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Sun Hydraulics Corporation (NASDAQ:SNHY)

Q1 2010 Earnings Call Transcript

May 11, 2010 9:00 am ET

Executives

Richard Arter – IR

Allen Carlson – President & CEO

Tricia Fulton – CFO

Analysts

Robert McCarthy – Robert W. Baird

Joe Mondillo – Sidoti & Company

Kristine Kubacki – Avondale Partners

Jon Braatz – Kansas Capital

Operator

Good day, ladies and gentlemen, and welcome to the Sun Hydraulics first quarter 2010 conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions on how to participate will be given at that time. As a reminder, today's conference call is being recorded.

I would now like to turn the conference over to your host, Mr. Richard Arter. Please go ahead.

Richard Arter

Thank you. Good morning, everybody. Allen Carlson, Sun's President and Chief Executive Officer and Tricia Fulton, Sun's Chief Financial Officer, are presenting – are participating, excuse me, in today's call. Allen is joining us from Shanghai, China and right now we've got a great connection. We're going to hope that goes through the rest of the call.

Please be aware that any statements made in today's presentation that are not historical facts are considered forward-looking statements. For more information on forward-looking statements, please see yesterday's press release. We will take questions once we have completed our prepared remarks.

Before we begin, I would like to remind everyone that Sun Hydraulics' Annual Meeting of Shareholders will be held on Tuesday, June 8, in Sarasota, Florida beginning at 10 AM. You can see the investor relations area of our website for more information. It is now my pleasure to introduce Allen Carlson.

Allen Carlson

Good morning to those of you who are listening from the Americas. Good afternoon from Europe and good evening to Asia, where I am right now. We are very pleased with the recovery, which appears to be gaining strength each month. All indicators point to continuing growth throughout 2010.

April's PMI, which has proven to be a good leading indicator for Sun, recorded its highest reading since June 2004. As we pointed out in yesterday's press release, we experienced significant strength in demand during March. Expedited orders continued throughout Q1. We have no indication that Sun distributors are building inventory, or that inventory is being built anywhere in the supply chain.

Sun's U.S. workforce is, again, fully employed and the salary reductions we instituted last May have been reinstated. Our global colleagues either have or are bringing people back off furlough as demand dictates. We believe we have the personnel and infrastructure in place to meet demand for the foreseeable future.

Sun prides itself on being agile and responsive. By keeping our workforce intact last year and making productivity-related capital investments, we are able to timely ship products to meet our customer's needs.

As expected, we began to see the stirrings of the recovery first in the Asia-Pacific region, followed closely by North America. The recovery in Europe has been a bit slower, but that business rebounded nicely in the first quarter. This is the time in the business cycle where Sun gains market share. Key drivers that helped us gain share include our product offering and our ability to reliably deliver quality products when and where our customers need them.

We have seen new business opportunities as a result of our affiliations with High Country Tek and WhiteOak Controls. These companies enhance our capabilities and expand our addressable markets. Coupled with our growing offering of electronically actuated valves, we are able to take an aggressive approach to developing integrated solutions.

These integrated systems, combined with the best independent distribution network in the industry, helped established Sun as a solution-based company. This is beneficial to Sun's customers, who receive better value-added and more cost-effective solutions. And it's beneficial to our shareholder that expands the opportunities for Sun's growth.

I'll now turn it over to Tricia, who will detail the quarter and then we'll take questions and answers. Tricia?

Tricia Fulton

Thanks, Al. As we indicated in last quarter's call, with our workforce fully engaged we will regain our operating leverage. As our orders continue to accelerate, we will see positive gains in both growth and operating profits. Order rates have increased across the board geographically and heated up in both Asia and Europe in the first quarter.

Asia-Pacific sales were up 31% sequentially and 94% compared to the first quarter last year. European sales were up 22% sequentially and 11% compared to last year. North American sales have also continued to expand, up 8% compared to last quarter and 15% compared to last year. As Al indicated, we believe most of the orders we are receiving are needed to fulfill production requirements at the OEM levels. We don't believe there is any significant inventory build occurring, either in our channel or at our customers.

