently announced will not start bearing savings until we move well into next year.

We've generated $147 million of cash in the past nine months by reducing working capital. We do believe we have more opportunity and are focusing on the further reduction of inventory.

We also continued to reduce our capital expenditures down to $7 million in the third quarter. This is less than 50% of depreciation, which is also contributing to our positive cash flow. This positive trend will continue.

Finally, we have just entered in to a new $690 million of revolving credit facility with our majority shareholder, Danfoss AS. This new agreement replaces a $490 multi-currency term loan and revolving credit facility and a separate $50 million term loan agreement we already had with Danfoss. The new agreement provides us with an additional $150 of available credit and it extends the maturity date of the borrowing to April 29 2011.

This strong show of confidence by Danfoss in our business allows us to complete the needed restructuring as we right-size our business to the new lower sales force. In addition, the agreement provides us with the needed cash to fund the expected option in 2010 with its increasing production activities and working capital.

With that, I'd like to turn the call back over to Sven.

Sven Ruder

Thank you, Jesper. We've seen a number of encouraging signs that indicate that the worst of the recession is behind us. Nonetheless, even as our sales throughput begins to stabilize, we'll continue with our very aggressive cash generation work and cost reduction actions. We'll continue to incur cost over the next three-four quarters as we complete the remaining of our restructuring activities and by then, the full force of the savings will begin to be realized.

I'm of course will be optimistic as I look at next year. Recovery in our markets, will be at moderate with results on improved sales. This along with a reduction in ongoing operating costs will return us to operational profitability as we move to 2010 and full profitability in 2011.

As we mentioned in the press release, we are reaffirming our outlook for the year. We expect our sales to be down between 45% and 50% for the full year of 2009 and we expect our earnings to be at a loss of between $6.7 and $7.3 per share. This includes goodwill impairment charge of $1.05 per share, valuation allowances on deferred tax assets of between $2.35 to $2.55 per share and workforce reduction and restructuring costs of approximately $1.00 to $1.20 per share.

Finally, we continue to expect our CapEx, our capital expenditures will end in the region of $60 million for the year.

With that then I would like to the open the conference call for any questions that you may have.

Question-and-Answer Session

Operator

(Operator Instructions). The first question will come from Alex Blanton with Ingalls & Snyder.

Alex Blanton - Ingalls & Snyder

Just one, I have some clarification questions. The items you mentioned on page one of the press release $13.2 million in restructuring and severance. Where is that in the income statement, which lines?

Ken McCuskey

Alex this is Ken McCuskey. I can tell you what that is. About $6.1 million of that is in the cost to sales line. So, it was in gross profit.

Alex Blanton - Ingalls & Snyder

$6.1 million.

Ken McCuskey

Yes. $4.7 million is in SG&A so operating expenses. Another $1.5 million is part of the loss on sales of business and asset disposals, which we breakout as a separate line.

Alex Blanton - Ingalls & Snyder

$1.5 million in there.

Ken McCuskey

Then finally there is just a little over a million call it million one in other net.

Alex Blanton - Ingalls & Snyder

Other net. Okay.

Ken McCuskey

Okay?

Alex Blanton - Ingalls & Snyder

What about the tax deferral charge, the $28.5 million?

Ken McCuskey

Right.

Alex Blanton - Ingalls & Snyder

Where is that?

Ken McCuskey

That's on the tax line.

Alex Blanton - Ingalls & Snyder

So that's why you have a tax on a loss.

Ken McCuskey

That's correct.

Alex Blanton - Ingalls & Snyder

Okay.

Ken McCuskey

If you want to reconcile that’s the four year number, if you look at our year-to-date pretax income of just shy of $202 million Alex.

Alex Blanton - Ingalls & Snyder

Yes.

Ken McCuskey

Then you've seen we're reporting a tax expense of $59 million.

Alex Blanton - Ingalls & Snyder

Right.

Ken McCuskey

You take that $202 million and multiply it by kind of a blended rate around the world that you would expect of around 31.5%, you would expect a tax benefit of actually about $63 million.

