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Altra Industrial Motion Corp. (NASDAQ:AIMC)

Q2 2014 Results Earnings Conference Call

July 24, 2014 5:00 p.m. ET

Executives

David Calusdian – Investor Relations, Sharon Merrill

Carl Christenson – Chairman and Chief Executive Officer

Christian Storch – Chief Financial Officer and Vice President

Analysts

Matt Duncan – Stephens, Inc.

John Franzreb - Sidoti

Mike Halloran – Robert W. Baird

Jeffrey Hammond – KeyBanc Capital Markets

Anna Kaminskaya - Merrill Lynch

Scott Graham - Jefferies

Operator

Greetings and welcome to the Altra Industrial Motion's second quarter 2014 financial results. At this time all participants are in a listen-only mode. A brief question-and-answer-session will follow the formal presentation. (Operator Instructions) As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, David Calusdian of Sharon Merrill. Please go ahead.

David Calusdian

Thank you, Satchi. Good morning everyone and welcome to the call. With me today are Chief Executive Officer, Carl Christenson; and Chief Financial Officer, Christian Storch. To help you follow management's discussion on this call, they will be referencing slides that are posted to the altramotion.com Web site under Events & Presentations in the Investor Relations section.

Please turn to Slide 1. During the call, management will be making forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements are inherently uncertain, and investors must recognize that events could differ significantly from management's expectations. Please refer to the risks, uncertainties and other factors described in the company's quarterly reports on Form 10-Q and annual report on Form 10-K and in the company's other filings with the U.S. Securities and Exchange Commission. Except as required by applicable law, Altra Industrial Motion does not intend to update or alter its forward-looking statements whether as a result of new information, future events or otherwise.

On today's call, management will refer to non-GAAP diluted earnings per share, non-GAAP income from operations, non-GAAP net income and non-GAAP free cash flow. These metrics exclude certain items discussed in our slide presentation and in our press release under the heading, Discussion of Non-GAAP Financial Measures and any other items that management believes should be excluded when reviewing continuing operations. The reconciliations of Altra's non-GAAP measures to the comparable GAAP measures are available on the financial tables of the Q2 2014 financial results press release on Altra's website.

I'll now turn the call over to Altra's CEO, Carl Christenson.

Carl Christenson

Thank you, David. Please turn to Slide 2. Our second quarter revenue and earnings growth were quite strong compared with a year ago. Revenues increased 19% from the second quarter of 2013 while net income rose 20% from the year ago period. Net of acquisitions, net sales were $193 million, up 6% from Q2 2013.

Non-GAAP earnings grew 20% to $13.1 million or $0.48 per share. Given the robust topline and the operating leverage we have generated through our strategic initiatives, our earnings performance would have been even stronger but for costs associated with two significant supplier issues and unusually high medical expenses. These issues adversely impacted earnings by approximately $0.03 per share. We resolved the supplier issues during the second quarter and expect to lower impact to our third quarter profit from these issues. However the increase cost from the high medical claims will continue into the third quarter.

Please turn to Slide 3. Demand in most of our end markets was up in the quarter when compared to the prior year. Let's begin with our distribution channel which is predominantly made up of sales of aftermarket parts and original equipment parts for small OEMs.

In the second quarter, distribution sales were up nicely year-over-year. The increase was across a broad range of our distribution. In Turf and Garden, where we have a significant share of the market, we experienced our best quarter ever in terms of sales. Growth accelerated during the quarter in part because of recent rebound in U.S. housing starts. Last year we experienced much better than normal demand in the third quarter as our customers extended their build season. Based on current schedules, we unfortunately do not expect that to repeat this year.

The Ag market began to slow during the second quarter. This market has been one of our strongest as we have ramped up production on new programs. However, the outlook for Ag is for overall demand to continue to slow.

Transportation was about flat when compared with last year. In the materials handling market, forklift and elevator sales were very strong compared with the second quarter a year ago due to on projects in Europe. Meanwhile the crane and hoist markets rebounded after a long soft patch. While demand in conveyors continued to be weak.

Turning to our late markets. Energy overall was again very strong led by higher demand in oil and gas and wind. Drilling rig counts, permitting for future drilling, fracking activity and directional drilling are all up compared with a year ago. Power generation revenue improved slightly sequentially as shipments were up from the first quarter.