Now, I'll move on to some details for the quarter. Compared to Q1 2009, first-quarter sales were up 25% and earnings increased from $0.03 last year to $0.20 this year. Sequentially, sales increased 16% compared to the fourth quarter. Foreign currency accounted for 3% of the first-quarter sales. Gross profit in the first quarter was $10.1 million. As a percentage of sales, gross profit increased to 32%, compared to 22% in the first quarter last year.

The furlough program had no material effect on gross profit in Q1, as U.S. employees gradually returned to work full-time throughout the quarter. We were able to leverage our fixed costs and pick up substantial growth profit on the incremental sales increase. Our operations are lean and running at a highly productive rate. We believe we still have room for additional productivity improvements, even at higher demand levels.

As of April 24, all U.S. employees have been brought back from furlough and all salary reductions have been reinstated. Our forecast for the second quarter takes these changes into account.

Gross profits going forward could be affected by changes in currency valuation. All cartridge valves sold around the world are manufactured in Sarasota and sold in U.S. dollars. As the dollar strengthens, the cost of sales will increase for our global operations and could have a negative impact on gross margin. Based on ending April rates, we do not expect this to be material for Q2. SE&A expenses were up $400,000 compared to the first quarter last year or 8%. SE&A expenses were flat sequentially.

While the changes from Q1 last year were relatively small, there were a few items that accounted for the majority of the increase. The first is a variable portion of Board compensation that is held in Sun stock under a deferred compensation arrangement. And the remaining items, which are operational in nature, include increased marketing efforts in Asia and fringe benefit costs related to self-funded health plans in the U.S.

The provision for income taxes for the first quarter was 35.7% compared to 23.7% for the first quarter last year. The prior year provision included a tax benefit recognized in the U.S. The current period provision was affected by discrete items related to a reserve for uncertain tax positions from previous years.

Excluding these discrete items, the effective rate would have been approximately 31%. We expect the Q2 effective rate to be between 32% and 33%. Net cash from operations for the quarter was $2.1 million. Inventory turns were up half a turn over Q1 last year. Day's sales outstanding were up one day to 41, compared to Q1 2009. A quarterly dividend of $0.09 was paid on April 15 to shareholders of record as of March 31.

Looking ahead to the second quarter, we expect business to remain robust. Our sales estimate for Q2 is approximately $39 million. This represents a 23% sequential increase in revenue and an 81% increase compared to the second quarter last year. Earnings are projected to be between $0.34 and $0.36, a clear indication that we have regained our operating leverage.

As we have repeatedly stated, we believe market share gains are the results of how a company responds early in the business cycle upturn. Sun has the capacity and workforce necessary to meet the steadily and rapidly increasing demand. Our suppliers and distributors are working with us to ensure our customers are receiving quality products when they need them. All the fundamentals are in place for Sun to continue to gain market share.

Thank you. We will now open the call for Q&A.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question comes from Robert McCarthy of Robert Baird.

Robert McCarthy – Robert W. Baird

Good morning, everybody. Can you hear me okay?

Allen Carlson

Yeah. Good morning, Rob.

Richard Arter

Good morning, Rob.

Robert McCarthy – Robert W. Baird

I have to compliment you on a good-looking quarter, but it's really – it's the second-quarter outlook that is a little breathtaking. We only have about, I think like 14 years of quarterly records. I can't find three quarters in a row that would show the same kind of sequential sales growth as you've just had in the last two and are now looking for, actually, acceleration in the third.

So, obviously, it raises questions about what's going on industry-wise. A great deal of interest among investors in trying to discern whether we are going to have a faster than usual recovery because of how deep we went, or very impressive incremental gains in terms of market penetration by Sun. So I'm guessing it's a little of both, but Allen, can you help us out in terms of understanding the incredible momentum that you are showing?

