Gardner Denver CEO Discusses Q2 2011 Results - Earnings Call Transcript

Jul.22.11 | About: Gardner Denver (GDI)

Gardner Denver, Inc. (NYSE:GDI)

Q2 2011 Earnings Call

July 22, 2011 9:30 am ET

Executives

Barry Pennypacker – President and CEO

Michael Larsen – VP and CFO

Analysts

Rick Hoss – Roth Capital Partners

Jim Lucas – Janney Montgomery Scott

Kevin Maczka – BB&T Capital Markets

Richard [ph] – Credit Suisse

Wendy Caplan – SunTrust Robinson

Mike Halloran – Robert W Baird

Joshua Pokrzywinski – MKM Partners

Jeff Hammond – KeyBanc Capital Markets

Mark Barbalato – Vertical Research

Jamie Sullivan – RBC Capital Markets

Joe Mondillo – Sidoti & Company

Operator

Greetings and welcome to the Gardner Denver Second Quarter 2011 Financial Results conference call. 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, Barry Pennypacker, President and CEO of Gardner Denver. Thank you, Mr. Pennypacker, you may begin.

Barry Pennypacker

Thank you, Rob. Good morning, everyone, and welcome to Gardner Denver’s second quarter earnings conference call. I'm joined this morning by Michael Larsen, Gardner Denver's Vice President and Chief Financial Officer.

Before we begin with our remarks, Michael has a few comments regarding our forward-looking statements.

Michael Larsen

Thank you Barry and good morning everyone. First, a reminder that all of the statements made by Gardner Denver during this call other than historical facts are forward-looking statements made in reliance upon the Safe Harbor of the Private Securities Litigation Reform Act of 1995.

As a general matter, forward-looking statements are those focused upon anticipated events or trends and assumptions, expectations, and beliefs relating to matters that are not historical in nature. Such forward-looking statements are subject to uncertainties and factors relating to Gardner Denver's operations and business environment, all of which are difficult to predict and many of which are beyond the control of the Company.

These uncertainties and factors could cause actual results to differ materially from those matters expressed and/or implied by such forward-looking statements. Please refer to Gardner Denver's second quarter 2011 earnings press release issued on July 21, 2011 for further information regarding potential uncertainties and factors that could cause actual results to differ from anticipated results.

Gardner Denver does not undertake or plan to update these forward-looking statements even though the Company’s situation may change. Therefore, you should not rely on these forward-looking statements as representing the Company's or its management's view as of any date subsequent to today.

As a reminder, this call is being broadcast in a listen-only mode through a live web cast. This free web cast will be available for replay up to 90 days following the call through the Investor Relations page on the Gardner Denver website, gardnerdenver.com and the Thomson's StreetEvents site, earnings.com.

Now, I'd like to turn the meeting back over to Barry.

Barry Pennypacker

Thanks Michael. There are a few around the office today that want me to start this call off by saying that the only thing hotter than the chilly weather is Gardner Denver’s results. So Michael told me not to, so so much for that. Gardner Denver had an outstanding second quarter as we established records for revenue, backlog, operating income and diluted earnings per share.

As you recall in our first quarter call, in April, we also announced a number of record results, and at that time I noted the celebration was over and our focus was on executing for the future. Well, I think our second quarter results are a testament to the focus and the fact that we are never satisfied with past performance, and always focused on improving the business and delivering results in the future guided by the principles of the Gardner Denver way.

Before I discuss the quarter in more detail, I would like to thank the 6200 employees worldwide from Gardner Denver. Their relentless focus on serving our customers, and executing on the five points of our strategy, supported by the Gardner Denver way continues to deliver outstanding results for our shareholders.

I also want to recognize the management team we have assembled here. They are committed to the long-term success of this company, and I could not be more pleased with their individual progress. I like to spend now sometime discussing the second quarter results.

Organic growth remained strong in the second quarter, as orders increased 27% to $637 million with 19% organic growth. The broad-based strength that we saw speaks to the diversity of our product lines and the diversity of our end markets and geographies that we operate in. End market dynamics continue to be favorable for Gardner Denver, especially in the oil and gas space, which I will provide some more color on in a few minutes.

Our backlog has reached $682 million, an all-time high, and sales were up 36% to 611 million with organic growth of 27% as foreign exchange contributed 8%. We continue to focus on our profit improvement goals, as operating income for the second quarter increased 75% to $99 million from $57 million last year, driven by higher sales and progress on our productivity efforts.

Consistent with prior quarters, we were able to offset material inflation with price in the second quarter. I also want to note that price did not contribute to margin expansion. Adjusted operating margins increased to a record 17.1%, or 410 basis points higher than the second quarter of 2010. In 2008 during the economic downturn, we decided to take some tough actions and reduced our global footprint. Now three years later, we’re on a pace to match our 2008 pro forma output with eight fewer plants and 2300 fewer people, a 27% reduction. That is why our margins are expanding. It is the Gardner Denver way.

Net income was $67 million, up 80% over last year’s second-quarter as diluted earnings per share increased 79% to $1.27 and $1.35 on an adjusted basis. Operating cash flow was strong at $67 million, an improvement of 63% versus prior year and in line with net income.

Turning our attention to our two segments, our engineered products group had a tremendous quarter. Orders increased by 43% to 313 million, 36% organically. This now marks the fifth consecutive quarter that EPG order rates have increased by more than 35%. Every EPG business unit experienced revenue growth, greater than 25%, with our petroleum and industrial pump business more than doubling, both in order intake and revenue growth versus prior year.