In the metals market, sales were up significantly from a year ago. We said last quarter, metals demand appeared to be reaching a bottom and the performance in the second quarter seems to confirm that assessment. In contrast, mining OEM activity continues to be very weak. Sales were down both sequentially and from Q2 of last year. While the aftermarket is stable, we see no catalyst for improvement for the original equipment side of the business.

In aerospace and defense, sales were down year-over-year. The overall defense market remains weak. However, we continue to work on some significant projects that we believe are vital and stand a good chance of being funded. Commercial aerospace continues to be strong. In terms of geography, North America and Europe were both up mid-single digits from a year ago while sales in most of Asia were up low double-digits. Australia was down year-over-year since most of our business is related to mining.

The outlook for the global economy is quite mixed and we remain cautious about international sales in the near term. With that I will hand the call over to Christian then close with a discussion of our strategic initiatives.

Christian Storch

Thank you, Carl and good afternoon everyone. Please turn to Slide 4.

We had a solid quarter. Reporting an increase of net income of 20%. On an earnings per share basis, we are reporting $0.48 on a non-GAAP basis. As Carl mentioned, two supplier issues resulted in increased cost of goods sold and SG&A. We also experienced a significant increase in year-over-year medical cost. Combined, these had a negative impact on EPS of approximately $0.03 in the quarter and we expect that these issues will also negatively impact EPS in the third quarter.

On the top line, foreign exchange rates had a positive impact of approximately 130 basis points while price added 120 basis points. Net of acquisitions, sale increase 6.4% year-over-year to $192.7 million. Net of acquisition North American revenues increased 7.6% while European revenues increased 5% year-over-year. Sales to Asia Pacific and other geographies were up 1.8%.

Interest expense was $3 million, up $300,000 from the prior year due to the financing cost related to the Svendborg acquisition. During the quarter the average price of the company's common stock exceeded the conversion price of the convertible notes. This resulted in an additional 705,000 shares being included in the diluted earnings per share calculation, causing a $0.02 reduction in diluted net income per share. The $0.02 reduction in diluted net income per share compares to $0.01 dilution in the sequential first quarter.

We recorded a tax rate of 31.7% during the quarter compared with a tax rate if 31.3% in the second quarter of 2013. Slide 5 is a reconciliation of our non-GAAP measures.

Please turn to Slide 6. Our balance sheet remains strong. Book equity was $287 million and our cash balance was $69 million. Slide 7 reviews our working capital performance. Our inventory turns continued to improve as we are gaining traction with our operational excellence strategy.

Capital investments during the quarter totaled $5.3 million and depreciation and amortization was $8 million. Please turn to Slide 8 and our guidance. The company is maintaining its sales forecast in the range of $800 million to $825 million for 2014. However, the given the additional cost we incurred primarily stemming from the aforementioned supplies issues as well as the higher than expected medical cost and the expected continued dilutive effect of the convertible notes, we are lowering our EPS guidance for 2014 to the range of $1.75 to $1.85.

We expect our tax rate for 2014 to be in the range of 31% to 33% before discrete items. We also expect capital expenditures in the range of $28 million to $30 million and we are revising our depreciation and amortization guidance to be in the range of $32 million to $34 million.

With that, I will turn the discussion back to Carl.

Carl Christenson

Thank you, Christian. Please turn to Slide 9. Let's talk briefly about some of the strategic initiatives we are working on. We feel very good about the traction we are seeing from our lean efforts. In Columbia City, Indiana, for example, we are consolidating three locations in two one newly leased facility and we expect to have moved the majority of the equipment early in the third quarter. Production should be ramping up in the first quarter of 2015. The product flow that will be achieved as a result of the consolidation is expected to have a significant impact on inventory, quality, delivery and cost.

Our various operational excellence activities are yielding lower inventory levels and better turns. The inventory reduction contributed to a record free cash flow. We are equally excited about the reduced lead times we were able to promise our customers. We believe this will provide us a strategic advantage. It is a real testament to the dedication and hard work across all Altra that our lean initiatives have been so successful.

Our SAP initiative is progressing nicely. We have two sites remaining for implementation, one of which will be completed in Q3. The final site in France is scheduled for implementation early in Q4. Our profit improvement initiatives are right on track. Pricing is contributing the margins in line with our plan and these targeted increases should continue to contribute to our performance going forward.

