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Executives

Magnus Larsson - Head of Investor Relations

Olof Faxander - Chief Executive Officer

Mats Backman - Chief Financial Officer

Analysts

Andre Kukhnin - Credit Suisse

Markus Almerud - Morgan Stanley

Guillermo Peigneux - UBS

Ander Esberg - Nordea

Alex Whight - JPMorgan

Peder Froelen - Handelsbanken Capital Markets

Sebastien Gruter - Societe Generale

Colin Gibson - HSBC

Martin Wilkie - Deutsche Bank

Alexander Virgo - Berenberg

Anders Roslund - Swedbank

Ben Maslen - Bank of America

Daniel Schmidt - SEB

Sandvik AB (OTCPK:SDVKF) Q2 2014 Earnings Conference Call July 17, 2014 4:00 AM ET

Magnus Larsson

Ladies and gentlemen, very welcome to this presentation on Sandvik's second quarter earnings and results. My name is Magnus Larsson, Head of Investor Relations. This coming hour will look the way it normally does. We will have a presentation by the Chief Executive Officer, followed by the Chief Financial Officer, after which we will have the normal question and answer session. With that said, Olof Faxander, please carry on.

Olof Faxander

Thank you very much Magnus. And welcome everybody who is here in Stockholm with us, and of course all of you joining us over the web here. I will do a brief presentation together with Mats, and then of course we'll have our usual question and answer session.

To start with summarizing our quarter I think the most important events that happened during the second quarter for the Sandvik Group was that we took several steps forward along our strategic agenda.

We initiated a further closure of four production units, and actually completed the closure of one. And we also closed the deal with the acquisition of Varel, which lays the foundation for us to continue to build future profitable growth.

The market conditions in the quarter were stable. And well overall largely unchanged compared with the end of the first quarter. So overall for the Sandvik Group a fairly stable development.

And I think which is also important that in mining, where we have for many quarters seen an actual declining trend, we have now seen a, I would say, quite firm stability in the market at the levels where we are at right now.

Our EBIT came in at just below SEK2.6 billion for the Group. And we had a number of items affecting the EBIT in the quarter. Acquisition related costs related to the closure of the acquisition of Varel International. We had certain currency effects of about minus SEK200 million for the Group. And in a positive direction we had the effects from positive metal price effects amounting to nearly SEK200 million as well, so a number of items affecting the EBIT in both ways.

Looking at our strategic agenda in Sandvik that we've drawn up, and I've shown this slide before at previous quarterly presentations. I'd like to highlight some of the steps that we've taken forward in our direction to build a Sandvik which is exposed to high growth segments, increasing its margins gradually and reducing our earnings volatility.

And the main steps we've taken during this quarter is the initiation of the closure of four production units within mining. And this will help us to shift our footprint closer towards -- closer towards our customers and of course reduce our cost base.

In the quarter we signed the letter of intent with the Chinese producer of metal cutting tools Zhuzhou. And this gives us a strong opportunity within the midmarket segment within machining solutions. So these negotiations are still ongoing, the letter of intent was the first step. But this will be a method for us to accelerate our inroads into the midmarket area within metal cutting tools, which is important and it is a fast growing sector in the market.

And then finally within Sandvik Venture on our journey to gradually shift our portfolio to fast growing sectors in the market, we closed the acquisition of Varel International. And this lays a great platform for us, I think, moving into the future to see high growth rates and also good profitability developments in that area. So a number of things have been progressing during the quarter along our strategic agenda.

Looking then at Varel specifically, well Varel has a strong position in the oil and gas sector and is very active then in drilling technologies but also down the whole tools and completion tools regarding after the well has been drilled, and this is also an area which is growing very rapidly.

And an interesting thing with the drill bit from Sandvik's perspective to highlight that is that the drill bit itself is a fairly low part of the total cost for the operator drilling the hole. But it does have a significant impact on the productivity of drilling of that hole, and the security of drilling that hole.

And that means that the drill bit itself has a similar dynamic to what we see in our metal cutting tools, where the actual metal cutting tool is a small part of the cost but it can have a big impact on productivity and hence save a lot of money for the customers if you perform better than your competitor's drill bits.

And Sandvik has a lot of technology we can put in and support Varel with. We know industrial diamonds, we know cemented carbide and we know a lot about cutting in hard materials. So we go into an area which is technically close to what Sandvik really knows, but which opens up new market opportunities for us for future growth.

Looking at the financial performance of Varel, the first 12 months, if Varel would have been part of the Sandvik Group, they would have delivered an EBIT of SEK144 million and a margin of just over 12%. This has been a bit under pressure amongst other due to the developments that we have seen in for example the Russian oil sector during the first half of this year.

The EBIT margin trend has been improving during the year. And if you look at the period that is included into Sandvik's results from May 21 we have seen a higher EBIT margin during that period.