While servicing pumps in aftermarket fluid ends remaining in particularly high demand, shale activity continues to rapidly expand across North America. Rig count and drilling activity remained healthy, and we have not seen any indication of a slowdown in our oil and gas business. With our significant investments in this business over the last two years, we have increased capacity, and reduced lead times, to a point where we can fulfill the increased demand for our customers, but recognize that investment in this business segment is far from over.

Our later-cycle Nash liquid ring pump business also showed strong growth versus prior year, and coating [ph] activity remains high, which bodes well for 2012. International segments such as China and Brazil continue to deliver strong results, driven by favorable end markets like power generation, paper and mining. In addition to the strong orders growth, EPG backlog reached 427 million, an increase of 65% versus last year, which positions the business very well for the balance of 2011.

EPG also made very good progress on margin expansion, with adjusted operating margins arising to 23.3% a 380 basis points improvement over prior year. We have recently selectively increased prices in our well servicing business, and expect to see the benefits in our financials as we ship those order in the latter half of 2011. Focusing on IPG, the team had another great quarter.

The IPG business continued to show good growth with orders up 15%, of which 6% was organic, as the global industrial economy continued to progress. Within the US, order growth once again reached double digits as demand for compressors; blower and aftermarket parts remain strong. Emerging markets, where we have a significant local presence, such as China, remain a source of strong growth, as second-quarter orders expanded about 20%. This is in line with prior quarters, as we have not seen an indication of a slowdown in China, and as we execute our growth strategy, we continue to invest in faster growing markets such as India, Indonesia, Vietnam, and Brazil.

Europe’s growth rate remained mixed on a regional basis with Germany continuing to be the leader. While we expect steady growth to continue within the region, we’re keeping a close eye on order trends, especially given the uncertainty now surrounding some of the larger economies such as Italy. On margin expansion, the IPG business reported adjusted operating margins of 11.7%, which is a 310 basis point increase year-over-year and 40 basis point increase over the first quarter.

In fact, this now marks the ninth consecutive quarter of IPG margin expansion as we continue to make progress on our goal of reaching 14% operating margins by 2014, driven by cost reductions, plan efficiency, and strategic restructuring in higher cost locations.

I would now like to spend some time discussing our 5 point growth strategies as we continue to execute and progress on organic growth, after market growth, innovative products, selective acquisitions, and margin improvement. In terms of organic growth, our focus is to position Gardner Denver’s broad product lines in faster growing end markets, such as medical and shale gas, as well as emerging markets such as Brazil and India.

That said you don’t have to go abroad for fast growth. One of our fastest growing product lines in the second quarter was our truck blower business in the US. Over the past few years we have invested within our Sedalia, Missouri facility, and brought in new processes to help facilitate our lean philosophy and reduce our lead times.

Now as we see order growth for truck blowers doubling year-over-year, I’m happy to say that lead times to our customers have actually come down by nearly 58%. This is a great example of the Gardner Denver wave, and how our employees and investments are focused on meeting customer needs in a growing market.

This takes us to our second strategic area, aftermarket growth. We have stated previously that our target is to have 40% to 45% of our revenues coming from aftermarket channels, and the teams continue to make great progress towards this goal. A great example of this progress is we are making in the replacement for fluid ends in the petroleum pump business, a business that this quarter doubled in size year over year.

The demand for fluid ends for our growing installed base continues to increase as hydraulic fracturing of valves and demands on our fracturing pumps and fluid ends in particular increased to the point, where we know that the replacement cycle is decreasing from historical averages. Keep in mind that the fluid end represents a third of the cost of a new pump. In order to meet the rapidly growing demand for our customers, we have invested, and will continue to invest in aftermarket fluid end capacity.

At the same time based on the voice of customer to new product development, we are working with customers to extend the life of our fluid ends, and getting good feedback on one of our recent introductions called the super GWS triplex fluid end. Now a little more color on hydraulic fracturing business. A number of you have asked recently about our market share. My response now is that if you add up all the suppliers in the industry and leave Gardner Denver out, you reach 100%.

I think all of you know that we are better operators than to have invested a significant portion of our capital in the last two years, and another significant portion of our capital going forward to not have a nice current market share and a plan to increase it over time. A number of you have seen our (inaudible) facilities; have heard me talk about our investment at Fort Worth, as well as our evaluation in areas where we need to support our customers, as they continue to grow. And therefore, you know that we are producing shipping pumps and fluid ends at record rates, in fact double year-over-year.

It is not unreasonable to expect another doubling in the future. We are resolute in our execution of our five-point strategy; I hope you realize that of all of our business segments this one supports all five points. So we will continue to invest and grow, and let others tell you our share. But rest assured, we know how many horsepower are being added to the industry and we know how many horsepower we ship, therefore it is a simple math which we can do.

We continue to evolve from a me too company that completes and expands share with innovative products. I told you last quarter that the PZ-2400 pump or that has been named recently surf and turf, which shipped and used on onshore shale application. This pump is now operating and feedback from our customer is terrific. We have seven more pumps in the backlog including three for offshore; we expect this product to be a great win for our customers.

The IPG business has also found success with new product introductions. In the second quarter we had our first repeat customers for the (inaudible) oil free compressor, as two separate customers placed orders for additional units. This shows that when the voice of customer is incorporated within the innovation cycle, a new product can hit the market and find success in a relatively short period of time.

As you know, innovation comes in many forms. One way is to delight your customers so they want to do business with you. This is just the case with our Elmo Rietschle located in Schopfheim, Germany. We recently introduced an app for iPad that customers can use to access our solution software, as well as innovations, applications, highlights some sales and marketing campaigns in all of our ship brochures. And just so you know, I have an iPad and I can actually use this app.