We officially broke ground for the new construction in Germany for our Bauer business. The new factory addition will enable us to consolidate five Bauer facilities into one and will be completed by the end of this year. The office building is expected to open in May 2015. The Svendborg integration is inline with the projections we gave at the time of the acquisition. Svendborg continues to be accretive to the bottom line and is on pace to meet our initial target for earnings accretion of $0.10 to $0.15 per share for 2014.

Turning to emerging geographies. Our new plant in China is now slightly ahead of plan and we are quoting an increasing number of order there. We have also moved some production work to the facility which has helped improve its performance. In Brazil, we are localizing production of some Altra products in order to both meet the needs our current customers in that current and to generate increased sales in Brazil.

In terms of M&A. Our balance sheet is very solid and the market for potential acquisitions is starting to open up after being relatively thin earlier in the year.

To close, we are very pleased with the results we are seeing from our initiatives to grow revenues and expand profit margins. Many of our markets are performing well, although we are cautious about the global economy in the near term, especially in Europe where growth is still very choppy. And finally, we remain excited about the number of opportunities we have.

Now we will open up the call for Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) The first question is from Matt Duncan of Stephens, Inc. Please go ahead.

Matt Duncan – Stephens, Inc.

So the first question I have got is on the guidance. Really, looking at the sales guidance, you guys kept that unchanged and I don’t know if you pay attention sort of where estimates are, but you actually beat estimates pretty nicely in the quarter. And the consensus for the year was already above your guidance range that implies that the back half estimates are too high. Are you guys seeing a slowing of revenue relative to what you had from a growth perspective in the second quarter? Is that the reason to sort of leave guidance unchanged? Or rather you are just being conservative a little bit here because some of the choppiness, Carl, that you mentioned.

Carl Christenson

Yes, I think it's -- you know there is always a big question mark about what happens in the summertime particularly in Europe and as people have vacations and plants shut down for maintenance activities. So we are being cautious. I think when we look at Europe, there was probably a little more enthusiasm at the end of the year last year then there has been lately on the economy there. So we are just -- we are very cautious about what we see. You know there is bad news in China. The good news is North America compared to last year, I think the sentiment is much better. So we just didn’t see any benefits of taking it up.

Matt Duncan – Stephens, Inc.

Sure. How much of a growth headwind to you have in North America from the Turf and Garden business being really good in the 3Q last year and it sounds like it won't be as good this year.

Carl Christenson

How much of a growth headwind do we have in North America?

Matt Duncan – Stephens, Inc.

Yes. I mean, I guess I am looking at the strength that you had in Turf and Garden in the 3Q last year. It sounds like that’s not going to repeat this year. How much do you think that takes out of growth by not seeing that repeat?

Carl Christenson

You know we don’t typically get into specific amounts by end market and what's going on each end market by a specific amount. So I am not going to go there. But it's meaningful but we hope to be able to offset that with some other areas. Some other markets that are doing well.

Matt Duncan – Stephens, Inc.

Okay. And then on order intake. What kind of growth rate are you seeing in order intake right now? Is it similar to the 6% organic growth you had in revenue in the second quarter or is it tracking a little lower?

Carl Christenson

Again, we don’t talk about bookings per se and part of that is because a lot of times with some of the big OEs we work with production schedules. And they give us an annual schedule and then we drop in the orders each week for what we are going to deliver the next and it's not a contractual commitment until we do that. So we have very short lead time and visibility to the order. So it's difficult for us to talk about the order rates. But I would say in general some of the schedules are probably softer than what they were -- schedule increases are probably softer than they were at the beginning of the year.

Christian Storch

And I would also add, Matt, that we at this point now believe that we will see more typical seasonality whereby second half revenues are 48.5% to 49%, which we have experienced typically. If we get a better in now for how Svendborg behaves and I think it fits right in line with our normal seasonality that we have experienced in the past.

Matt Duncan – Stephens, Inc.

Okay. Christian, that helps. And then last thing from me, on the EPS guidance cut. How much of that is from the higher healthcare cost? I am trying to see if we can maybe bifurcate a little bit the higher healthcare cost versus the two supplier issues that hit you here in the second quarter?