Allen Carlson

Sure. And thank you for the compliments, Rob. You are absolutely right. It's some of both. And my gut would tell me that it's probably just about equal. As to the market versus some additional penetration in the market by ourselves, I'll take the first part of it and answer that first.

We've been saying all along that when our market turns up or turns down, it happens very quickly. And of course, we saw that beginning in late '08, '09 with the downturn. It dropped pretty precipitously. I don't think we have seen three quarters in a row with that kind of record drop, ever, either.

So the three quarters in a row of a record increase probably is not really surprising. And that's why we implemented the furlough system, to preserve our capacity and capability, because we know that the upturn, when it happens, happens very quickly. And as it's played out, it played out very well for us, because we had a workforce that was ready, willing and charged up to get off the furlough and come back to work full-time and ramp up our production capacity. So that played out very well. Not only are we getting the orders, we can ship them.

The second part is, yeah, we are picking up some market share in a lot of different areas, both geographically in new markets and with new products. As I've said quite repeatedly over the last five years or so, that our electro-hydraulic products are taking us into new markets. Our ability to have some electronic controls and leveraging those controls within our products is also paying dividends. So we are finding new markets for our products. As I've said, my sense is that it's probably – we are equally charged with, it's just the time when the ramp-up occurs, but we are also getting new markets and it's equally split.

Robert McCarthy – Robert W. Baird

And where you are winning new business, it's – I mean, from the way you talk about your dealer partners, where you are winning new business, it sounds like it, for all practical purposes, is exclusively following the traditional business model of the distributor and dealer getting the door open for your engineers to be working with the actual OEMs team to then create the incremental OEM because if I hear correctly, most of the growth right now is happening because of a – stepped-up OEM schedules.

Allen Carlson

That's correct. And we are getting some new business as well. So it's not only stepped-up existing customers, but we've had some wins and a few of them are somewhat significant. Our annual report just came out, I believe last week, so investors should be getting the annual if they haven't already gotten it. And I think the annual report does a really good job of talking about moving our business from being a component supplier to a solutions provider.

And there are a couple of pictures in the annual report that exhibit what we are referring to and both of the pictures that are in there that I'm thinking about are pictures that have come from OEMs. And our distributors have played a part in helping us secure that business. So, the annual report is a pretty decent read. If you haven't gotten it or haven't had a chance to look at it, I think it really speaks to moving from a components provider to a solutions provider.

Robert McCarthy – Robert W. Baird

I'm sure everyone will, Allen. The other question I wanted to ask about was operating expenses, SE&A costs. It continued to show very strong control, but as you mentioned, as of the 24, all employees back to work now. In terms of the drivers that Tricia talked about that created the 8% growth number, a piece of that almost sounded as if it were something that, the compensation piece perhaps confined to the first quarter, I'm not sure about that, but surely you anticipate greater than 8% expense growth for the year. So can you talk about, in some ways, the most important line item in terms of the execution, how you expect or even if you want to talk about budget number for the year, but how do you expect this number to develop in the robust volume and growth environment that – I mean I realize that you always like to say you don't have a lot of visibility, but I'll bet right now, Allen, you think your visibility is – may be better than usual.

Allen Carlson

Well. I'll take the first shot and then turn it over to Tricia, who may have better definition on that.

Robert McCarthy – Robert W. Baird

And then I'll let somebody else go.

Allen Carlson

Okay. As we move from the bottom of the cycle of late last year going forward, we've actually been hiring some people in key areas. For example, in Asia-Pacific, we've hired someone who is going to help promote our products.

We've actually hired some folks back in Sarasota from a manufacturing perspective. This is a great time to hire good people. They're readily available and we don't budget for it. We really don't. If we see a right person come along and we have a need for that person, we don't have a budget that says we can't or shouldn't do it.