A few words on selective acquisitions, the fourth point of strategy. The pipeline remained strong as we proactively look for businesses that have great fit with our existing product portfolio, and allow us to leverage the Gardner Denver way as a means of unlocking synergies and expanding margins. Our balance sheet and cash generation give us the flexibility to make acquisitions that deliver value to our shareholders. We are in a strong position to compete for an acquisition, if we find the right strategic fit, and rest assured that we continue to be disciplined and rigorous in our approach. And I remain confident that we will add to the product portfolio yet this year.

The final area of our five-point strategy is margin expansion. You see the results in our financials, and I’m very pleased with the progress we have made, particularly the nine consecutive quarters of margin improvement in IPG. That said we still have a long way to go, and we are confident that opportunities remain to expand margins. For 2011, excluding volume leverage, we remain committed to delivering 150 basis points of margin expansion in IPG, and 50 basis points in EPG through our focus in continued restructuring, productivity and low-cost country sourcing.

Now I would like to provide an example of how the principles of the Gardner Denver way were applied to the supply base to help us expand margins. A number of you on this call have visited our Memmingen, Germany facility, and know that they are advancing very nicely with lean manufacturing principles. One supplier tried to pass on a very nice sized price increase to the business, the management team decided not to accept it, but convinced the supplier that we could help them reduce their cost, and if so receive no price increase but ultimately a decrease.

So our team converged on the suppliers’ plant, and through SMED and TPM [ph] principles demonstrated a 75% reduction in change over time on a critical machine. The price increase was rescinded and a 5% reduction in price is expected, after the kind [ph] and newspaper items are implemented. Great work Memmingen team.

Turning to our outlook for 2011, we expect the business to continue to show solid growth in 2011 with particular strength in our petroleum and industrial pump business. Our record backlog, strong portfolio of businesses, and continued progress on margin expansion position us well for the balance of 2011. That said, we have also noticed some softening in the industrial production and capacity utilization metrics, and we will continue to monitor these order trends closely.

Earnings for 2011 are expected to be in the range of $5.05 to $5.15 per diluted share of 54% to 57% over 2010, reflecting the higher sales and operational improvements. This guidance is 12% higher than our April 20 guidance, and includes $0.15 of restructuring and other items. We estimate our third quarter earnings per share to be approximately $1.27 to $1.32, an increase of 44% to 50% over last year’s third quarter. This guidance includes $0.03 of restructuring and other items. Keep in mind that activity in Europe, particularly in the areas that we serve has a tendency to slow in August, and may impact sequential growth, particularly in IPG.

So in summary, our businesses had a very strong quarter, as we set records for essentially all key financial metrics. We expect top and bottom line growth to continue in 2011, as end market dynamics remain favorable, and we execute on our profit improvement initiatives to deliver superior margin growth and earnings.

With that, I will turn the call over to Michael for some more detail on the financials.

Michael Larsen

Thank you Barry. As Barry said, we had an outstanding second quarter with excellent financial performance and high quality of earnings. Let me give you some additional detail in a couple of areas. First, we’re making good progress on SG&A. SG&A as a percentage of sales was 17%, down more than 300 basis points from prior year as we maintained good cost controls, and essentially flat headcount with strong top line growth.

Our SG&A spend was $105 million, the increase year-over-year primarily driven by the impact of higher sales commissions, foreign exchange and comp and benefits. Foreign exchange contributed approximately $0.08 to earnings on a year-over-year basis, and a penny compared to our April 20 guidance, and as always our updated guidance assumes current exchange rates.

We had more than $5 million or $0.08 of restructuring and severance costs in the second quarter as we continue to focus on reducing our higher cost footprint, particularly in Europe and consolidating transactional finance activities in lower cost regions. Related to these restructuring costs, you will notice that even though operating margins improved sequentially in both EPG and IPG, the quarter-over-quarter fall through on incremental revenue is less than in prior quarters, because we allocate these restructuring costs and the higher corporate costs discussed earlier to the segments in line with past practice.

Going forward, we expect fall through to be in line with historical trends, approximately 25% in IPG, and 35% in EPG. Our effective tax rate for the quarter was 28.7%, up slightly from the first quarter, as a result of higher pre-tax earnings, particularly from our petroleum and industrial pump business in the US. Even with this tax rate headwind, we estimate the tax rate for the second half of the year to be approximately 28%, which is in line with previous guidance.

On working capital, we made some progress as our DSO improved by three days, and days to pay improved by eight days compared to prior year, as we continue to align our customer and supplier terms with our industrial peers. Inventory was flat versus the first quarter as revenue increased by 15%, and our turns improved to 5.3 turns, or 0.6 of a turn compared to the first quarter.

As Barry mentioned, our capital expenditures for 2011 are expected to be in the $50 million to $55 million as we invest in capacity expansion primarily focused on well servicing, and productivity improvement projects on the shop floor. Payback on the CapEx and restructuring projects were improving, continue to be in the 12 to 24 month range.

Depreciation and amortization in the quarter was $15.3 million, and is expected to be around 62 million for the full year. Total debt was $186 million as of June 30, down 97 million from the end of the first quarter, as we redeemed our $125 million senior subordinated note on May 2, as discussed on our call in April. Due to this redemption, we did not buy back the creep [ph] in the second quarter, but we fully expect to do so before the end of the year.

At June 30, we had more than $300 million of cash on existing credit facilities to fund our organic and inorganic growth activities. So in summary, we had an outstanding second quarter as we established several financial records for the company, and we are well positioned for continued growth supported by the Gardner Denver way as we remain focused on operating the business well and delivering cash and earnings growth.

And with that I’ve turn it back over to Barry. Barry.