Alex Blanton - Ingalls & Snyder

Right.

Ken McCuskey

Then the first thing you do is you got $50 million of goodwill impairment from the first quarter in there and we can't tax effect that. So that's a hit of about $18 million that you have to add back to the benefit or expense if you will. Then finally there's $109 million of deferred tax valuation allowance that are hitting negatively against it. Once you adjust with those two things you get down close to your $59 million of tax expense on a loss.

Alex Blanton - Ingalls & Snyder

Very good. Now on page two, you mentioned that you've reduced fixed production and operating expense by $46.8 million? Is that actually what the cost reduction was in the quarter or is that a rate?

Ken McCuskey

No that's the amount that we compare the third quarter of '09 to the third quarter of '08. Then we look at our fixed production costs in our SG&A costs.

Alex Blanton - Ingalls & Snyder

Okay. So you actually reduced the costs by that much but that includes some variable costs, doesn't it, its not just fixed?

Ken McCuskey

No that's mostly fixed, because we're just picking a fixed production costs like fixed production cost in our plants and then we're picking up marketing and G&A, general and admin costs, which for the most part you consider fixed.

Alex Blanton - Ingalls & Snyder

All right. So could you break that down then like you did the others?

Ken McCuskey

Yes. On the fixed side, the reduction was around 20, lets say about $18 million and the rest is in the G&A line.

Alex Blanton - Ingalls & Snyder

Of the 46 is in G&A?

Ken McCuskey

Yes.

Alex Blanton - Ingalls & Snyder

Okay. All right. So one finally as you said, you thought the recession, the worst of the recession is behind. Does this mean you think it's over?

Sven Rude

No, we definitely don't think is over, Alex but we've bottomed, our sales have bottomed, we are about now where we were on bottom. Some of the sales in the months of the last quarter was very, very low indeed and we're seeing a pickup from that, some modest pickup but this is what we mean by modest pickup. We don't see that the recession is over and we definitely don't see any indication, that we're getting anywhere close to previous levels of revenues.

Jesper Christiansen

I think where we're sitting in the value chain, we also read that our customers are now coming to an end by reducing their inventories and that is what is done to stabilize from our – how I see it in the value chain.

Alex Blanton - Ingalls & Snyder

They're still reducing their reducing their inventories?

Sven Ruder

It's coming towards an end.

Alex Blanton - Ingalls & Snyder

In the construction side, you said you saw positive signs?

Sven Ruder

Just negative yes.

Alex Blanton - Ingalls & Snyder

Just negative. Just one more thing. I just want to say that I was driving to Washington, this weekend I saw a awful lot of construction equipment and construction going on in the highways from between New York and Washington D.C. It seemed like a lot of equipment out there but the equipment sales have according to Caterpillar, down 80% from the peak. Does this mean that they're just using up? What's your sense of it? Are they just using up the equipment they've got?

Sven Ruder

Yes. I sense that the people are just stretching the lifetime of that machine and they have difficulties in getting new financing. They aren’t sure about how long their contracts, the new contracts are out there are going to last for. So, people are stretching the lifetime of their machines.

Alex Blanton - Ingalls & Snyder

Yes.

Sven Ruder

So, we also as we drive to work here everyday from Denmark to where we are located here in Germany we see a lot of machines on the roadside, unfortunately few of them are new machines.

Operator

The next question will be from Joe Mantello with Sidoti & Company.

Joe Mantello - Sidoti & Company

First in terms of the restructuring, I was wondering if you can tell us how much of the total benefit you expect to see when the restructuring is over and what the incremental benefit in 2010 should be from 2009?

Sven Ruder

Well. Let me put at this way Joe what we are planning for is very small revenue growth next year. Then there are operational efficiency improvements that we planned for and we have some level of confidence that we will make. So the rest of that is coming from these costs savings that we have made. So, we are heading for a small positive operating profit in 2010, and that’s what I try to reflect in the conference call. So, what we are heading for is a run rate, what we are heading for is the run rate of cost that the business can bear in 2010.