And the synergies that we will work on are related to, of course, supply chain cost synergies. We can supply diamond cutters, cemented carbide and other materials into Varel that we are not doing today, creating cost synergies. And maybe most importantly leverage on our technical know-how within the Sandvik Group to support and build better drill bits, giving us a competitive edge in this market.

A further advantage for Varel, being a smaller company, is Sandvik's global reach. We cover really more or less the whole world with current daughter companies and sales presence. And we can help Varel to support them in growing at a more rapid pace than they have in the past based on the strength that we have in Sandvik, and the presence that we have with the Sandvik Group.

If I move in more specifically to the quarter here then and our various regional developments, most regions actually had a negative development, you can see the development on the southern hemisphere that was clearly affected by what we've seen in the mining sector, with the continued deterioration of sales, of sales catching up with the lower order intake that we've seen over a longer period of time now.

North America was stable to positive when it comes to the metal cutting business within Sandvik, but was affected negatively by the effects of the mining industry. And Europe had a similar pattern also when it comes to our sectors. And also here we saw better developments in the western parts of Europe, but have a negative impact of the developments around Russia due to the political situation there with Ukraine and the economic effects that that is having around the Russian economy. Asia saw all in all growth for the Sandvik Group.

Then looking at our sectors, and our sector exposure, this again highlights a picture of, I would say, stabilized demand at where we are right now. Mining saw a continued deterioration in the year-on-year on invoicing, the orange part of this pie chart. And the sector where saw continued growth was the aerospace sector. And more or less all the other segments in the Sandvik Group saw flat developments compared to the same period last year.

Sequentially, all areas, with an exception of aerospace, showed a flat development while aerospace we did see a continued positive development. And I think it's important to note that mining appears to have stabilized at the level we are right now. And hopefully in quarters to come we have prospects of seeing that trend changing to the positive direction.

Sandvik's order intake year-on-year was neutral 0% in price/volume terms, while our invoicing dropped mainly driven by the developments we saw in the mining sector. And -- but invoicing increased compared to the preceding quarter, and the higher order intake that we had there, and again noting that Sandvik mining showed a stable order backlog.

Our EBIT came in just below SEK2.6 billion. And as I mentioned we have a negative currency effect by about SEK200 million. The biggest area seeing the negative currency effects was Sandvik mining where we have a lot of production in Euros and in other areas, and our sales in mining related currencies.

Sandvik materials technology on the other hand, which has the largest part of its production base in Sweden, saw actually positive year-on-year currency effects in this quarter.

Nickel prices, driven by the developments in Indonesia where they have restricted exports of nickel pick iron and also the effects of what's happening in Russia, have been going up quite significantly. And this has had a very material impact on the results for Sandvik materials technology, which gave them a positive impact of SEK177 million in the quarter.

Cash flow improved somewhat compared to the preceding quarter. We have seen some normal seasonal build-up of inventories in Sandvik machining solutions and Sandvik materials technology. But somewhat more limited than what we normally have seen in the past from Sandvik. And as we have talked about before it's our ambition to gradually even out the seasonal effects that we've had through the third quarter.

Investments came in, in the quarter, at SEK1.1 billion. And we have slightly revised down our CapEx estimates for the full year from between SEK5 billion to SEK5.5 billion to about SEK5 billion for the Sandvik Group.

Then finally looking then at our financial targets, well all in all we did see a decline in our sales in the quarter. This was driven by what has been happening in mining areas I've talked about before.

But we are focusing on creating that platform for our future growth in the Company by our R&D efforts, by the shift of our portfolio into high growing segments and through the acquisition of Varel, and gradually adjusting our geographic footprint to the areas in the world where we see the highest growth.

Looking then at our return on capital employed it was for the last 12 months 12.3%, but actually annualizing the current quarter we came in at 15.5%. And the main drivers to improve this is, of course, stabilizing and bringing up the results again for Sandvik construction and Sandvik mining, but also reducing our capital base by driving down our net working capital and being restrictive on our capital allocations in the Company.

Our net gearing for the Group increased, as we talked about earlier it was expected due to the closure of the Varel acquisition and the dividend payment we had in the second quarter. So at the end of the second quarter we were at a net gearing level of 0.96, but we expect this to drop down fairly rapidly in the coming quarters back below our financial target of 0.8 due to the underlying strong cash flows that the Sandvik Group generates.

And then finally our dividend was paid to all of you shareholders during the second quarter, and it was representing a share of 88% of our reported EPS. And again Sandvik has an uninterrupted dividend payment since 1870, and we have strong cash flow out to our shareholders through the dividend payments.

So that summarizes my part of this presentation. So I'd now like to hand over to Mats to make some further maybe more detailed comments about some parts of the report.

Mats Backman

Thank you, Olof. I will elaborate on some of our key priorities now going forward. I am starting with the supply chain optimization program, where we are aiming for reducing our number of production units from today's 150 to 125 over the next three to four years.

The first step of this program includes the closure of about 10 production units with annual savings of SEK800 million with full run rate end 2015.