Barry Pennypacker

Thanks Michael. You have become accustomed to me telling you about stories centered around accomplishments related to the Gardner Denver way that yield us increases in productivity, decreases in lead time as well as square footage, and yes ultimately inventory.

Today I’m going to stray a bit from these types of successes and tell you about Kevin [ph]. Kevin was a temporary employee in our Fort Worth Texas plant; Kevin approached Russell, our plant manager, and enquired on how to become a full-time employee. Russell told him that his performance, attendance and attitudes and all his criteria, and the only thing that was missing was his high school diploma.

I hope you know what Kevin decided to do. He went back to school at night and received his degree, and now has become a full-time Gardner Denver employee. But the story doesn’t end there, Kevin’s son, who also did not receive his diploma, decided to get his degree as his father set a great example for his son. Now you may question why I tell you this story.

Let me explain, you are familiar with our triangle that includes customers, shareholders and employees. We do not routinely talk about specific employees; however, it is an honor to have employees like Kevin that take initiative. Initiative not only in their personal live, but initiative in making Gardner Denver better today than it was yesterday. Kevin I commend you and your son, and I want you to know that I’m proud to have you here as part of our team and many others just like you, and you are an inspiration for us all.

With that Rob, I will turn it back to you for questions.

Question-and-Answer Session

Operator

(Operator instructions) Thank you. Our first question is coming from the line of Rick Hoss of Roth Capital Partners. Please state your question.

Rick Hoss - Roth Capital Partners

Hi, good morning Barry and Michael.

Barry Pennypacker

Good morning Rick.

Michael Larsen

Hi.

Rick Hoss - Roth Capital Partners

Barry that 3Q guide was that a GAAP or non-GAAP number?

Barry Pennypacker

Which one are you talking about?

Michael Larsen

I gave you both.

Barry Pennypacker

He gave both.

Rick Hoss - Roth Capital Partners

I am sorry. I heard $1.27 to $1.32.

Barry Pennypacker

That is the range, $1.27 to $1.32.

Rick Hoss - Roth Capital Partners

Right, is that GAAP or non-GAAP?

Barry Pennypacker

That is GAAP and that includes $0.03 of restructuring and other items.

Rick Hoss - Roth Capital Partners

Perfect, okay. And then as far as the IPG bookings goes, sequentially it was flat. I know there is some seasonality, you talked about it a little bit, is this the source I guess of your concern when you think about overall direction and differences in momentum against – IPG versus EPG?

Barry Pennypacker

No, I don’t think it is a concern. But as we have stated, since I put the strategy together for 14 by 14, we don’t need revenue to increase our margins 150 basis points a year. We like incremental revenue, and we are charging each of our individual business unit managers with increasing their overall revenue. But keep in mind, I know what you are looking at, you are looking at the organic growth rate.

And you know, if you go back and look at the growth rate in the quarter of 2010, we are 33%. And if you want to look at some of the other publicly available data, which I have already done, because I anticipated this question, our competitors were in the low 20s. So we are coming off a pretty tough comp, but when I look at where we are positioned in the markets that we serve, we are very strong. And where we’re not strong, we’re investing in order to be strong.

During this quarter, we opened a brand-new facility at Brazil, completely dedicated to IPG type of products. We are evaluating what we are going to do in India, and I think by the conference call for the third quarter, we will be able to communicate with you more what that strategy is. We have recently hired in Indonesia, places like Vietnam, country managers to give us that growth. Our competition have been in those areas for 30 years, and what we had to do first is get our cost base fixed.

Trying to go into low-cost regions with a high cost based just doesn’t work. So, you know we’re happy with that growth rate, as long as we can continue to sequentially improve our margins, we are very happy.

Rick Hoss - Roth Capital Partners

Okay. So it sounds like the source of growth is emerging markets, in your opinion what is the biggest impediment to the US economy at this point?

Barry Pennypacker

Based on our incoming order rates in the first two weeks of July, I don’t see any impediments. I mean, our IPG business continues to perform very well. In the Americas there has been and will continue to be a substantial amount of pent-up demand. That is still as you know a substantial amount of uncertainty, but with our distribution base in the US, we’re out there every single day pounding the pavement and we are finding opportunities.

I think our new product offerings have given us the opportunity to grow faster in the US than maybe some of our competition. Being able to leverage some of the CompAir products through the GD channel have proven to be very good organic growth enablers for us, and as we continue to evolve the product portfolio, I think you will see strong organic growth rates for us in established regions. And as we continue to invest in emerging markets, Brazil, as I just mentioned as well as India, we are going to get up there into those higher teens and low 20s like some of our competition.

Rick Hoss - Roth Capital Partners

Okay, and last question from me, EPG any large orders in the quarter?

Barry Pennypacker

No, nothing that was substantially different than the first quarter.

Rick Hoss - Roth Capital Partners

Fantastic. Thank you gentlemen.

Barry Pennypacker

You are welcome.

Operator

Our next question is from the line of Jim Lucas with Janney Montgomery Scott. Please state your question.

Jim Lucas - Janney Montgomery Scott

Thanks, good morning guys.

Barry Pennypacker

Good morning Jim.

Jim Lucas - Janney Montgomery Scott

First question, Barry if you could flush out a little bit more on the acquisition pipeline with the high-class problem with the balance sheet being in exceptional shape, when you look at the pipeline today, and the size of the transactions in there, could we potentially see one larger one or should we expect to see more singles, if you will?

Barry Pennypacker

Jim, we have in our pipeline acquisitions as small as 10, and you know as high as 700 million in revenue. We are looking for the opportunity to continue a perfect streak of having accretiveness in year one. I sometimes receive criticism for that but I believe if you internally drive yourself to that type of accretiveness, you will not make a bad acquisition, and we’re not going to do that. But I can tell you as I said in my prepared remarks, I think we’re very active, and I think that I would as I said I will be very disappointed if we don’t expand the product portfolio this year.