Christian Storch

Let me explain a little bit what happened on the healthcare cost. This is actually related to medical cost as opposed to workers compensation. We have experienced a significant increase in what we call large medical claims which we define as claims that exceed $50,000. In a typical year we have two, maybe maximum of five of these claims. We hardly ever see anybody hit our stop loss of $250,000. We have seen this year 12 of these large claims with quite a few hitting stop loss. Since we are self-insured until that 250,000 stop loss, it has really had a significant impact on our medical expenses and explains a significant portion of the sequential increase in SG&A.

If you look at Q1 and Q2, SG&A is up $2 million, in that neighborhood. The biggest piece of that is related to these medical costs. We think that trend will continue but hope that it will start to soften as we go, approach the end of the third quarter into the fourth quarter, but we can't be sure. The supplier issues -- yes?

Matt Duncan – Stephens, Inc.

As you can say, that’s something you accrue for? Are you recording this so that the 12 significant claims, have you already recorded all the expense from that or is that accrued to the balance of the year?

Christian Storch

You actually expense it as you go with the exception of, what is referred to as the incurred but not reported. So you have people go and see the doctor and incur expenses but they are not reported to us with a time lag of a month or two. And for that piece we accrue, but other than that it's expensed as incurred.

Matt Duncan – Stephens, Inc.

Okay. So the reality is you may not see healthcare cost continue at this second quarter level but you are taking the conservative approach and assuming that they will play it safe is what it sounds like?

Christian Storch

Yes, we have to believe that some of these claims will continue to develop. That they are not done with treatment and so forth and therefore this trend will at least continue for another three months. So that’s a meaningful part of the reduction in the guidance. I think the second part in the guidance is that the convert has become more dilutive than what we had anticipated at the beginning of the year. And then the third part is the two supplier issues which were fairly significant in terms of EPS impact.

Operator

The next question is from John Franzreb of Sidoti. Please go ahead.

John Franzreb - Sidoti

Back to the revenue guidance. If I look at the first half, roughly 3% organic growth in the first quarter, 6% in the second quarter. Based on the midpoint of your guidance, stripping out Svendborg. It suggests that maybe organic revenue will be flat to down in the second half of the year. Am I doing the math properly there? And if so, what's the biggest driver of that kind of a decrease year-over-year?

Christian Storch

Yes, I think your math is right that it's flat to slightly down. One big driver is, we have become a little bit more cautious in respect to Europe.

Carl Christenson

It's the normal seasonality that...?

Christian Storch

Yes, the normal seasonality...

John Franzreb - Sidoti

Seasonality (indiscernible) year-over-year.

Christian Storch

Yes.

Carl Christenson

So last year it was the -- if we get back to normal seasonality, we had a very good third quarter last year. And I think you will see that. And I think that was better than we expected last year and abnormal from a seasonality standpoint. So I think part of it is if we get back a more normal seasonality.

John Franzreb - Sidoti

Okay. And you mentioned these onetime costs. I assume they go away. Are we still on target to hit that EBIT margin by the end of 2015 when you start rolling in the pricing initiatives, the SET benefits, some of the cost savings of new facilities? Is that still intact or is something structurally changed in that longer-term outlook?

Christian Storch

If I go through the four initiatives, I think we are on track in terms of the strategic pricing. We actually -- you have seen 120 basis points year-over-year on price in the second quarter. 50 basis points of that is related to strategic pricing in the first half. Bauer is doing better than last year. Our losses in China have come down by about $300,000 in the first half of this year. SAP is moving to the right a little bit. We thought we are going to be done by the end of June but we are taking the two most complex sites live. So one implementation has slipped into early Q3, the other into early Q4. So we won't see that. But in next year we will have that benefit. So by '15 we should -- I mean we are still on track in terms of these major initiatives.

Carl Christenson

Right. No change on the initiatives.

John Franzreb - Sidoti

Great. And one last question. Could you remind me what the supplier issues were and when do you expect them to be fully resolved because it sounds like they are carrying on into the second half?

Carl Christenson

Yes. So there were two issues we had. And one of them was related to a raw material situation where they were a sub-supplier of processes raw material and it wasn’t evident to us until they got into the finished product that there was a defect in it. And that was fully resolved in the second quarter. The issue was behind us. Now there might still be some flow through of expense because we have got -- we had to expedite some parts through, we had to work overtime. We have got an outside source doing some subcontracting for us to help us catch up. So there will be some additional cost flowing into the third quarter but the issue is resolved and behind us.