Joe Mantello - Sidoti & Company

So, is there anyway you can quantify that?

Sven Ruder

I hope that answering your question.

Ken McCuskey

Joe maybe another way to look at, this is Ken, is look at that $47 million we brought down our fixed costs from the third quarter a year ago, that will continue to improve here for the next quarter or two and be a bigger number and that's the kind of magnitude of cost reduction we're talking about.

Joe Mantello - Sidoti & Company

You guys don’t know what to quantify or what the 47 will increase to?

Ken McCuskey

We don’t at this time, no. It’s kind of a fussy number and the other way to look at it, Joe is we typically expect that when we do these reductions on things like closing plants et cetera we usually typically get a payback within one to three years.

Joe Mantello - Sidoti & Company

Any idea on what the incremental benefit from the second quarter to the third quarter in terms of the restructuring? Just trying to get an idea of what kind of benefit you saw this quarter from?

Ken McCuskey

I will go back and look at what we were at last quarter.

Joe Mantello - Sidoti & Company

In terms of efficiency, I was just wondering if you could maybe given us an idea the last cycle, your margins were up and down, didn’t seem as efficient as you probably would have liked, could you give us an idea of what the problem was back then in the last cycle and how the restructuring is going to benefit or any other future plans that you have on the table is going to help the business improve better than it was last time.

Sven Ruder

Well, we're closing several plants as you've seen, we're scaling back the infrastructure that we have in the company. This is the benefit that we're going to get as we go forward. In Europe, different from the US when you dismiss people to scale back on your work force, many of these people they enjoy notice periods that are substantially long, so we went out at the end of the last year and during the first and second quarters of this year and these are people that were on notices, but these people were still available on our payroll until very late in the process. Some of them are still there now. As we get into 2010, these inefficiencies are not going to be in there. So we do as I said expect improving constitution margin as we get into 2010.

Joe Mantello - Sidoti & Company

Was it just a case of over hiring and a couple of different inefficient plans here and there and you're sort of trying to take that out now?

Sven Ruder

There was mix issues in there as well, there were pricing issues in there. We're directing this from various angles. So we have a program called [Low-Fly] program where we go into unprofitable products and price them right, that’s going to have an impact as well. So there are many initiatives on different fronts to make sure that we increase the gross margins as we go into 2010.

Ken McCuskey

Another couple of examples of the unprofitable business we have gotten out of. You saw that we got out of the electric drive business which was hugely unprofitable for us. We shutdown an Sauer Swindon England plant and product line which was also unprofitable at the times. Besides cutting costs in our current operations, we've also got another business line which just weren’t making money.

Joe Mantello - Sidoti & Company

Can you quantify at what production level you see the business has to get to be able to breakeven?

Sven Ruder

We reckon that the business will breakeven at a revenue similar to what we’ve had in 2009 during 2010.

Jesper Christiansen

On an operational level?

Sven Ruder

Yes, on an operational level.

Joe Mantello - Sidoti & Company

So you are enough to get above the interest expense, taxes and everything to breakeven in?

Sven Ruder

Correct.

Joe Mantello - Sidoti & Company

Do you have any idea of what point you can start being able to pay down this debt? It doesn't sound like it could be anytime soon, any plans on when you are able to do that and also if you could go into where you went into the calculating to the 150 to 150 of additional million of additional capital that you need how you determine that?

Jesper Christensen

I think addressing the last question of the 150, it's simply driven by being ready for faster pickups than we actually anticipate. So being ready and having the safety margin to deal with that, but also being able to finalize the remaining restructurings we have and thirdly I would say be able to cover the seasonal swings we have over the quarters of the year, actually the monthly swings. So, this was what drove us to secure the additional 150 million.

Joe Mantello - Sidoti & Company

When is your goal to start paying down the debt?