Jim Lucas - Janney Montgomery Scott

And when you look at the different size of acquisitions, do you have different ROIC hurdles that you target on the larger versus the more bolt on type acquisitions?

Barry Pennypacker

The smaller ones Jim are more filling out the technology in some of the areas where we suspect in the future there will be higher growth rates. So some of the smaller ones, we really don’t have as high a hurdle rate as we do on the larger ones because really they don’t really affect the needle. But a $500 million acquisition, if we’re not targeting high teens ROIC and seeing our way through that, we’re just not going to make that acquisition.

Jim Lucas - Janney Montgomery Scott

Okay, that is helpful, and then switching gears, the new product side, lot of color in the prepared remarks, last year there were two products in particular that you were highlighting, which I think was more an example of bringing the innovation to as part of the Gardner Denver way, when you look at the new product pipeline today, as you have added the engineering resources, are there any meaningful new products, or again is it just going to be more kind of single as you go along?

Barry Pennypacker

Well, I will tell you that in the short term, there is a bunch of singles, but in the long term, three to five years from now, I believe there are some grand slams and home runs. And let me just provide a little color on that. I mentioned one today, that I went over very quickly, but you know, we see our aftermarket and we understand how strong it is in our well servicing business. But that is very costly and does have a tendency to take capacity away from our customers.

So the ability to increase the life of a factory [ph] is absolutely critical to our long-term success. And I mentioned that we introduced this quarter to a number of customers the super GWS fluid end, which has dramatically increased the life of a fluid end in high demand service. So as we continue to innovate, our customers are willing to pay for that. And we believe that ultimately, as we continue to innovate even in the aftermarket that we will continue to gain share and see our way through expanding margins.

Jim Lucas - Janney Montgomery Scott

Okay, and finally for Michael, on the payables side, lot of progress made there this quarter, and I know that has been an area of opportunity that has been overdue in being addressed, when you look at what you have been able to do there, as well as supplier feedback, where can payables go from a day’s standpoint going forward?

Michael Larsen

Well, we obviously have a internal target here Jim to close the gap between our days to pay and our DSOs and improve our cash cycle here. I will tell you that we are working with our suppliers in a constructive manner to extend our payment terms to something that is a little more reasonable and in line with what is expected in the markets that we operate in.

So you know I think if you look at some of our peers you’ll see a gap that is significantly closer than what we have today. But we are making good progress. So stay tuned on that.

Jim Lucas - Janney Montgomery Scott

Okay. Thanks a lot guys.

Barry Pennypacker

Thank you Jim.

Operator

Thank you. Our next question is from Kevin Maczka of BB&T Capital Markets. Please state your question.

Kevin Maczka - BB&T Capital Markets

Good morning.

Barry Pennypacker

Good morning Kevin.

Michael Larsen

Hi Kevin.

Kevin Maczka - BB&T Capital Markets

Michael I wanted to ask a question about the incremental margins in EPG, you made some comments there that I didn’t totally follow, I’m just wondering if you can revisit that, why we stepped down a little bit in Q2, and then as we look forward, I think you threw out some guidance of 35%, and is that, how much of the well servicing price increases in the presumably more favorable mud pump mix, how much does that play into that?

Michael Larsen

No it did not. I mean the 35% that I am giving you is in line with historicals, and I think if you look in the more recent quarters it is actually a little bit closer to 40% in EPG when you look at the incremental margins. If you look at the year-over-year improvement in incremental margins in EPG you will see it somewhere around 30%. And what I was saying is due to the restructuring and some of the higher costs unusual non-recurring items that we had in the quarter, you should expect that to go back closer to 35%. And as prices start to flow through here, higher prices, and well services start to flow through in the second half, we expect it to go higher than the 35%, which is what we have seen historically.

Kevin Maczka - BB&T Capital Markets

Got it, and that flow through on higher pricing on well services, that happens fairly immediately in Q3, and then…

Barry Pennypacker

Latter part of the year.

Kevin Maczka - BB&T Capital Markets

Latter part of the year and then what is your outlook on the drilling pump side, is that – should we expect a more favorable mix there as we get out later in the year?

Barry Pennypacker

Yes, I think our drilling pump backlog has filled in very nicely. We understand quite frankly where we are going to be in the first-half of 2012. And we are very encouraged by the drilling pump backlog, and I think the one dynamic that we’re going to continue to have to monitor and we will of course communicate to you, is the PZ-2400. That really has an opportunity to contribute in a way that maybe some of us on this call don’t really understand. And as that does, we will continue to spike that up and let you know how that progresses, but for the regular drilling side based on rig count, and where we think things are going, we are very solid into the second quarter of ’12.

Kevin Maczka - BB&T Capital Markets

Got it, and does the same hold true on the fracking side Barry in terms of what your customers are telling you out into 2012?

Barry Pennypacker

Yes, absolutely. We see absolutely no degradation in the need. In fact there is a lot of reports that have been published in the last few weeks that indicate that the strength that we are currently seeing will proceed well into 2013 also.

Kevin Maczka - BB&T Capital Markets

Got it, and just finally from me, on the Fort Worth expansion, when do you expect that to be fully online, and how much capacity did that add?

Barry Pennypacker

We expect it to be fully online in the second quarter of ’12, and it will almost double our aftermarket capabilities in rebuilding of frac pumps.

Kevin Maczka - BB&T Capital Markets

Got it. Thank you.

Barry Pennypacker

You are welcome.