During the second quarter we announced the closure of a further four units, all of them related to Sandvik mining. And with that we have announced and initiated the closure of 11 units, which actually completes the announcement for the first step of this program.

We also closed one unit during the quarter, and that's a production unit related to Sandvik construction in Chauny, France where -- affecting about 40 employees.

Looking on the phasing of the remaining 10 units and the closures, we will close another four units in the second half of 2014, and then the remaining six in 2015.

So all in all this program is running according to plan. And we have actually started the process to detail the plans and activities for the second step of the supply chain optimization program.

Moving over to net working capital, the relative net working capital increased slightly compared to the first quarter from 29% to 29.5% in the second quarter.

In terms of value it increased with some SEK2.7 billion. But out of the SEK2.7 billion SEK900 million is related to structure coming from -- for bringing Varel into the Sandvik Group, SEK900 million approximately is due to currency effects and the remaining SEK900 million is related to volume changes in our current [periods].

So looking on the different business areas and the development in the second quarter mostly due to a good control over inventory and especially looking on the stock replenishment during the quarter it is a positive development.

Materials technology was some -- was a disappointment looking on the development in the quarter with an increase in volume of SEK700 million, where about SEK350 million is related to increases in inventory volumes but whereof SEK180 million is due to the changes in nickel prices during the quarter affecting the inventory value as well.

Accounts payable also had a negative effect on the net working capital for materials technology, but that's mainly due to lower raw material purchases going forward. So it's actually having an initial negative impact on the net working capital, but that is in line with our plans to reduce the inventories going forward then.

Sandvik mining had a negative relative development of net working capital, but we actually decreased the volume in mining in the quarter. And in terms of destocking, we had the destocking of more than SEK200 million. But the negative effect on the relative net working capital is coming from a lower top line in combination with lower advanced payments from customers in the [product] business.

So all in all looking on net working capital what can you expect from the third quarter? We are looking on destocking in all business areas. We have a lot of focus and a lot of activities on net working capital going forward. And we are targeting a sustainable level of 25% for the Group by end 2015 when we are through the first step of the supply chain optimization program. And I think that is important to remember.

Moving over to another area that we are -- where we have been quite active in the second quarter and that is the funding. And like Olof said we have had a cash outflow in the second quarter due to the dividend and due to the closure of the Varel transaction.

So we are now taking the opportunity to further improve the maturity profile for us, and also to very attractive rates. So we made a bond issue in Sweden totally SEK4 billion with maturities in 2020 and 2021 with an average yield of slightly below 3%. We made a bond issue in a Eurobond as well of EUR350 million, maturing in 2026 with a coupon rate of approximately 3% or at 3%.

So with that, I'm leaving for you Olof to summarize.

Olof Faxander

Thank you Mats. So before we open up for questions from the audience and all of you calling into this conference call I just would like to summarize what I feel are the main points in this report for the second quarter.

We are delivering on our strategic agenda, and we have taken several steps, very sizeable steps forward on that agenda during the second quarter. And this will help us to build a more profitable, a less volatile, and a faster growing Sandvik in the future.

And the main items where we made progress during the quarter is the supply chain optimization. We have now announced 11 closures and that marks the completion of the first phase that we communicated in December last year.

So now we are going to close these according to the plan that Mats showed here earlier. And you can expect in the first half of 2015 that we will then embark on the second step of this plan to improve our production structure in the Company.

We see further potential to improve our capital efficiency. The main driver in terms of volume development and net working capital in the Company was reduced payables, and reduced prepayments from the mining systems part of the business. But the reduced payables is a sign of our efforts to, in coming quarters, reduce our inventory levels in the Company, so that's a step in the right direction when it comes to net working capital.

And overall in the market we are seeing a fairly stable demand pattern, some growth in machining solutions while mining most importantly we seem to see firm ground in the markets where we are standing right now.

So, thank you. And with that I suggest we open up for questions and answers.

Magnus Larsson

Yes that is a good suggestion Olof. Thank you for that. Thank you Mats as well. Now follows the question and answer session. And as I suppose most of you know it follows the usual pattern. Please be crisp and short with your questions. I know a lot of you will -- are having questions, so -- and time is of an essence, so please keep it short and crisp and also limit your question to one at a time.

We have questions here on the floor in Stockholm we have questions from the web as well. And I suggest that we start with questions coming from the phone. So operator, would you please assist us with the first question?

    

Question-and-Answer Session

Operator

Our first question comes from Andre Kukhnin from Credit Suisse. Please go ahead.

Andre Kukhnin - Credit Suisse

Good morning. Thanks for taking my question. I actually wanted [to ask about] Varel what you said on benefiting from Sandvik's global reach. Can you just help us to understand how that will work within the Sandvik organization? Given its within venture, will it be using venture's global reach or other divisions and who would be the people selling those products and do you expect -- do you plan to invest in that?

And then if I could have just a quick follow up. Mats thanks very much for taking us through the working capital dynamics. Could you just sum up what was the real underlying inventory increase that is non-currency, non-nickel related in the quarter? Because you said it was smaller than the usual seasonal ramp-up but on the balance sheet number actually it was quite big so would be good to have the underlying number. Thank you.