So, from a budget perspective, it's very, very difficult to comment on when the next great opportunity to hire somebody comes along and we are looking around the world at doing that. Tricia, I don't know if you've dialed in anything at all in terms of a look-forward as to what that number might be. If you have, I will turn it over to you, because I don't have a number.

Tricia Fulton

We don't have a lot of visibility on the rest of 2010. I don't think we have any more information in this quarter than we do in any of the other quarters as far as looking forward at the sales levels. But one of the more specific questions that you asked was about the SE&A and what we are looking at projecting forward on that.

And that number does not tend to be a variable number with sales, like a lot of other companies might be, because we don't have a sales force. Generally, as your sales increase, when you have a sales force, the compensation for the sales force goes up. So it becomes a more variable cost, but –

Robert McCarthy – Robert W. Baird

I recognize that, Tricia, but I'm thinking that sometimes in very difficult and constrained economic environments, companies elect to postpone certain initiatives or they could be – any number of different kinds of programs that might get pushed to the right.

Tricia Fulton

Yes. Absolutely. And we did have some of those that we, in the downturn, looked at and we called them discretionary expenses, things that could be postponed without affecting the long-term look-forward of Sun.

Robert McCarthy – Robert W. Baird

Sure.

Tricia Fulton

And we did have some of those and as we are starting to see the ramp-up in demand, we probably will proceed with some of those projects. And we will have some increase in that SE&A line related to those, especially if they are IT-type projects that require any consulting-type work, but when you are coming out of a period where you took such a tight look at discretionary expenses, I think that we are still in that mode to a large degree, even though we are seeing the increased demand. And I would expect that those – we'd still have some constraint on that type of spending going forward.

Robert McCarthy – Robert W. Baird

So, even with something in excess of a $6 million top-line increase sequentially, when you look at the SE&A line, it's really the number that – from the prior quarter that provides the best guidance and it's unlikely you did what, $5.2 million, probably does not go above $6 million in the second quarter.

Allen Carlson

I believe that's true.

Tricia Fulton

Yes. I believe that's true as well.

Robert McCarthy – Robert W. Baird

Okay.

Allen Carlson

Again, keep in mind, as we've bottomed out and actually started to ramp-up, some of the hiring that you might think we would start now, we actually started it six months ago.

Tricia Fulton

But Rob, one of the other questions you asked about was that variable comp in the quarter. That's actually variable because it's a deferred compensation arrangement. Every quarter is adjusted to the current stock price. So, there is an effect in every quarter, either up or down. We just saw a little bit more this quarter.

Robert McCarthy – Robert W. Baird

So, you are hoping that the number goes completely down?

Tricia Fulton

No, no. I did not say that.

Robert McCarthy – Robert W. Baird

Okay. Thanks a lot.

Tricia Fulton

Thank you.

Operator

Thank you. Our next question comes from Joe Mondillo of Sidoti & Co.

Joe Mondillo – Sidoti & Company

Good morning, everyone.

Tricia Fulton

Hi, Joe.

Allen Carlson

Good morning, Joe.

Joe Mondillo – Sidoti & Company

I was wondering if you could comment on the statement that you made, in terms of, you don't believe inventory is being built up in the system or among your customers. Could you give us a little more detail on why you don't think that?

And then also, with your orders being so expedited here, do you have any more of a sense or a better picture of what is driving the growth? In other words, if the orders are flowing so much faster through the network of distributors to the end users, do you have a better picture of what those end users are and what is driving the growth?

Allen Carlson

I'll take the first shot at that, Tricia. And you can chime in if you've got anything more to add.

Tricia Fulton

Okay.

Allen Carlson

Inventory in the channel, we just recently conducted our quarterly inventory report, which goes out to our North American distributors and that inventory report came back with a basically flat, maybe even slightly down, inventory reading. So we know that inventory is not – of our product – is not staying within our distributors.