And it's pretty much the same thing on the third one. That was actually a component that we buy and it was a supplier in Taiwan that had a quality issue, so we had to go to a supplier in Europe that had made the product for us before and we had to pay higher prices and then we had to airfreight the parts to our assembly operation in China. And that additional cost will flow into the third quarter some. But again that problem has been resolved. So they are both resolved but some cost will flow into the third quarter.

Operator

Next question is from Mike Halloran of Robert Baird. Please go ahead.

Mike Halloran – Robert W. Baird

So what were the core incrementals if you exclude these onetime items. So what where the actual incrementals on the volumes?

Christian Storch

I think we have seen an incremental of 25% to 30% if we exclude those onetime items.

Mike Halloran – Robert W. Baird

And is that kind of consistent what you would have expected the pull through to be at this point?

Carl Christenson

Yes. I think that’s what we have said in the past that that would be kind of pull through. So we'd have had a really good quarter internally if we had not had those issues.

Mike Halloran – Robert W. Baird

No, that makes sense. And then, on the revenue progression side. I know mentioned the orders and kind of how some holdbacks are occurring? How does the revenue progression worked through the quarter? Did you see any actual revenue, any slowing as you work through the quarter? Was there some improvement there or was there just more stability as you work through the quarter and into July here?

Carl Christenson

I think from a shipment standpoint it was pretty good. I think as we get into the summer months, the incoming orders, we have lots of our big OEMs in the first half of the year give us blanket orders etcetera, for the year. So it probably feels like it's slowing down a little bit for the summer time.

Mike Halloran – Robert W. Baird

But anything different from what you would have expected a normal seasonality curve to look like?

Carl Christenson

No, probably not anything other than a normal seasonality. Last year was different where we had that really good third quarter. You know it was in Turf and Garden but it was also in a couple of other markets really were quite strong last year.

Mike Halloran – Robert W. Baird

Makes sense.

Carl Christenson

Mike, you have asked it but on the distribution side, you know the distribution business has picked up a little bit. I think when we look at the numbers that we are doing with most of our general line industrial distributors, it's pretty good.

Mike Halloran – Robert W. Baird

No, I guess I am just like everyone else on the call. I am just triangulate into why the downside in the back half of the year from a guidance perspective relative to kind of what we thought the expectations were. That you were lining out last quarter. And obviously I understand some of the mining commentary, some of the Ag commentary and even the order acceptance. But it certainly seems like you are pushing revenue a little bit lower than maybe the core trends that you are actually seeing would imply. I don’t know how you necessarily respond to that but I think that’s what the issue people are trying to triangulate to here is.

Christian Storch

I think, as Carl mentioned, last year we had a very strong third quarter with a very strong Ag driven garden market in the third quarter. We don’t think that that will repeat. Second, we do see some areas in Europe slow down, others are still doing well. But particularly mining is really hurting. In our European business we see continued disruption in our sales in Russia. Bauer sales in Russia are down 30%, just as an order of magnitude. Those are headwinds compared to last year. We feel reasonably good about North America but we don’t think that 7% growth will continue in the second half. That that would slow down a little bit but it's still positive growth. Those are kind of like the framework in which we (indiscernible) deal.

Carl Christenson

I think the biggest uncertainty, we know Turf and Garden is going to not repeat the third quarter and I think the biggest uncertainty is in Europe and in Asia, as what's going to happen there. You know it's just choppy. I mean the report we read from some of the larger industrial companies in Europe are -- there is some uncertainty there.

Operator

The next question is from Jeff Hammond of KeyBanc Capital Markets. Please go ahead.

Jeffrey Hammond – KeyBanc Capital Markets

So Svendborg I think you said is going well and it's still set to be accretive. Is that still within that $0.12 to $0.15 range that we were thinking about before?

Christian Storch

We guided to a net assurance out of that range.

Jeffrey Hammond – KeyBanc Capital Markets

Okay. And then from your perspective, as you look at the Bauer restructuring initiatives and strategic pricing, are those hitting your targets as well?