Olof Faxander

Good, thank you for your questions. I would like to try to explain that with -- what we mean with Varel; because we have presence today from the Sandvik Group in 130 countries around the world which is a much higher number than what Varel has.

And we have daughter companies we have basic resources in terms of an organization to support a faster development of the sales presence in these countries. So that's really what we mean that we have this Sandvik global platform in terms of daughter companies and sales reach.

And by letting also Varel use that network and if necessary employ people in those regions, we believe that we can accelerate growth rates faster than what they maybe could have sustained as an independent company.

And the second question I'll hand over to you.

Mats Backman

Yes of the volume development of net working capital. It's slightly below SEK800 million looking on the actual volume, taking out the nickel effect. Out of those SEK800 million I would say something like two-thirds is related to payables, to the payables development.

Andre Kukhnin - Credit Suisse

And the rest is inventory I guess?

Mats Backman

Yes it inventory built up and its two business [as] out of five, or building inventories and that's materials technology and machining solutions. But I should add that machining solutions it's kind of a lower stock build up than normal kind of seasonality. So we are following the same pattern as we had last year with a lower stock build up in the second quarter meaning a kind of [little] bit lower destocking in the third quarter then.

Operator

Our next question comes from Mr. Markus Almerud from Morgan Stanley; please go ahead.

Markus Almerud - Morgan Stanley

Hi, Markus Almerud here from Morgan Stanley. I would like to ask you about the margin and I'll start with the mining margin which came under significant pressure I guess on the back of the sharp drop in sales. But now we are at the book to bill of about [1] and the comparison getting easier, so I guess the operational gearing impact should decrease going forward.

What should we expect on the margin in the second half of the year? Should we bounce back to kind of Q1 levels or is the current level a sustainable one? And when is the savings from the closures starting to come in?

Olof Faxander

If we look at the mining margin, leverage was a bit more negative than what we normally see that was driving amongst others that we had some reserves that we had to do for stock obsolescence within the mining business area. And those risks we still have a bit at these low activity levels also going forward.

But everything else unchanged, same market conditions there is room for stable to slightly improving margins I would say going into the third quarter where I would say in normal seasonality we would find some slight pressure in the negative direction on margins due to lower activities in the northern hemisphere during the holiday period.

And going forward with the site closures, and so they are just initiated now and the effects from them will come gradually during 2015. But with the ongoing programs we have even if the market stays exactly as it is today there is room to believe that we will see a gradual improvement in the mining margins going forward due to ongoing activities.

I don't know if you want to add anything Mats to that.

Mats Backman

No.

Markus Almerud - Morgan Stanley

Maybe you can talk a little bit about the [SMS] margin as well.

Olof Faxander

Yes, average was a bit lower than what we normally see at 30% for SMS. And that is due to the fact that we have communicated earlier also that we are making a larger investment right now especially into our selling costs within machining solutions, enable to strengthen our market positions and help us to improve growth rates going forward. So that cost increase in our sales force is what has resulted in the lower leverage that we saw for machining solutions here, so that's really due to an investment in the future.

Markus Almerud - Morgan Stanley

So same thing that with the current market environment we should expect similar kind of margin levels because I assume that investors will go on throughout the year as well.

Olof Faxander

Yes, I mean those -- this increased cost base will stay. Our plan is of course to find future growth as a result of this investment. Now looking into the third quarter we do normally have certain margin pressure due to the seasonality in the business, but we expect that to be maybe half of normal levels due to lower swings in the inventories and so than what we have seen in the past, so slightly lower seasonality effect in Q3.

Mats Backman

And looking on a normal seasonality for machining solutions between the second and third quarter is somewhere between 1% to 2.5 percentage units on the margin then. And due to the control over net working capital and the stock control we have less volatility between the second and the third quarter now than we used to have in the past.

Magnus Larsson

Thank you very much. Thank you for that, and please remember to limit your questions to one at a time. May we have the next question from the floor in Stockholm, please?

Guillermo Peigneux - UBS

Hi. Thank you for taking my question. Guillermo Peigneux from UBS. Related actually to your investments in selling and R&D in machining solutions, are you at the level you want to be, or are you planning to continue to increasingly or incrementally add people, feet on the street, and actually R&D expenses as we move forward?

Olof Faxander

You're welcome to answer it.

Mats Backman

What you need to put the actual amount is in relation to sales, because what we are expecting is a growth coming from the effort we are doing within the R&D and on the sales side. So in terms of the relative number, we don't expect any kind of big changes.

Guillermo Peigneux - UBS

But given the fact that -- sorry. Follow-up, but now you're doing the effort, and you're expecting the growth contribution.

Mats Backman

Yes.