Jesper Christensen

Our plans for next year stay at stable level of revenues. We keep our cash position. We are not going to be able to pay down debt as it looks right now during 2010, but we believe we have rightsized the company and as the sales pick up, then the bottom-line will improve sizably and we'll be able to start paying back the debt. That will happen when the market picks up. Right now we have no plans that say that 2010 is going to be particularly strong. Remember that we have very, very high depreciation expenses. The company had too many capital expenditures in the past and these are harder to compress in times of trouble like these but it does means that they are non-cash expenses and as sales pick up, then the ability to generate cash is there and we'll starting back under that.

Joe Mantello - Sidoti & Company

Okay. Then just in terms of working down your working capital how much further do you see you're able to reduce inventory and accounts receivables with things seeming to stabilize right now?

Sven Ruder

Well, we have net working capital around 24% right now, 25% as we go towards the end of the year we can probably get this a bit lower down to 20%. If we look at our peers around they've had an increase in their net working capital and but they've been at lower levels, they've been lower to 20s. So there's still lots we can do there but of course at some point in time you exhausted the possibilities of taking that of your balance sheet, but we believe there are still more to come there, maybe then get another 20, 30 million of the balance sheet still and get the net working capital back.

Joe Mantello - Sidoti & Company

Okay.

Jesper Christiansen

Maybe just to add. In the past it appears that this was not really a very strong focus area for the company and now we have put much more focus on driving working capital.

Operator

[Operator Instructions] The next question will be from David Lieberman with Southpoint Capital.

David Lieberman - Southpoint Capital

Hi, guys, a couple of quick questions. Well, first just on the orders which came in, were at 305 I think. Do you feel that's a temporary part or is that sustainable? Is it up because cancellations are down? Just trying to get an idea of how to think about it?

Sven Rude

I believe that's different quarter charge Dave but I think what happened is that our customers are beginning to order with very, very short horizons. So before they'd be placing orders in the systems for a nine month, 12 month delivery horizon, these have come down and they're very, very short right now. Still we believe it's sustainable, we believe that our customers have had sales with higher levels than the sales that we've experienced and they've been working down the inventory.

So what we see coming in now as customer building machines. So we believe that it is sustainable and what gives us actually more optimism is that we see this as very, very broad spread. So it's not one particular segment that is getting ahead of the others but we see parts of recessionary effect. We see a general pickup in all different types of customers in different types of segments. So that leads us to believe that this small step up is sustainable.

David Lieberman - Southpoint Capital

Okay. Then when I look at your guidance, the main point of the sales guidance, it seems like you're projecting for another season decline in Q4 sales in the face of I guess having a better orders number. I'm just curious if you can give us more thought behind what you think sales will take another large step down?

Sven Ruder

I don't think so. I think what you'll see is declining drop. So that the gap to last year will be smaller.

David Lieberman - Southpoint Capital

All right.

Sven Ruder

I think we'll be seeing that we're moving away from these minor 50s that we have seen, remember there were and it will be in the minus 40s perhaps a bit lesser in the coming months. A big uncertainty around December and how customers are going to react, but people are going stay open the lot of the year end holidays. So they are going to extend that plants shutdowns. They've got no inventories, so some of them will just put out lead times for my customers and others will say now what. So that anybody with an order, they will come deliver it to me. So, we are seeing different customers behave in different ways. So we are uncertain about how December is going look. So as I said I think in the quarter in general we'll see smaller gaps to 2008 than we have seen in the rest of the year.

David Lieberman - Southpoint Capital

Yes. Sure on a year-over-year basis. I guess I was thinking sequentially that Q4 looks likes its going to be lower than Q3 and I think you are saying that just a typical seasonality then?

Jesper Christiansen

Dave I think that if we come close to the minus 45% of the range that we have guided for the year, then we should see the fourth quarter maybe coming closer to the second quarter.

David Lieberman - Southpoint Capital

Okay.

Ken McCuskey

Yes David, its Ken again as Jesper said based on, if we come into our mid-point of our guidance, our sales will be about 30 million from third quarter to fourth quarter.