Operator

Thank you. Our next question is from the line of Julian Mitchell of Credit Suisse. Please state your question.

Richard - Credit Suisse

Hi, guys.

Barry Pennypacker

Good morning Julian.

Richard - Credit Suisse

It is Richard [ph] for Julian. Nice quarter by the way.

Barry Pennypacker

Thank you.

Richard - Credit Suisse

Just had a quick question on the frac business, it seems like the growth there is pretty outstanding, I guess you could say, has your outlook changed on CapEx, I know you guys have added a bunch of capacity just to basically produce more fluid and do things. Based on your outlook now, do you think you have to add more capacity, or can you guys respond to the growth with current capacity?

Barry Pennypacker

Yes, I mean, I think in my prepared remarks, I noted that we have doubled it year-over-year and I would expect the opportunity for another doubling.

Richard - Credit Suisse

Okay, and so you would need to spend more?

Barry Pennypacker

Not above our current guidance of $50 million to $55 million. We are very efficient in the way that we deploy capital, and the way that we expect revenue from that deployment.

Richard - Credit Suisse

Okay. So the outlook on that hasn’t changed. And then how much market share do you think you can take?

Barry Pennypacker

Well, that all depends on a number of factors, not the least of which is how innovative we are. As you know, there is a substantial amount of horsepower out there, and you know, as I said if you listen to the pundits [ph] out there, we don’t participate very heavily, but I can tell you that our market share is north of 25, and south of 50. I’m not going to give you the exact number. But with our investments and our throughput capability and the Gardner Denver way principles of relentlessly increasing productivity by 25% year-over-year, I think we got a great opportunity.

Richard - Credit Suisse

Great, and then just one last question if possible, just had a question on the organic growth in the EPG division, 48% year-over-year, just to know if you could maybe breakdown what was volume, what was price? I mean it just seems like you guys are shipping those pumps as fast as you can make them, still now if you are getting good price there, just kind of what the mix was?

Barry Pennypacker

We got about 2% price in the EPG business to offset about 2% of inflation that component.

Richard - Credit Suisse

Thanks a lot guys.

Barry Pennypacker

You are welcome.

Operator

Our next question is from Wendy Caplan with SunTrust Robinson. Please state your question.

Wendy Caplan - SunTrust Robinson

Hi good morning.

Barry Pennypacker

Good morning Wendy.

Wendy Caplan - SunTrust Robinson

You know, many of your industrial peers have been adding inventory to ward off supply chain disruption. Your inventory was flat this quarter versus first, are you seeing any supply chain disruptions, or how are you addressing them if you are?

Barry Pennypacker

No I will not allow us to add inventory to offset potential price increases when we have the opportunity within our shop floors to offset that through productivity. That strategy will not be employed at Gardner Denver. I don't believe it's very lean, and we will continue that as we raise revenue drive inventory turns to a half a point a year.

Wendy Caplan - SunTrust Robinson

Good answer Barry. And as to your free cash flow, I know Jim asked about your plans for that. Can you – at what point – when do we get to the point where if you haven't done a major acquisition and used your balance sheet how do we – how do you think about that in terms of using your cash in a different way?

Barry Pennypacker

Well, we still have a little debt to pay down. You know, we still have a dividend and you know, we still have an outstanding share buyback that has somewhere around 2 million shares authorized, and, you know, there is probably the order of which we would deploy it, but as I said I would be very, very disappointed if that cash and or debt wasn’t deployed this year in another way.

Wendy Caplan - SunTrust Robinson

Okay, thank you very much.

Barry Pennypacker

You're welcome Wendy.

Michael Larsen

Thanks Wendy.

Operator

Thank you. Our next question is from Mike Halloran of Robert W Baird. Please state your question.

Mike Halloran - Robert W Baird

Good morning guys.

Barry Pennypacker

Hi Mike.

Michael Larsen

Good morning Mike.

Mike Halloran - Robert W Baird

So first question is on your order book and your visibility out on the fracking side as well as on the drill pump side. How far out do those orders go, and it doesn't sound based on the strength that there is any concern about double bookings or anything like that but just curious about how far the visibility out and how far are you guys are booked at this point.

Barry Pennypacker

We are booked out to the balance of the year on frac pumps and we're into the first quarter on drilling pumps.

Mike Halloran - Robert W Baird

It sounds good, and then maybe you could talk a little bit about what the fracking opportunity looks like internationally, what your customer base is saying and when you think that opportunity can more aggressively materialize in some of those international shale formations?

Barry Pennypacker

Yes, we still believe it's a couple of years away and the primary hindrance to that is not the capacity or the ability for us to efficiently frac in those formations. The issue with the infrastructure there is just not good pipelines, there is not good roads, there is not good bridges, and in areas like Eastern Europe in particular, we continue to see investments from the government in putting that infrastructure in place. So based on what I talked to when I talk to our customers and what their expectations are, they believe it's a couple of years away, and there are very, very excited about the opportunities internationally.

Mike Halloran - Robert W Baird

It makes sense and then lastly could you just give an update on the loading arms side of the business, how the coating activity looks there both on the kind of normal loading arms that guys put out as well as the larger LNG oriented ones.

Barry Pennypacker

Yes, I think as we stated in the prepared remarks all four of the businesses within EPG grew 25% in the second quarter and, you know, of course the loading arm business is one of those. So it had nice growth, and when we look at the backlog for some of the larger marine loading arms, it's quite healthy and the coating activities continues and you know, we're about our business of innovating that area and we are working with some customers on some new technologies that I think will bode well for us in the marine side of the business going forward. So we are very encouraged.

Mike Halloran - Robert W Baird

Great. I appreciate the time.