Guillermo Peigneux - UBS

You can continue to do so, but at the same time, what we [not] appreciated in your organic developments is that 43% of your organic growth in revenues is gone, while you added selling and R&D expenses, and the drop-through has been lower. So I was wondering whether you will continue to add, regardless of the organic developments we see, and as we speak, because you expect to capture future growth.

Mats Backman

We need to be prepared to adjust that if we don't see the growth coming. For sure, yes.

Olof Faxander

Absolutely. We need to of course continuously take into consideration the market development, but so far, in the second quarter, we've seen a stable and strong demand. Looking into the first trading days of the third quarter, we've seen a good, solid, stable demand at the levels we've seen going after the second quarter, so we have no reason, to date, to really have a more negative view on the markets.

The only deviation of maybe what we could have expected is what we've seen in Russia and that negative development. That I would say.

Magnus Larsson

Very good. Do we have another question from the floor in Stockholm? Yes, please?

Ander Esberg - Nordea

Thank you. It's Ander Esberg from Nordea. A question on the Chinese midmarket and the LOI on the JV. Could you contrast the growth rates happening in the premium markets versus the midmarkets and give us some kind of rationale why the midmarket is that interesting?

And also, on that JV, will it go for the export markets or will it only be domestically focused on the Chinese market?

Olof Faxander

Well, the challenge we've seen in the past with our exposure, Sandvik has three main brands, which are all positioned in the premium sector. If you look at a number of our competitors, they have a brand portfolio positioned in different value parts through the market. So it's been important for us through the Carboloy efforts in trying to achieve this joint venture to build the position in the more price-driven part of the segment. We've been very much in the value selling part of the metal cutting tools.

And that has been growing clearly higher, and a lot of the growth has happened in emerging markets. Especially with local companies, I would say, it has been driven by more price-based selection of product than actually productivity-based selection. So that's why that is important.

And we also see, longer term, it is a strategic risk for us not being there, because if we let other companies fill that space, in the longer run, they're also going to develop and want to compete with us in the premium sector. So it's both in terms of growth development but also strategic positioning of the company to cover the broader part of the market that we feel this effort is important.

Ander Esberg - Nordea

And will the JV only be China, or it will it be global?

Olof Faxander

Sorry. No, we're going to have both a JV regarding the Chinese market but also for export into other parts of the world.

Magnus Larsson

Thank you very much for that. Operator, please, may we have the next question?

Operator

Our next question comes from Mr. Alex Whight from JPMorgan. Please go ahead.

Alex Whight - JPMorgan

Good morning, everybody. It's Alex at JPMorgan. My first question is on the mining division. How far through the inventory adjustment process are you there? Should we be expecting to see a similar level of destocking for another couple of quarters? Just a little bit of guidance there, if you could.

Mats Backman

Yes. You will see a similar kind of destocking going forward, the coming quarters.

Alex Whight - JPMorgan

And is that like two quarters, four quarters, six quarters? How should we think about that?

Mats Backman

At least two quarters.

Alex Whight - JPMorgan

Okay, at least two quarters. And then my second question was around construction. The restructuring doesn't really seem to have taken hold yet. What's the future course of action there?

Olof Faxander

Well, we're driving an active program, both in terms of aiming at building top-line sales in the business area -- the biggest cost-saving effort we have ongoing is the closure of the Swadlincote site in the UK, which has been initiated but won't be completed until the early part of 2015. But that will have a material impact, also, on reducing the cost base in Sandvik Construction. And then we have general cost-saving efforts going on throughout the business area.

Alex Whight - JPMorgan

And then the final question was machining solutions demand in Europe. The organic growth number has come down from 5% in Q1 to 2% in Q2. We heard SKF talking about weaker demand within its industrial distribution business later in the quarter. I was just wondering what you saw in Europe as we went through the quarter.

Olof Faxander

We have not seen any negative or deteriorating trend during the quarter, so we have seen a stable demand throughout the quarter, and I have no reason to indicate any deterioration in market activity. What has been weaker in Q2 or sequential are the effects in Russia, which is a fairly important market for machining solutions, whilst in many parts of Western Europe, we actually saw better development.

Mats Backman

I think it's also important to remember, when you look on the price-volume figures for Q1 and Q2 that we have a working-day effect in the second quarter due to Easter holidays between the first and second quarter, so that's approximately 1% as well.

Alex Whight - JPMorgan

Okay, that's helpful. And how big is Russia for machining solutions?

Mats Backman

I would say maybe around seven or eighth in terms of the size of the markets. But that we need to double check, that number.

Alex Whight - JPMorgan

7% or 8%?

Mats Backman

No, no, no, in terms of the size of --

Olof Faxander

Ranking of global markets. It's the seventh or so in terms of size, globally. But it's, of global sales, a few percent.

Alex Whight - JPMorgan

Global sales of 2%.

Olof Faxander

A few. I won't be more specific than that, but we can get back to you with that more specific number.

Magnus Larsson

Thank you very much. Operator, may we have the next question, please?

Operator

Our next question comes from Mr. Peder Frolen from Handelsbanken Capital Markets. Please go ahead.