Sven Ruder

It’s a little over 1.1 billion, 1.2 billion for an EBIT breakeven. The 1.2 billion corresponds to this year's revenues more or less adjusted for the exchange rate, but the dollar has got a little bit weaker and so this is more or less the sales in 2009 when we'll make an operational breakeven at EBIT level. That's without any restructuring. We have a list of restructurings that we wish to carry out and as we develop we'll make those decisions, but this is clean without any restructuring.

David Lieberman - Southpoint Capital

The CapEx in Q4 steps up quite a bit, can you address that?

Sven Ruder

We came into the year with a huge order book of machines that had been acquired last year and we went back to the suppliers and said that we can't receive these machines right now and entered into lot of renegotiations and some of these orders were cancelled and some were pushed out into 2010 and some were pushed out towards the end of 2009.

That's why you're seeing this pick up from the 37 million you were at the end of the third quarter to the $60 million for the year. We're still working on that and trying to push some of these out or even still cancel some of them. That's why the 60 million is in there.

David Lieberman - Southpoint Capital

So we'll be on the right side of the 60 million.

Sven Ruder

We'll be on the right side of the 60 million, that’s for sure.

David Lieberman - Southpoint Capital

Propel has certainly been the bright spot in the business over the past few years, whereas work functions and controls has struggled in terms of the margins. Can you address what the future of work functions and controls could look like in a normal environment and what your plans are specifically for those divisions?

Sven Ruder

We're going through a strategy review process right now. We will have a clear picture perhaps with the next conference call, I could tell what we are going to do exactly, but I think both these businesses can provide us with good profits in the future.

We have divested some of the very bad businesses in there and we expect the control division to contribute positively to the company in the future. Work function is even less profitable and controls has been and this will take a longer turnaround, but these two products in the work functions division, it's the number one and number two in their respective markets.

So in steering, we have a 60% global market share and in the motors we have 35%. We're number one in steering and number two in orbital motors. This leadership team believes that this is going to be good business, we just got to get it right.

We've got to have the right footprint, we got to have the right value chain integration. We got to be purchasing the products from the right parts of the world and really have the benefit of having these market leadership positions. So, we believe in these businesses and we'll work to make them into a very profitable businesses.

David Lieberman - Southpoint Capital

In terms of the loan from Danfoss, is there a timeframe that you maybe able to discuss in terms of when you would like to see that taken out by a third party lender?

Sven Ruder

No there is not such a timeframe.

David Lieberman - Southpoint Capital

Going back to fourth quarter guidance, if you were to take the guidance being down for sales for the year of minus 58% to minus 45%, then you were to just take the percentages there and come up with a revenue for the fourth quarter. Will it be roughly 165 million to 270 million?

This is what the implied guidance is for Q4 based on my calculations and just to clarify based on your commentary from before given the backlog and given the fact that some of these orders are more short term in nature. Did you suggest that the revenue will probably be to the higher end of that range?

Sven Ruder

That's what we were suggesting.

Operator

We do have a question from John Emrich with Iron Works Capital.

John Emrich - Iron Works Capital

The book value per share of the company is now like 335 or something like that. What type of return on equity or return on capital if you prefer, do you think this business should generate under normal economic circumstances? Do you have a view on that?

Sven Ruder

I think if you look outside and if you look at the likes of companies in our business from hydraulics, propel, it should give probably more than it has given in the past and I think we will be able to give that once we finalize the strategy review process. We'll be able to give you better picture on this but we are optimistic that with the strong market positions that we have in some of these core products that we have there's no reason why we should not perform and clear this.

John Emrich - Iron Works Capital

Can you just either repeat or quantify the he potential tax reversal you referred to earlier kind of on our approximate dollar for share basis? What is that tax asset?

Ken McCuskey

John this is Ken.

John Emrich - Iron Works Capital

Hi, Ken.

Ken McCuskey

We've already set up reserves for the first nine months so of a $190 million.

John Emrich - Iron Works Capital

Okay.