Christian Storch

Strategic pricing has added 50 basis points year-to-date.

Carl Christenson

On the Bauer restructuring, the restructuring activities are going well. I think they are behind a little bit on the top line on the sales. So they had a nice improvement in their operating margin but it was impacted a little bit by not getting the sales that we were hoping to get.

Christian Storch

So as compared to last year, Bauer's performance is up in a meaningful way. The top line is also slightly ahead of last year. The disappointment there is the Russian market and that’s why they are probably performing below our expectations for this year. But year-over-year they have improved.

Jeffrey Hammond – KeyBanc Capital Markets

Okay. And then I am confused on on the guide. So it looks like you took the midpoint down 12.5. I mean it seems like this supplier and health medical issue is maybe $0.03 this quarter or an another $0.03 next quarter. Is that the right way to look at it? And then $0.05 for the convert?

Christian Storch

Yes.

Jeffrey Hammond – KeyBanc Capital Markets

So that’s basically the guidance revision.

Christian Storch

It's basically what it is.

Jeffrey Hammond – KeyBanc Capital Markets

But I mean didn’t we have $0.05 last quarter built in? Are we just not finding ways to make that up or because the share count issues is kind of built in?

Christian Storch

Last quarter we assumed $0.04 for the year. And it's a rounding thing. I think it came to be 1.8 cents or something like that. The stock price continued to be where it is, it was $0.02, so in our mind we cannot make that up while we had hoped that we can make up to $0.04 that we had in the initial guidance. But now with the supply issues, with medical, with the things we are describing, we just don’t -- we can't make up for the dilutive effect of the convert. So in our mind that is $0.05 or thereabout. And then we had about $0.06, there they are about for the medical issues and the supplier issues. That’s essentially it.

Jeffrey Hammond – KeyBanc Capital Markets

Okay. And then distribution. I mean it seems like you are still pretty downbeat about that. When you last reported, what changed, when did it kind of inflect, what's kind of the tone in the 3Q? Does it feel sustainable?

Carl Christenson

It's not -- I mean there was really no clarity there on where they are seeing it. But it's I think, the genuine parts, motion had a good quarter. We had a good quarter across a broad-base of our distribution. There was a couple of places where it's down but in general it's been very good. So there is really no specifics, it just started to pick up a little bit. And I think some of it, housing is up a little bit. Some of it is just the general economy we are finally starting to see it in that that general industrial piece. So I am going to be -- hopefully we will get out and talk to some folks and find out a little bit more now that the quarter is kind of behind us and find out what's going on there. But it was very good news that that part of the business picked up.

Jeffrey Hammond – KeyBanc Capital Markets

Okay. And then just finally, can you just talk about your -- I think you said M&A is kind of opening up a little bit. Just talk about your capacity at the higher end and appetite to do deals in this environment.

Carl Christenson

You saw we did the Guardian deal. That was a nice little bolt-on for us. And I think the balance sheet is in very good shape. The environment, the financial environment makes it a little more difficult because of the cost of money and private equity guys that we have to compete with and what they can do with leverage etcetera. And I think we have seen a little more activity from sellers that there are some more books out there to look at and it just feels like things are getting a little bit better. But again, we are not going to overpay for something. We are going to make sure that we get the right business and at the right price. And thus, again, I think we are more than open to do some acquisitions.

Jeffrey Hammond – KeyBanc Capital Markets

Okay. And then how do you balance that with buyback appetite. If we assume maybe the market reacts negatively to this earnings revision?

Christian Storch

What we said is that we will continue to buy, repurchase our shares. That might change should we make a meaningful acquisitions and at that point we revisit what we can do from a repurchase program. But given that there was a significant lack of opportunities other than the small Guardian deal and our step change in our ability to generate free cash flow, we thought the best was to start to return more to our shareholders. And again, that might change if a big, another [swap up] (ph) opportunity comes along, we might change that.

Operator

The next question is from Anna Kaminskaya of Merrill Lynch. Please go ahead.

Anna Kaminskaya - Merrill Lynch

First of all, what would your gross margin have been without the supply issue? You reported it was 30.9, would it be possible to quantify what the number would be without the supply issue?

Christian Storch

I think the supply issue probably would have added about 50 to 75 basis points to the margin.