Peder Froelen - Handelsbanken Capital Markets

Yes, good morning and thank you. Could you please give some clarity on the price component on Group, obviously, but also by division? That's my first question.

Olof Faxander

Well, overall, we saw a neutral to positive price development across the business areas, and for the Group, we talk about roughly 1%. Mining, I would say, saw fairly flat pricing development, while we do see some price progression in Sandvik Machining Solutions.

Peder Froelen - Handelsbanken Capital Markets

Okay, and given the metal price effects in the SMT business, I guess that contributed to the Group figure, as well, or is that excluded in your price thinking on roughly 1% on Group?

Olof Faxander

That's related to the base price effect, so that's not included in the general raw material price that we transferred through the Company.

Peder Froelen - Handelsbanken Capital Markets

Okay, that's very important. A follow-up on this. On SMS, are we closer to 2% then than 1%? Sorry about the nitty-gritty, but it is quite important, given the R&D and your efforts there?

Olof Faxander

Well, we haven't been that specific, really, in our communication, but of course that has to be after, above the Group average, to achieve the 1% level there.

Peder Froelen - Handelsbanken Capital Markets

Okay, okay. A follow-up if I may, I small one on Varel, 13.2% adjusted margin. How adjusted is that compared to the future? Will we see an increased pressure on the accounting efforts, on PPA, on others, or could we assume that this is a very clean margin, if we look ahead?

Olof Faxander

This is the margin before the PPA, so that's why we put the word adjusted in there.

Peder Froelen - Handelsbanken Capital Markets

Okay.

Olof Faxander

And as I said, we have been on a positive trend in terms of improving underlying EBIT margins for the business, and we see opportunities or reasons to believe that that trend will continue into the second half of 2014.

The specification of the PPA effects we put into the presentation as the first backup slide, so there you get the details, and as normally, we have more significant inventory PPA adjustments coming in the first quarters after an acquisition like this. But there it was specified for you in some detail in that first slide.

Peder Froelen - Handelsbanken Capital Markets

That's very clear. I'll get back in line. Thank you.

Olof Faxander

Thank you.

Magnus Larsson

Thank you very much. Operator, may we have another question, please?

Operator

Our next question comes from Mr. Sebastien Gruter from SocGen. Please go ahead.

Sebastien Gruter - SocGen

Hi. Good morning. One question first on the FX, SEK208 million in the quarter. You were guiding for SEK150 million. While exchange rates improved through the quarter, I think there is a negative item in the corporate line. Could you give some color about what happened and why guidance was too conservative? That's the first question.

Mats Backman

Looking on the Group activities, we have a negative currency effect of SEK60 million in the quarter, and that's related to the strategic hedges we have on their transactional exposure, so we are hedging about 25% of the total transactional exposure, so we have a negative effect from the valuation of hedges by the closing of the quarter.

Sebastien Gruter - SocGen

Okay. That's a one-off.

Mats Backman

Yes.

Sebastien Gruter - SocGen

Yes, okay, thank you. And just a follow-up question, looking at the big picture, you had a positive FX impact quarter on quarter. I think at the Group level, you had slightly higher production rates, as well, but the underlying earnings, ex inventory gains at SMT and ex other one-offs are stable quarter on quarter. When do you think, Olof, we could see volumes and cost savings more than offsetting investments in the business? Could it be H2, or is it more 2015, 2016?

Olof Faxander

More than offsetting what? Could you just specify?

Sebastien Gruter - SocGen

The investments you make in the business to improve the cost profile?

Olof Faxander

In Machining Solutions or in the Group?

Sebastien Gruter - SocGen

Overall, for the Group.

Olof Faxander

Well, the effects from the program we have ongoing with these 11 sites that are initiated so far will follow roughly the profile that Mats showed when these sites actually will be closed, and it's of course after the completion of that closure that we start to see the cost savings coming through in the gross profit.

So during the second half, we're going to have a number of closures, but the bulk of them are actually going to be during 2015, or more than half of them will be there. So that's when that improvement will come from these savings.

Sebastien Gruter - SocGen

So excluding any improvement in volume in H2, you don't expect earnings to improve from the Q2 level?

Olof Faxander

Well, we have a seasonal effect in Q3 that we talked about. I think we're generally focusing on improving our costs and all the small efforts that you continuously do in a company, and we have certain effects from these closures coming through. So I think there are things that are moving things in a positive direction also in the second half, but from the site closure program, the big effects will start to come during 2015.

Sebastien Gruter - SocGen

Okay, thank you. Very clear.

Magnus Larsson

Thank you very much. I am looking around on the floor to see if -- yes, we have another question from the floor in Stockholm.

Guillermo Peigneux - UBS

Hi. Guillermo Peigneux from UBS again. Maybe a follow-up on mining. Most of the companies we hear nowadays are talking about stabilization towards a slightly positive development in terms of demand, which is coinciding with the fact that the mining companies are growing its production very heavily, in fact. But what happens if that growth, which is actually outpacing demand growth for minerals, slows down and flattens? Do you think that you could actually see further, let's say, deterioration in overall order intake or demand from the miners?