Their customers, the end customers, the OEMs, are the ones that are placing a lot of expedited orders on our distributors, which are placing expedited orders on us. So there's a clear indication that the OEMs are building for spot demand. When they get an order, they want to build it and ship it fast. And that's reflected in our expedited orders.

I think the inventory in the pipeline actually started being depleted in late 2008 continued through 2009 and by early 2010 was at a very low level. And probably will stay at that level for the foreseeable future. What's driving the demand? As we've said all along, our customer mix is just a whole lot of different types of end users and that's good news and bad news.

The good news is that when demand picks up, we see it coming from all different angles and all different directions. I guess the only piece of bad news is that it's very, very difficult to put your finger as to what is driving it, because there is no one single driver just a lot of different end-use applications. Tricia, go ahead. If you have anything you want to add?

Tricia Fulton

No. We have had a few product categories where we've seen some increases. That doesn't point necessarily to any specific end market, but our load holding valves, which Sun is very well known for as well as our electronically actuated valves have seen significant growth throughout the first portion of 2010.

Joe Mondillo – Sidoti & Company

So when you are talking to your distributors trying to get these expedited orders out as fast as possible. You don't hear any similar type customers, similar type end markets that are maybe a little stronger than some others or is it just everything sort of all at once? Okay.

Allen Carlson

No. Joe, in fact, in today's world, we don't even talk to our distributors when they place an expedited order. That comes in for the most part electronically. And the order just flows through our system and hits the shop floor and we produce product and ship it as needed. So there's not even a lot of conversation that goes along with expedited orders.

We do get some feedback when we do our inventory analysis quarterly with our distribution network. But there's nothing that is showing up as there's one single market that is driving this. It's just a whole lot of various markets.

Joe Mondillo – Sidoti & Company

Okay. My second question has to do with just the geographic regions that you sell to. I'm wondering if you can just give a little more color on – obviously, you told us what you saw in the quarter. Could you just touch on how you think that's going to play out going forward, what the real strength is maybe in April and May, is Europe – do you see any slow down there? It didn't seem like it, you saw a 22% sequentially, but if you could just touch on those three main geographic regions that you are selling to?

Tricia Fulton

We have not seen any change in our order patterns going into Q2 from what we saw in Q1 geographically. The expectation is that they will all sort of stay on that same track in a growth pattern. I think there were some concerns about Europe with what was going on there specifically in Greece that might have an effect on orders that were coming out of Europe. But we don't expect there to be any effect on the capital goods side from that in Europe.

Asia continues to be strong. Our Korean operation was hit pretty hard initially in the downturn in mid part of 2008. And their business seems to be coming back nicely and so does China's.

Joe Mondillo – Sidoti & Company

With the Asian stock market has been down, I think for three, four, five months, do you see any slowdown in terms of that or any possibility of that?

Allen Carlson

I think the stock market sort of flutters around and does its thing. And might be a longer term prediction of what might come, although I think PMI is a much better leading indicator than the stock market. So I think the market is driven – at least now, is being driven mostly by monetary and credit concerns and issues. And I think there is – like daily reactions upwards and downwards and sideways that really have little impact on our quarterly business.

Joe Mondillo – Sidoti & Company

Okay. And then third question has to do with pricing. You guys, you just mentioned the PMI the pricing component. The PMI was close to 80 in North America – in the U.S. at least. Are you seeing any increases in your component costs yet? And when that happens, do you think you can pass that through?

Allen Carlson

Most of our component costs are buried within the softer costs such as healthcare costs and not necessarily directed to the components. There's a little bit of upward pressure. But it's mostly in the soft costs – energy related and healthcare, et cetera, et cetera. We are looking at a mid-year price adjustment that will cap – that will capture some of this. Tricia, anything you want to add to that?

Tricia Fulton

We don't have anything built into our Q2 estimates related to pricing actions. And on the material side, we really haven't started seeing a lot of pressure upward, but we have heard back from some of our suppliers that they are starting to see increased material costs. And they always take a while to absorb that before passing it on to us, as we do before passing it on in a price increase.