Anna Kaminskaya - Merrill Lynch

Wow. And would it be possible to kind of provide the breakdown of how much mix helped, how much was pure volume, and maybe savings from your restructuring initiatives and what type of gross margin can you achieve in the second half of the year? And once again, any big moving pieces that we should be thinking about? Especially as energy is picking up?

Christian Storch

So second half of the year typically has gross margin profile slightly below the first half given the seasonality and the lower volume. And that’s all expectation going into the second half.

Anna Kaminskaya - Merrill Lynch

So in your outlook you're forecasting a lower gross margin from the first half?

Christian Storch

Slightly lower than the first half.

Anna Kaminskaya - Merrill Lynch

Because I thought on the previous -- I'm just looking at my model of the previous two years, it was always higher in the second half of the year. Is something different in the mix that's not capturing in my model?

Christian Storch

As Carl mentioned, last year we had a very strong performance in Turf and Garden and in the Ag market. And I think the other thing that has changed compared to last year is that mining is down which is a very profitable piece of our business. Svendborg is now included which wasn’t there last year and that has an effect on margins. They have slightly higher gross margin but higher SG&A also compared to the Altra average.

Anna Kaminskaya - Merrill Lynch

Okay. And you don't have kind of big drivers of margin year-over-year in terms of mix or positive pricing, not of material cost inflations, that you could kind of provide 2Q 2014 over 2Q '13?

Christian Storch

No, I mean...

Anna Kaminskaya - Merrill Lynch

Or I can take it offline. Okay. And then if I look at just North American growth given how strong it was, how much of that was kind of growth with your OEM customers and how much was distribution? Am I reading correctly from your comments that distribution was stronger than OEM, or is it just comparable growth rates?

Carl Christenson

No, they were comparable. Yes.

Anna Kaminskaya - Merrill Lynch

Okay. And do you get a sense of....

Carl Christenson

It was actually a little bit stronger than the distribution side.

Christian Storch

Distribution was somewhere 3%-4% and on the OEM side...

Carl Christenson

The OEM side was stronger.

Christian Storch

Stronger.

Carl Christenson

Stronger than that.

Anna Kaminskaya - Merrill Lynch

And is it the same in Europe, or no?

Carl Christenson

In Europe the...

Anna Kaminskaya - Merrill Lynch

In terms of distribution, OEMs?

Carl Christenson

The majority of our business in Europe is OEM business. Relatively a small percentage is distribution.

Operator

(Operator Instructions) The next question is from Scott Graham of Jefferies.

Scott Graham - Jefferies

And I am sorry to beat this thing to a pulp here. But on the sales side I think someone earlier alluded to I think all of us trying to triangulate toward this thing. Because you say in your end market review page that sales and distribution were up significantly and broadly, suggesting that that's a pretty good channel for you and that's your largest channel. This would then imply that Turf and Garden, and Ag, will then be down significantly in the second half of the year, not just slow like I think you said, but down significantly. Otherwise, I'm just missing something. Could you -- I got the Europe piece, I certainly have the mining, but when we consider this in the context that the second half of last year's sales organically were essentially flat on easy comparisons from the year before, I'm just having trouble rolling all of this together and getting to my math which says second half sales at your midpoint, organically at the midpoint of the guidance, are actually down.

Carl Christenson

So I think when we said distribution significantly, it had been down, North America was down year-over-year. So now it's starting to grow again and so it was nice, significant improvement for us to see it starting to grow again. So it's not like it's a 10% growth. It's a much smaller number than that. And it is broad. I think, Scott, we just are a little bit concerned that the third quarter seasonality and some of the businesses are -- may see some softening in that third quarter. And then Europe and Asia piece is a big wild card. So we thought holding the guidance before we had projected it was a reasonable thing to do at this point?

Scott Graham - Jefferies

All right, fair enough. I guess my other question would be, and I guess this is sort of piggybacking off of what Jeff was getting at. It's that it sounds like, I think initially the implication was that the supplier issue running into the second half and the healthcare thing was the bigger part of the guidance, EPS guidance takedown. But in fact, it's really the sales. Is that correct?

Christian Storch

The sales, yes. It's a combination of the supplier, medical issues and the incremental dilutive effect of the convert. Those are the big items that account for almost the entire reduction in the guidance.