Olof Faxander

That's a very speculative question here, but looking at the general dynamic in the mining industry, there's been a massive CapEx cut at the miners. Actually, global mine production has continued to tick upwards during this period, and I think there's reason to believe that that dynamic is not sustainable. So given that the continued demand for metals is there and that this production development continues, this is going to have to trigger more investments in OpEx to start with and then, in the slightly longer term, also more CapEx investments in the mining companies.

At Sandvik, we remain very positive about the long-term prospects of the mining industry for our Company, and we see it as an important part and an area where we have great opportunities to improve. And looking out, relating to an earlier question, what can drive margins going forward, what we need to do and focus hard on and drive is working with the aftermarket business in these market conditions, the consumables, the spare parts and these parts. And that's very much on Scot Smith's agenda, who joined the company earlier this year.

He also has, I think, a strong track record from his -- especially time at Weir, where they built up the aftermarket very, very successfully. So these kind of efforts are also on our agenda, so even in a flat market, we should have through these efforts a gradually improving margin in our mining business.

Guillermo Peigneux - UBS

Thank you.

Magnus Larsson

Thank you very much. Operator, let us move back to the other audience.

Operator

Our next question comes from Mr. Colin Gibson from HSBC. Please go ahead.

Colin Gibson - HSBC

Hi there, everybody. Two questions, please, but I'll take them one at a time, as requested. First of all, on Varel, you mentioned synergies in the presentation, but there's no sizing of those synergies, nor a timetable over which we might expect you to achieve those synergies. Could I tempt you to say anything more on either of those two fronts, please?

Olof Faxander

We don't have details that we've chosen to share regarding that, but we do have improvements in cost and profitability for Sandvik coming through that we internalize supply of metal powders within [some] carbide diamond cutters and these kind of areas. But the most important thing to leverage on Varel for the future for Sandvik is a high growth rate an dollar strong underlying EBIT margin that we feel we can develop even further through volume increases, but also in part through the cost synergies.

So I would say the growth and the volume development are the key areas that we see as an opportunity in this business, and not necessarily the cost-saving part.

Colin Gibson - HSBC

Okay, thank you, and a follow-up question. I've asked about this before, but in September, it will be three years since you said you were going to review the Group's involvement in materials technology and construction, subject to their future performance. Obviously, since then, we've seen a turnaround at materials technology but not really at construction. When would you anticipate getting back to the market with more information on your September 2011 comment?

Olof Faxander

Today, we don't have any more information to share about that, but this will of course be one topic we will discuss at our capital markets day this autumn, where we will try to clarify our future direction more on how we look at these assets.

Magnus Larsson

Thank you very much for that. Operator, may we have the next question?

Operator

Our next question comes from Mr. Martin Wilkie from Deutsche Bank, please go ahead.

Martin Wilkie - Deutsche Bank

Yes, good morning. It's Martin Wilkie at Deutsche Bank. Just coming back to mining, I think you mentioned in your opening remarks that there was some write-down or some impact from obsolescence of equipment in mining. Just wondered if you could clarify that. Were these inventory write-downs, or just if you could clarify what you meant by that obsolescence.

Olof Faxander

This is for stock obsolescence. When we have aged inventory, we do certain write-downs in our books, and that's due to the low volumes we have in the business right now.

Martin Wilkie - Deutsche Bank

So this is not one end market doing worse than the other, it's just simply a timing effect, if you like?

Olof Faxander

I think that's a fair -- yes.

Magnus Larsson

Yes. Just to clarify, this is more accounting. It's not a physical obsolescence.

Martin Wilkie - Deutsche Bank

Right. Okay.

Olof Faxander

Exactly, yes. That's right.

Martin Wilkie - Deutsche Bank

And is that something that we should expect in future quarters, or is an annual thing, or how should we think about that impact?

Olof Faxander

Well, there are further risks of stock obsolescence with these low activity levels. I cannot say that we won't have those kind of effects going forward, and the important thing for us to work with is getting the inventory levels down in the business, because then, of course, we remove the risk of stock obsolescence.

Magnus Larsson

Thank you very much. We do have another few questions left. Operators, please carry on.

Operator

Our next question comes from Mr. Alexander Virgo from Berenberg. Please go ahead.

Alexander Virgo - Berenberg

Thanks. Morning. Just on that last question, can you actually quantify it for us, the amount of the obsolescence write-down?

Olof Faxander

Well, we have chosen not to quantify that, but I think the 40% negative leverage we had in mining was driven a lot by these factors, and without that, we would have been at a more normal negative operating leverage in the quarter here.

Alexander Virgo - Berenberg

Okay, thanks. And then just the second question, on the investments in SMS, if I look sequentially, obviously, the margins are pretty similar. If I look at your gross margin at the Group level, it's pretty similar Q2 versus Q1. Your headcount in SMS is I think down sequentially and about the same as it was year on year. So I'm just wondering what the investment is going in on. Can you be a bit more specific on that, please?