Barry Pennypacker

No trouble Mike.

Michael Larsen

Thanks Mike.

Operator

Thank you. Our next question is from Joshua Pokrzywinski with MKM Partners. Please state your question.

Joshua Pokrzywinski - MKM Partners

Hi good morning guys.

Barry Pennypacker

Good morning.

Michael Larsen

Hi Joshua.

Joshua Pokrzywinski - MKM Partners

Just a couple of questions, first on the third quarter and kind of you know, seasonal shutdowns in Europe around the holidays, if you had any feedbacks from your customers around those being either longer or shorter than they have been in the past?

Barry Pennypacker

Well, shorter than last year. That's the feedback we've got.

Joshua Pokrzywinski - MKM Partners

Got you, but there are no signs in Italy of maybe folks with a little bit more nervousness or –

Barry Pennypacker

No.

Joshua Pokrzywinski - MKM Partners

You know, choppiness.

Barry Pennypacker

No.

Joshua Pokrzywinski - MKM Partners

Okay, and then shifting over to the food end side of frac, I know you have added some capacity in total [ph], how have lead times responded and is that proven to be an advantage versus your competitors near term, if you feel like you’ve taken share on some of those additions.

Barry Pennypacker

I'd like to say that you know, that we have utilized lead time reduction to gain share but we're not quite there yet. As I stated last quarter and I'll state again, we are about 60% of the way there on our overall strategy for capacity increase, and I think when we're in a position to tell you that we're 100% of the way there then the conversation will be a little different.

Joshua Pokrzywinski - MKM Partners

Okay, but I guess just in that same thought to the extent that you are bringing capacity up, lead times are to the extent that you know, orders are still to coming in at a very healthy pace, (inaudible) lead times.

Barry Pennypacker

Absolutely.

Joshua Pokrzywinski - MKM Partners

The comment of price being a 2 point positive and just offsetting inflation in EPG I guess was a little surprising, it seems like you'd be able to turn the dye a little bit more on price just giving the healthy incoming order pace. Is there something I'm missing and maybe other pockets of EPG or is that just something that you are not prepared to do at this time on –

Barry Pennypacker

We're you know, if we were 100% on-time you know, with the industry and we were reducing our lead times, you know, it will be a different story, but, you know, we're not 100% on-time with our customers. And I truly believe that we should pass on our inefficiencies to our customers because you know, that’s short-lift and, you know, some of our competition is in fact raising price but you know, we have the opportunity to expand our margins through our efforts and productivity.

So until we get our shop and our operations to the point where I feel like they're efficient, and I did mention to you that you would see some price in the latter part of the year, which would indicate to you that maybe I think that our efficiencies are going to be increased in the fourth quarter of this year that's when price will take effect.

Joshua Pokrzywinski - MKM Partners

Excellent, thank you Barry.

Barry Pennypacker

You're welcome.

Operator

Thank you. (Operator instructions) The next question is from Jeff Hammond of KeyBanc Capital Markets. Please state your question.

Jeff Hammond - KeyBanc Capital Markets

Hi good morning guys.

Barry Pennypacker

Good morning Jeff.

Jeff Hammond - KeyBanc Capital Markets

Just last question on frac pump, can you give us a sense of where your OE aftermarket mix is today, and where you’d ideally like to see it you know, a few years down the road?

Barry Pennypacker

About 75-25 to 60-40.

Jeff Hammond - KeyBanc Capital Markets

Okay, and then you know, clearly you know, order momentum was you know, was very good in EPG, you know, certainly tough comps in IPG but you know, lot of mixed signals out there. Where do you think, you know, where do you see your business has been most vulnerable to slow down or anywhere you're seeing pockets of weakness.

Barry Pennypacker

When I look that our incoming order rates, which we have a tendency to do here weekly right now I do not see other than Australia a weakness in our incoming order rate. Australia I think is you know, is obvious, you know because of the recent announcement of carbon tax as well as you know, still recovering from some of the flooding, and our Asia Pac business quite frankly through the acquisition of CompAir was very well established in Australia. So other than Australia in IPG we are really not seeing any significant slowdown.

Jeff Hammond - KeyBanc Capital Markets

Okay, great. Thanks guys.

Barry Pennypacker

You're welcome Jeff.

Operator

Thank you. Our next question is from Mark Barbalato with Vertical Research. Please state your question.

Mark Barbalato - Vertical Research

Good morning.

Barry Pennypacker

Good morning.

Mark Barbalato - Vertical Research

When I look at your new guidance it looks like you increased the amount of spending on profit improvement initiatives, where is that spending going?

Michael Larsen

We did not increase the guidance on restructuring, but you know, as Barry said we are never you know, happy with our past performance. We are always looking to improve the business. So we’re going to continue to have you know, restructuring in the form of streamlining our footprint as we move that from higher cost locations to lower-cost and there may also be some things in there around our back-office, where we're now taking the Gardner Denver way to the back-office and looking at how we can become more lean and more productive whether it's in finance or some of the other functions in the back-office. So, I would, you know, if you look back historically Mark, we’re typically you know, you will see every quarter a couple of pennies here of restructuring as we continue to you know, fine tune the operations.

Mark Barbalato - Vertical Research

Okay, thanks, and then can you give a little bit more color on Nash liquid pumps. I guess one of your more later cycle businesses and I'm kind of interested to hear about you know, the activity going on there.

Barry Pennypacker

Yes, again that's one of the four businesses within EPG that we stated you know, grew in excess of 25%. Coating activity remains very strong particularly in developing countries where engineered packages are necessary for coal-fired plants, chemical treatment, those types of applications. Nash also participates very well in the paper industry, and in the Far East in particular there has been a resurgence in paper, and we are participating in that in a very large way, but you know, the book and bill in that business is much stronger than what it was last year and the large packages, which is the last part of the later cycle are truly starting to be talked about and quoted in a lot more detail than they have in the past.