Joe Mondillo – Sidoti & Company

Okay. And then last question, use of cash. Could you just talk about that?

Tricia Fulton

Yes. We are still paying dividends. We've continued to pay dividends throughout the downturn. I know there were a lot of companies that reduced their dividends or discontinued them entirely. And we have not done that. We kept it level with where we were prior to the downturn. We also made some significant investments in capital related to productivity improvements in the U.S. throughout 2009. We believe that those will payoff for us long-term in productivity improvements as the demand continues to go up.

Joe Mondillo – Sidoti & Company

Okay. So acquisitions, is that a possibility or is that still really not a high focus?

Tricia Fulton

Yeah. I think it's the same story that we've had before. We don't have a specific target list of companies that we are constantly looking at. But if there's an investment opportunity out there that we think is a good strategic fit for us. It's something that we would definitely pursue.

Joe Mondillo – Sidoti & Company

Okay. Great. Thanks a lot.

Operator

Thank you. Our next question comes from Kristine Kubacki of Avondale Partners.

Kristine Kubacki – Avondale Partners

Good morning.

Allen Carlson

Good morning, Kristine.

Tricia Fulton

Good morning, Kristine.

Kristine Kubacki – Avondale Partners

Just a question a little bit more on your supply chain. You did cross a pretty strong inflection point in March. We heard that industrial wide. Do you think that the distributors and maybe not so much the OEMs, but do you think that they want to start restocking at this point, but can't?

Allen Carlson

I think there's some of that. I think two things are happening. The demand that they are seeing caught them kind of flatfooted as well. And that demand is pulling down their inventory, what's there. At the same time, they are placing orders on us – that are some stock orders and some are expedited orders for immediate demand. So I think both areas are happening.

I think there's also some uncertainty in the channel as to how much inventory did they put in, companioned with the question well, how much do we need, because especially of Sun inventory because we can get it when we need it. So why put in a huge stock at this point in the business cycle. Because there's still some uncertainty out there as to what the rest of 2010 and 2011 is going to look like.

So we don't need to carry it. Why carry it, we can get it when we need it. So I think all of this is kind of happening, but there's a huge pull on that inventory reservoir that's out there from the OEMs. And that's probably, I think your question is it having a dry down effect? And yes, it is.

Kristine Kubacki – Avondale Partners

And then I guess on the flip side, then to you, are you worried in any way about any of your suppliers in the supply chain at this point, where you see orders going?

Allen Carlson

We have – about three or four months ago, we actually started looking at our supplier base very, very close. And there are probably two or three suppliers that we are working with on a daily basis to remove any restrictions in capacity and capability. But in general, the supplier base is doing very, very well ramping up. We have a really close conversation with our suppliers, daily and monthly. The monthly is like, here's what's happening at Sun get ready, both on an upward and a downward.

So I think the communication within the supply chain is rather tight and we are able to respond quickly. Because we know that it's an important component for us to be able to have access to the parts that go into our products, us being able to ship products because we have a workforce that is ready to go is only useful if we can get the parts that we need from our supplier base. We recognize that in the downturn.

Kristine Kubacki – Avondale Partners

That's helpful. And then I'm going to ask you to speculate a little bit here on a more of a macro side. It was a quarter ago that you talked a lot about the levels of idled equipment globally and the end market. And it seems like things have rapidly changed, especially in the month of March. I mean what do you see as kind of the tipping point that changed that direction in terms of ordering equipment, especially on the mobile side here, the CapEx cycle here getting started?

Allen Carlson

Boy, this is really speculation.

Kristine Kubacki – Avondale Partners

You know better than I do.

Richard Arter

Like (inaudible).

Allen Carlson

Yeah, right. I think that the cycle just played itself out. And at some point in time – my own view is that the bottom of the cycle occurred sometime in June, at least for us occurred in June of 2009, it was the bottom. It took us six to eight months to get there and six to eight months to get out. If you look at the PMI as the leading indicator, again it's been very, very true. So when the PMI started rising about eight months ago historically, we've plotted this about six to eight months later we start going up and following the PMI.