Ken McCuskey

That amount would continue to build as we are operating as we have pre-tax losses in the US and Denmark are not going to project but those might get to hopefully I guess start breaking even next year.

John Emrich - Iron Works Capital

Right.

Ken McCuskey

Although that before interest expense which is also increase your tax loss. So but in theory what's going to happen once we start becoming profitable in the US and in Denmark as of right now that $409 million would swing and go back to the income statement as a tax benefit.

John Emrich - Iron Works Capital

Right. Which should be another $2 a share in book value I guess?

Ken McCuskey

Right, exactly.

John Emrich - Iron Works Capital

535. Okay. That's all I have. Thanks.

Operator

The next question is a follow-up question from Joe Mondillo with Sidoti & Company.

Joe Mantello - Sidoti & Company

Hey, guys. I was just wondering if you could first in terms of your end market, I was wondering if you could give us a sense of, you gave us the year-over -year comparison but were there any end markets that saw a sequential improvement, one and also in terms of your orders, what end markets are you're seeing that strong performance in terms of orders?

Sven Ruder

I wouldn't call it strong Joe and as I said what we see is, across the board perhaps of exception of Ag, across the board, a small step up in orders from these customers. There's no particular market we can point out as being particularly good right now. It's just that generally across the board, we see customers placing more orders with us with short horizons than we have just a couple of months ago.

Ken McCuskey

Joe this Ken, what I would add to that is, as we mentioned in the call sequentially the decreases from a year ago, were less this quarter than they were last quarter. Now, as we look at the absolute levels of sales, this quarter to a quarter ago, you'll see seasonality hits us so much. The third quarter is typically our weakest quarter and you saw sales were down in the third quarter than the second quarter. So, for that matter sales in every market will be down from the second quarter. Then that's expected because of the seasonality. People aren’t building,. The lawn care people aren’t building during this quarter, same with any equipment and construction equipment.

Joe Mantello - Sidoti & Company

Great, okay. In terms of the orders, I guess I shouldn’t have used the words, strong but you did see a pretty decent increase from the second quarter, was there a region or different types of products in terms of end markets that were particularly maybe stronger than others compared to the second quarter?

Sven Ruder

No, I don't think. China is better than others. Brazil was bad and is getting a little bit better as well perhaps a little bit faster than the others but it's a small step up across the board.

Joe Mantello - Sidoti & Company

How about pricing? What are you seeing in pricing? Is that sort flat right now or are you taking perhaps…

Sven Ruder

We think it's flat right now. As I said before with some various specific products we are addressing individually, but we are seeing flat pricing right now.

Joe Mantello - Sidoti & Company

Okay. Then in terms of new products or opportunities, is there anything on board or on the table there? Or are you just completely focused on restructuring and all that there is really nothing in the pipeline or anything significant?

Sven Ruder

We have kept our some of the most exciting products that we have for the future. We have kept them in the pipeline.

Joe Mantello - Sidoti & Company

Okay.

Sven Ruder

In the R&D projects, we have some completions to do for the new Propel products that have been introduced but there are different capacities that need to be brought on to the markets to replace the old series [PVG 90s] product. So we have continued with these R&D products. So, that is we are continuing to focus on the future., but of course the lot of our attention right now is just rightsizing the company and making sure we get the customers right and making sure that we keep our customers consented, making sure we get the financing right. So we haven't stopped. We've stopped a lot of R&D projects but we have not stopped the core R&D projects that may come in to the future.

Jesper Christiansen

At the same time we continue to bid for new business and we do win businesses just like we had done in the past. So there is no difference in how we address the market from there in these difficult times.

Operator

The next question will be a follow-up from David Lieberman with SouthPoint Capital.

David Lieberman - SouthPoint Capital

Hey, guys. Can you give us an idea on what incremental margins should look like?

Jesper Christiansen

The incremental margin.

David Lieberman - SouthPoint Capital

The higher sales.

Ken McCuskey

Typically, we expect 30% to 35% of higher sales that come down to our EBIT line.