Olof Faxander

It's on R&D efforts, and it is on salespeople.

Alexander Virgo - Berenberg

So it's being offset by people coming out elsewhere then, is it?

Olof Faxander

Well, I guess that's correct, yes.

Alexander Virgo - Berenberg

Okay.

Olof Faxander

Due to the net effect we have, but the biggest personnel movements in the quarter we had in mining, where we had a quite sizable reduction of the number of employees.

Alexander Virgo - Berenberg

Yes, and that presumably isn't going to feature until Q, as well -- I suppose Q3, but Q4, Q1, really.

Olof Faxander

Once again, the mining reductions. Well, this is part of adapting our cost base to the current market conditions that we have that reduction, and of course, depending on the market development, we will continue to adapt our number of employees accordingly.

Magnus Larsson

Thank you. Adding to the machining solutions sales increase, as well, that is relating not only to people but also other efforts that go into these investments that we make. So you might not necessarily see them in the headcount number, so it's not a one to one on that one. Operator, the next question, please?

Operator

Our next question comes from Anders Roslund, Swedbank, please go ahead.

Anders Roslund - Swedbank

Yes. Hello. I had one question regarding FX. When will you start to see more positive effects of the weaker Swedish kroner and a little bit in which divisions?

Olof Faxander

Well, actually, I think you saw some effects of that already in the second quarter with Sandvik Materials Technology actually having positive year-on-year FX development. But the net effect we expect going into the third quarter, compared to where we're at at the second quarter is about neutral here, from currencies.

Anders Roslund - Swedbank

Yes, and when should they start to get positive?

Olof Faxander

That will of course depend on the development of the currencies around the world. We give a guidance looking into Q3 based on the currency rates that we had at the end of the second quarter, and looking at that and the baskets exposure we have of currencies in Sandvik, that means that we will have a neutral effect going into the third quarter at the point we were at at the end of second quarter.

Anders Roslund - Swedbank

Okay.

Magnus Larsson

I suppose an easy answer is also to say, as the year progresses. Because if we had issued a guidance for the fourth quarter, that would have been a positive effect, naturally.

Anders Roslund - Swedbank

Okay, thank you.

Olof Faxander

That is a year-on-year comparison, so that's something you have to take into consideration.

Magnus Larsson

Technically, yes.

Olof Faxander

Sequentially, we had a positive effect on a number of areas of the Sandvik Group, as you can see in the report there, so the sequential effect was positive for many business areas.

Anders Roslund - Swedbank

Okay.

Magnus Larsson

Thank you very much for that. Was there a follow-up to it?

Anders Roslund - Swedbank

No.

Magnus Larsson

No. Thank you very much. Operator, may we have the next question, please?

Operator

Our next question comes from Ben Maslen from Bank of America, please go ahead.

Ben Maslen - Bank of America

Yes, thank you. Morning, Olof. Morning, Mats. Just on the coming back to the factory closures, we're getting to the point where, obviously, the pace of those closures will pick up. Do you expect any disruption in terms of building buffer stocks, dual production, obsolescence, as these closures happen, a bit more volatility in the business? Or is that kind of fully taken into account by the charges that you've taken? Thank you.

Olof Faxander

Well, we have taken charges for the closure costs, write-downs and so on in the fourth quarter last year, so we don't expect an effect from that. But there can be certain effects where we actually need to maintain production in two different locations during a transfer, and that is something we cannot take provisions for. But we don't expect any very large effects from this program.

In terms of inventory buildup, we actually saw some of that happening in the earlier part of this year, for example, in construction, and that is now being reversed, that effect, in this quarter, where we saw a drop in the construction's net working capital share as we transfer over to Northern Ireland the manufacturing [you see] there. So I don't foresee any big inventory buildups, any material effects from that, and more marginal in terms of cost effects when we do these transfers, because the bulk of the costs from these closures have been taken in terms of provisions.

Magnus Larsson

Thank you very much. There are no more questions at this time, which means -- actually, we just got one question. Operator, may we have that one?

Operator

Yes, the last question from Mr. Daniel Schmidt from SEB, please go ahead.

Daniel Schmidt - SEB

Yes, hello. Good morning. I just wanted to ask you guys, because last time around you actually gave us the number in terms of net working capital, the saves for the different divisions, and I think you mentioned that SMS was at 25% currently. What is the actual number for mining? I think it was 33% in Q1.

Mats Backman

Actually, I think you can see that from the presentation and the short presented by me, but then we can take the exact number through Magnus.

Daniel Schmidt - SEB

Okay, thank you.

Magnus Larsson

But on the graphical developments, you can see all the five business areas actually there.

Daniel Schmidt - SEB

Right, thank you.

Magnus Larsson

Thank you very much. That was actually the last question, which concludes this hour. I thank you for your attention. Have a good day. Thank you, and goodbye.

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