So for – I don't have to say this, but for all of you out there looking for a leading indicator for companies like Sun, I think PMI is the great one. And so really, Kristine, your question is when and what caused the PMI to start going north? What happened? I think it's just – it's like the cycle played itself out and it was time.

Kristine Kubacki – Avondale Partners

Good to hear. Thank you very much for your time.

Tricia Fulton

Thank you.

Operator

Thank you. Our next question comes from Jon Braatz of Kansas Capital.

Jon Braatz – Kansas Capital

Good morning, Allen. Good morning, Tricia.

Tricia Fulton

Hi, Jon.

Allen Carlson

Hi, Jon.

Jon Braatz – Kansas Capital

I have a question. If we look at your guidance for the second quarter $39 million and earnings of $0.34, $0.36, it comes out to maybe an operating margin of around 23%. When you look back historically, the best margin or close – the best margin you achieved I think was the second quarter of 2008, $51 million on 25% and 25.8% operating margin. As the cycle plays out, Allen, are we looking at a sort of a new level of operating margin that's possible for Sun, as orders continue to ramp up or are there – are we going to see some cost build and margins more in line with where they historically have been?

Allen Carlson

I think there are two things in play. One is the operating in your sweet spot, if you would and we are kind of there. Our workforce is fully back. They are fully charged. Our suppliers are ready to keep up with quality products to us. The projection you are seeing in the second quarter and the third – maybe even in the third quarter is really right into our sweet spot. So I'm not surprised that margins are strong and we are getting the leverage we are.

On top of that, during the downturn, we've added some capability and capacity in terms of equipment and processes and we are a better company than we were going into the downturn in terms of ratcheting up our sweet spot. So I think there's some legs to that, although I don't – I can't predict where the ceiling might be. But I do believe we've made improvements in our company and our processes and therefore our margins.

Jon Braatz – Kansas Capital

Does the mix more towards electronic products enhance that margin? Are we looking at a higher margin on those product offerings, correct?

Allen Carlson

Not really.

Jon Braatz – Kansas Capital

Okay.

Allen Carlson

No. The margin, I would say, would probably even be slightly less than our normal product. But our electronic products bring so many other products along with it. And so it's hard to say what the mix of the tagalongs product will be, but generally speaking when I take a look at electrically controlled products going out the door for every dollar of the electrical hardware that goes out, there's probably $6, $7, $8 of vanilla hardware going with it.

Jon Braatz – Kansas Capital

Okay. Allen, you are over in Shanghai today. I assume you've been over there for a while and you've been over there many times. Sitting back here, we read a lot of stories about China and where it may be headed and concerns about their markets and asset bubble over there. When you talk to people on an operational basis over there, not the financial people, what's your sense of what's happening over there good, bad, or not? How are the Chinese businessmen looking at his outlook?

Allen Carlson

By the way, I just arrived last night, so I haven't had a lot of opportunity on this trip. But I have been here quite a number of times over the last couple of years. And generally, I would characterize China as follows. The business people here are very opportunistic. They can see capabilities to use our products and to do things more cost effectively. And it's not just Sun's products, but all western products whether it's computers or cars or trucks or engines for locomotives. There's just a lot of opportunity here. There's a lot of building going on. It's very dynamic, a very dynamic economy. They like western goods. They are prepared to pay a premium for quality product.

And I think the general consensus in China is that there's good times ahead. They have plenty of money. They have lots of money in the treasury in the government. They just announced that the even though exports are down and imports are up, they still have a positive balance of trade for the quarter. Their currency is pretty solid. They make wise long-term investments as a country in bricks and mortar and infrastructure.

And so I think things are very positive in China and as China goes, I think so does the rest of Asia. Japan, Korea and other countries export a lot of products in here as well. So I personally am quite bullish on what's going on in Asia.