David Lieberman - SouthPoint Capital

Are you guys happy with costs savings you saw incrementally from the second quarter to the third quarter, it looks like your sales declining by 24 million and EBIT for operating income seems to decline by something a little over 9 million, that's kind of like a [sacramental] margin if you will of 37%. It doesn't like there is any kind of costs savings running through that I would have expected this team work is showing effect, some severance should have been rolling off from European employees, can just walk us through why we didn't see that?

Ken McCuskey

As far as the cost reductions, as we mentioned earlier, the number of actions we've just taken in the last month now either of closing the Lawrence plant, our Chicago office, selling of our steering column business in Kolding, Denmark. We haven’t seen any savings from that.

Second of all, the actions we've taken over the last nine months, there is still some of those costs that we are not seeing savings come in through yet because especially in Europe you have notice periods where anywhere for six to the nine months and so you still have employees getting paid yet before they leave.

So we're not going to start seeing the full benefit of those cost-reduction activities until the fourth quarter now and moving into next year.

David Lieberman - SouthPoint Capital

Do you feel like you saw any incremental benefit from Q2 to Q3 because sales declined by Q2 to Q3 by $24 million, but operating income declined by 9, so that was pretty severe detrimental to that?

Ken McCuskey

I think we have seen that, David. The other thing that hits us is we're reducing inventories. When you're reducing inventories, you're taking cost off the shelf and you're not utilizing the cost in your factories. So your factories are less utilized than your levels of sales would indicate.

So you're not absorbing overhead costs. There are no costs in any of our income statement. So whenever you're declining inventories, bringing inventories down, you're going to get hit on the P&L and likewise, if you're building inventories, you're going to have a good P&L positive hit. So that also factors in, David.

Operator

The next question is a follow-up from Cory Armand with Rice Voelker.

Cory Armand - Rice Voelker

In terms of 2010, can you give us a sense for what the CapEx maybe in the coming year? Will it be comparable to what we saw in 2009?

Sven Ruder

No, we expect to have it around 30 million in CapEx.

Cory Armand - Rice Voelker

The notion of 35% of incremental sales above, about $1.2 billion flowing through to the bottom-line, that wouldn’t imply that, let’s say that at a sales level of say, $1.7 billion, a level that was lower than, than it had been in the prior three years before this downturn. That would imply operating margins of say, 10%. Given all of the restructuring that you're going through, the type of operating margins that you are targeting and would be at normal market?

Sven Ruder

I think what you have seen in the past is that companies at the top of the cycle have been producing 11%, 12%,13% EBIT margins. Your calculation is not that far wrong, but I hate to be very specific about the Sauer-Danfoss case until we’ve finished our review process.

Operator

The final question is a follow-up question from Alex Blanton with Ingalls & Snyder.

Alex Blanton - Ingalls & Snyder

You were under-absorbed during the quarter, is there a way to get an estimate of that? What percent of the inventory reduction, typically it can be anywhere from 10% to 25% of the inventory reduction. It is under absorbed or over and in the case of inventory increase, it's over absorbed burden that we could then adjust your margin for that. That way we could get a better fix on what the actual incremental margin was because you shouldn’t really count the absorption factor in calculating incremental margins?

Ken McCuskey

With still 20 plants or 18 plants around the world to calculate, how much we are absorbing in any of those plants to come with a ` worldwide numbers is going to be not really possible, but that certainly is an effect.

Operator

There are no further questions at this time. I would like to turn the conference back over to management for any closing remarks.

Sven Ruder

We'll give 10 seconds if there's anybody else with a question. Well, I guess there are no further questions. So thanks very much for taking your time to join us today. If you do have any questions that come up later, please contact Ken, Jesper or myself directly and we'll be happy to take your questions. So once again, thanks very much for joining us today and have a good day. Bye-bye.

Operator

Ladies and gentlemen, thank you for participating in today's conference call. You may now disconnect.

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Source: Sauer-Danfoss Inc Q3 2009 Earnings Call Transcript
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