Scott Graham - Jefferies

Okay, so it's three things. It's the dilution, it's the sales and it's the medical, and the suppliers plays a very small part? Okay. But on the medical thing, I know that there was an earlier question that kind of got to some of the numbers behind it. But I guess my bigger question is why. Why is this happening and is this an issue with just maybe a demographic issue with workers? Are there problems with safety in facilities? I mean, it's just, it's kind of inexplicable, the delta that you've given us here.

Carl Christenson

It is. And so what happens is, we are self insured up to a certain point where we have an umbrella policy. And if there are large claims that can have an impact on us. And historically we have three, four, five large claims a year, two to five. And right now, there's just a large number of them and that can be a very expensive cancer situation. It can be an infant that’s gone into a neonatal ICU. That’s a very expensive thing that can happen. And so we just had a -- it was an unusual number of these large cases. And so you incur the expense plus you have to accrue for what has been submitted but not expensed yet. And it was just a very unusually high number. And it doesn’t happen very often. I can't think of another time in our history that we have had this kind of a medical occurrence.

Christian Storch

We have about 1900 participants in our medical plans in North America. If you include family members, that maybe, I don’t know, 3000-4000 people that have medical insurance through us. And what happened is that for whatever reason, there is quite a number of people that are very very sick. That is unrelated to work. There is a baby in the ICU unit, a newborn. That’s cost us $350,000 so far. It's above this stop loss. There is a couple of cancer situations. And I call it a statistical abnormality, it happens from time to time that you run into a period where you have a very large number of large claim. So clearly unrelated to -- this has nothing to do with the workers' compensation. So therefore has nothing to do with the work environment or anything. Its medical expenses.

Scott Graham - Jefferies

Okay. So the accruals going forward, Christian, are they based on a combination of what's been filed, not expensed, plus your estimate for future filings?

Christian Storch

No, you cannot accrue for the future medical expenses. What you accrue for is the expenses that you have incurred but that have not been reported to you. In other words, somebody went to see a doctor or had a surgery or a medical procedure in June, but we don’t get the bill until August. For that we set up an accrual. And therefore that accrual has increased because the general medical expenses have increased and it's a function of, essentially a matter of medical expenses for a certain period of time.

Scott Graham - Jefferies

Right. But you're implying it's a second half issue as well. So it seems to me like you're making some assumptions. Not necessarily accruing, but making some assumptions of a continuance of the same. Right?

Christian Storch

That’s right. That’s correct.

Carl Christenson

That’s correct. We are assuming that this situation continues on.

Christian Storch

So if you are a cancer patient and you currently have run up on $125,000 of charges, medical expenses. We now have to assume, as we look at our forecast, that you are going to hit the stop loss over the next six months and you are going to cost us $250,000. So that we take into consideration when we do the forecast.

Carl Christenson

That’s correct.

Scott Graham - Jefferies

Okay. So this is still a bit of a wild card for the second half of the year?

Christian Storch

Absolutely.

Carl Christenson

Absolutely.

Scott Graham - Jefferies

But the fact is, it could go either way? It could also go against you, right?

Christian Storch

Absolutely. It could go. He is done with his treatment. This person is done with his treatment and therefore no more medical expenses related to this case.

Scott Graham - Jefferies

Understood. Last question, another big end market for you, back to that questioning. The materials handling. You called that strong, and I just kind of want to make sure that I have that word strong correctly tabulated. Is that strong defined as a plus 5 or is that strong defined as a plus 10, or otherwise?

Carl Christenson

I would say in this environment anything above plus 3 I would consider strong. Because we are kind of in a -- so it's probably in a 4%-5% range for overall material handling. And that’s elevators, forklifts, conveyor systems, it's a pretty broad swath of equipment that goes into material handling for us. But it's in that kind of mid-single digits, 4% or 5%.

Operator

There are no further questions at this time. I would like to turn the floor back over to Carl Christenson for closing comments.

Carl Christenson

Okay. And I would just like to thank everyone for joining us this evening and we look forward to speaking with some of you at our next conference. Thank you.

Operator

This concludes today’s teleconference. You may disconnect your lines at this time. Thank you for your participation.

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Source: Altra Industrial Motion's (AIMC) CEO Carl Christenson on Q2 2014 Results - Earnings Call Transcript

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