Mark Barbalato - Vertical Research

Great, thank you.

Barry Pennypacker

You're welcome Mark.

Operator

Thank you. Our next question is from the line of Jamie Sullivan with RBC Capital Markets. Please state your questions.

Jamie Sullivan - RBC Capital Markets

Hi, good morning.

Barry Pennypacker

Good morning Jamie.

Jamie Sullivan - RBC Capital Markets

You talked about the capacity expansion in the aftermarket with food and et cetera, wondering if we look at EPG overall is there a way to think about the revenue capacity you have in that business in total.

Barry Pennypacker

I'm not sure I follow you. I think you know, –

Jamie Sullivan - RBC Capital Markets

How much revenue could EPG support, you know, following the expansions that you have planned with the aftermarket.

Barry Pennypacker

I'm not going to give that type of guidance.

Jamie Sullivan - RBC Capital Markets

Okay, all right.

Barry Pennypacker

Some of our competition does that but we're not going to.

Jamie Sullivan - RBC Capital Markets

Okay, and then, just a quick follow-up on the Nash comment you made, you said the coating activity was strong. Did you say developed or developing countries, it sounded like more developing.

Barry Pennypacker

More developing.

Jamie Sullivan - RBC Capital Markets

Okay.

Barry Pennypacker

More developing.

Jamie Sullivan - RBC Capital Markets

All right, and switching to IPG, can you talk a little bit about the mix of products that you're seeing in the orders, has there been any change in the types and sizes of flow or anything?

Barry Pennypacker

Not on, you know, not at the margin but I would tell you that in the US in particular and again, you know, this is one of the dynamics of Gardner Denver, our truck blower business as I mentioned earlier has doubled year-over-year and, you know, the primary reason for that is those trucks are being used for frac sand, and so we participate in that. It has doubled year-over-year and you know, that's contributed to the overall change in mix but when you take that out it's pretty much you know, a mix between low kilowatt and high kilowatt you know, high pressure or low-pressure blowers as well as high-pressure blowers.

Jamie Sullivan - RBC Capital Markets

Okay. All right.

Barry Pennypacker

End markets are about the same also.

Jamie Sullivan - RBC Capital Markets

End markets the same, okay. Last one just on the selling and admin expenses, Michael you talked about the nice leverage you are seeing there, do you see further leverage from current levels over the next couple of quarters here?

Michael Larsen

Yes, I think we still have a lot of opportunity here to continue to make progress. So we're not done and you know, I think we've done a good job keeping our headcount flat with revenue growth, but there is also within our SG&A some pockets with remaining opportunities, particularly in the back-office as I talked about couple of minutes ago.

Jamie Sullivan - RBC Capital Markets

Okay, great. That's helpful. Thanks a lot.

Barry Pennypacker

You're welcome Jamie.

Operator

Thank you. Our next question is from Joe Mondillo of Sidoti & Company. Please state your question.

Joe Mondillo - Sidoti & Company

Good morning guys.

Barry Pennypacker

Good morning Joe.

Joe Mondillo - Sidoti & Company

Most of my questions have been answered. My number one question that I wanted to address was you cited strength in the IPG was you know, you saw it in a lot of developing areas but you cited China is one and we saw preliminary I mean fracturing PMI data yesterday citing that that's potentially contracting. Wondering just what are you seeing and sort of what is your insight on the Chinese manufacturing industry?

Barry Pennypacker

Well, it's – you know, it's always going to be growing much faster than the US of course, that's what I see. We have only recently begun to leverage some of the other products that we have available globally into the Chinese market. In fact, you know, we have done what some larger companies have done, and that is designed products in China for the Chinese market and you know, we have an example of that with our you know, with our blower product line that is yielding us great organic growth opportunities in markets that we just haven't served before. So we remain very bullish you know, we again we track those orders weekly and we monitor those, but we truly believe with the product portfolio that we have and the markets that we serve we still have a great opportunity for continued double-digit growth in the Chinese region.

Joe Mondillo - Sidoti & Company

Do you think that region overall is slowing, or I mean a lot of talk about that region slowing. So I was just –

Barry Pennypacker

When you say region, you mean China particularly or you mean all of those –

Joe Mondillo - Sidoti & Company

China particularly.

Barry Pennypacker

You know, there is some moderation but as I said our overall incoming order rates continue to rise quarter-over-quarter and you know, we are very pleased with that rate.

Joe Mondillo - Sidoti & Company

Okay. All right, great. And then just lastly I was wondering if you can quantify you know, a couple of questions were related to new products anyway to quantify what new products such as you know, within the last three years makeup as a percent of sales this year compared to you know, last year the year before. Is that rising yet or should we –

Barry Pennypacker

Yes, it's rising, but it's not at the 20% level that I'd like to be at. You know, we're sub, you know, we're about 10% right now and I'd like that to get to 20%, and I'd like to really be in a position where organically we recreate the company every five years through innovation.

Joe Mondillo - Sidoti & Company

Okay, great. All right. Thanks a lot guys.

Barry Pennypacker

You are welcome.

Michael Larsen

Thanks Joe.

Operator

Thank you. There are no further questions at this time. I would like to turn the floor back to management for closing comments.

Barry Pennypacker

Very well. Thank you very much and we look forward to talking to you all in the future. It was a great quarter, but we have great things still to accomplish at Gardner Denver. So thank you very much. Talk to you soon.

Operator

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

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