Jon Braatz – Kansas Capital

Okay. And then the last question is, you characterized your order flow this quarter somewhat being expedited. Does that all suggest that you are moving orders and sales ahead from subsequent quarters or is that a wrong way to look at it?

Allen Carlson

There is some of that happening, but that's not the big driver.

Jon Braatz – Kansas Capital

Right.

Allen Carlson

The driver is new orders…

Jon Braatz – Kansas Capital

Yeah.

Allen Carlson

That hit the books. But if somebody had something on order that was scheduled for May, they might move it into March. But generally speaking, it's new orders.

Jon Braatz – Kansas Capital

Okay. All right. Thank you, Allen. Thank you, Tricia.

Operator

(Operator Instructions) Our next question comes from Robert McCarthy of Robert Baird.

Robert McCarthy – Robert W. Baird

Hi. I just wanted to follow-up on a couple of things. The discussion of distributor inventories and your quarterly survey, et cetera. I want to make sure I understand exactly what you've seen in your most recent one. When you say flat in the kind of environment we are talking about here, you mean flat on absolute level, right, not inflated –

Allen Carlson

Correct. Dollars and inventory, yeah.

Robert McCarthy – Robert W. Baird

Okay. So that means on a day sales basis, inventories are plunging in a sense?

Allen Carlson

Correct.

Robert McCarthy – Robert W. Baird

And that would help explain why distributors believe they need to be placing stocking orders as well.

Allen Carlson

That's correct.

Robert McCarthy – Robert W. Baird

Doesn't necessarily – well, you made the comment, Al, about that more expedited orders mean that the customers must be seeing better final demand, not just production rate – planned production rate increases. But I mean how the big OEMs can be. They love to give you four weeks firm and in a rising environment, you start out with them following the rules in terms of requested lead times, et cetera. But sometimes you just see that being – the envelope being pushed.

Allen Carlson

True. Absolutely.

Robert McCarthy – Robert W. Baird

How do we really know that we are seeing improved final demand?

Allen Carlson

Well, I think you have to look at the distributors algorithms, how they look at their inventory. And some of them look at it in turns, but the majority of them look at it in terms of stock outs. I need three pieces of this part number and I only have one in inventory. I have to expedite two from the factory, because I need to ship three. They don't drive their inventory procurement or stock orders based solely upon inventory turns. They are actually looking at the level of inventory on the stock outs.

Robert McCarthy – Robert W. Baird

Okay. And so…

Allen Carlson

And yes, the OEMs out there sort of move things around, but they are pretty firm out 30 days and we are pretty firm out 30 days. And what we've been seeing for more than 30 days now is an increasing rise in expedited orders and demand. So I don't think it's just a one-time blip. And if you put that in the context of what's going on with PMI. I sense that the remainder of 2010 will be quite strong unless there's – something strange happens somewhere around the world. But if things continue for the rest of the year as they have so far this year. I think you'll see a strong 2010 going into 2011. But watch PMI as a good leading indicator.

Robert McCarthy – Robert W. Baird

Well, Of course, one of our concerns is that it's a little early days to be deflecting the possibility of some impact from what's been going on in Greece and…

Allen Carlson

Correct.

Robert McCarthy – Robert W. Baird

The potential that that will repeat itself elsewhere. That' why – as you appreciate, the question of what's happening with final demand so important and I appreciate you shedding some light on it. Thanks.

Operator

(Operator Instructions) I am showing no further questions, sir.

Allen Carlson

Okay, thanks. And we'd like to thank you all for joining us on the call today. Again, the shareholders meeting will be held on June 8 at 10:00 AM in Sarasota. You can get further details if you go to the Investor Relations section of the website. Thank you and we look forward to talking to you next quarter.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may all disconnect. Thank you and have a nice day.

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Source: Sun Hydraulics Corporation Q1 2010 Earnings Call Transcript
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