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Executives

Jonathan Schlemmer - Chief Operating Officer

Charles Hinrichs - Chief Financial Officer and Vice President

Mark Gliebe - Chief Executive Officer, President and Director

John Perino - Vice President of Investor Relations

Analysts

Stephen Sanders - Stephens Inc.

Walter Liptak - Barrington Research Associates, Inc.

Joshua Pokrzywinski - MKM Partners LLC

Jeffrey Hammond - KeyBanc Capital Markets Inc.

William Dezellem - Tieton Capital Management

Holden Lewis - BB&T Capital Markets

Wendy Caplan - SunTrust Robinson Humphrey, Inc.

Jamie Sullivan - RBC Capital Markets, LLC

R. Scott Graham - Jefferies & Company, Inc.

Michael Halloran - Robert W. Baird & Co. Incorporated

D. Mark Douglass - Longbow Research LLC

Christopher Glynn - Oppenheimer & Co. Inc.

Regal Beloit (RBC) Q2 2011 Earnings Call August 5, 2011 10:00 AM ET

Operator

Good morning, and welcome to the Regal Beloit Second Quarter 2011 Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to John Perino. Please, go ahead.

John Perino

Good morning. Thank you, Sue. Welcome to the Regal Beloit Second Quarter 2011 Earnings Conference Call. Joining me today are Mark Gliebe, President and CEO; Jon Schlemmer, COO; and Chuck Hinrichs, Vice President and CFO.

Before turning the call over to Mark, I'd like to remind you that the statements made in this conference call that are not historical in nature are forward-looking statements. Forward-looking statements are not guarantees since there are inherent difficulties in predicting future results, and actual results could differ materially from those expressed or implied in forward-looking statements. For a list of those factors that could cause actual results to differ materially from projected results, please refer to today's earnings release and our filings with the SEC.

Now I'll turn the call over to Mark.

Mark Gliebe

Good morning, everyone, and thank you for joining the call and for your interest in Regal Beloit. We'll follow our typical agenda. I'll make a few opening comments. Chuck will give the financial update. Jon Schlemmer will provide color on products, markets and operations, and then I'll return and summarize our prepared comments, and we'll move to Q&A.

Overall, we felt good about our operating performance for the second quarter. Excluding the $28 million incremental warranty expense, we would have exceeded the high end of our guidance. Given the magnitude of the incremental warranty expense, I'd like to cover that topic first.

We have communicated to certain HVAC customers that we have detected a production flaw in certain standard sleeve-bearing motors produced in our Reynosa, Mexico facility. These Genteq-branded motors are used in outdoor condensing units for air conditioners and heat pumps. We estimate that there are 50,000 motors that may contain the flaw. The abnormality was caused by inadequate lubrication of the bearing and shaft, which may result in an early failure of the motor. The failure of the motor presents no safety concern. We are working with customers to contain the issue and identify, repair and replace the flawed motors.

This event is not characteristic of the company or of this facility. In fact, the last time that our Reynosa facility had a quality excursion such as this was more than 10 years ago. Further, prior to this episode, the defect rated our Reynosa facility measured in parts per million pieces received by our customer was excellent and continuously improving. We do understand the root cause of the problem, and we have fixed it. Most importantly, we sincerely regret the inconvenience to our customers, and we are determined to learn from this experience and be better and stronger for it in the future.

Now onto a brighter note regarding the acquisition of A.O. Smith's Electric Products division or EPC. We are pleased to report that we have made significant progress with the Department of Justice, and we believe that we will close the transaction within the month under materially the same terms that we agreed to with A.O. Smith back in December. This is positive news, and both our teams are excited at the prospect of closing soon.

In terms of our operating performance during the quarter, had it not been for the incremental warranty expense, we would have had a record quarter in terms of both revenues and EPS. We saw strength in our top line, which benefited from the general economic recovery and a number of new products, as well as the additional businesses from the acquisitions we completed in 2010.

Our commercial and industrial business has had an especially good quarter. The headwinds came from a slower-than-expected HVAC business and acquisition-related expenses, primarily related to our pending acquisition of EPC. The 2 price increases we announced in the last 10 months have now been fully implemented. In the second quarter, with the combination of the price increase and productivity, we were able to offset inflation. Excluding the incremental warranty expenses, our margins continue to climb in the quarter, and we would expect to see further margin improvement from the acquisitions as we implement synergies and drive improvements in the businesses.

As for the highlights of the quarter, first, we were pleased that the strength in our Commercial and Industrial, Mechanical and International businesses offset the general weakness in HVAC; next was the acquisitions of AFMC, or the Australian Fan and Motor Company, which John will speak to in a minute; the closing of our new financing arrangements, which Chuck will describe; the continuation of our new energy-efficient products; and the progress we made with the DOJ on the EPC acquisition.

With that, I will turn it over to Chuck Hinrichs.

Charles Hinrichs

Thank you, Mark, and good morning, everyone. We are very pleased with our results for the second quarter 2001 -- 2011, as we posted record quarterly sales and strong cash flow from operations. Sales for the first quarter of 2011 were $682 million, an increase of $98 million or 16.7% over the second quarter of 2010.

Sales growth in the first quarter was due -- sales growth in the second quarter was due to the addition of $60 million of sales from the 2010 acquired companies, volume growth and realizations from price increases. Our gross profit percentage for the second quarter of 2011 was 22.1%. Cost of goods sold in the second quarter included the $28 million increase in warranty expense. Excluding the $28 million expense, our gross margin for the second quarter was 26.2%, an improvement from the 24.6% in the second quarter of 2010 and the 24.9% margin in the first quarter of 2011.

In the second quarter of 2011, we recovered the commodity cost inflation we experienced with a combination of our price increase actions and operating productivity. However, commodity inflation is still a challenge in 2011. Let me give you some data on the cost inflation on 2 key commodities, copper and steel. As this chart on Slide 6 shows, spot prices for copper are stabilizing at a high level. The second quarter 2011 average spot price of $4.15 was down slightly from the first quarter of 2011. The July spot price jumped up to $4.40 per pound.

Now let's review the Steel Market. Here, I am quoting the index prices for cold-rolled steel. As seen on the chart, steel prices have spiked in the last 3 quarters. The average price in the second quarter was $915 per ton, an increase of $123 per ton or 15.5% compared to the second quarter of 2010. The index price for July declined to $832 per ton, perhaps indicating that steel prices have peaked for the near term.

Our steel purchases are based on the market index, but lagged for one quarter. So our cost for steel increased in the second quarter of 2011 and will increase again in the third quarter of 2011 before we should benefit in the fourth quarter from the recent decline in the index price.

Slide #7 provides additional financial data. Our capital expenditures in the second quarter were $10.8 million. As we've previously communicated, we have 3 big capital projects in 2011. The first one, which closed in the first quarter, was the purchase of our previously leased factory in Faridabad, India. In the second half of 2011 and into 2012, our capital spending will be higher as we spend on the relocations of 2 of our factories in China. Our depreciation and amortization was $22 million in the second quarter and should be a similar amount in the third quarter.

As we have discussed in previous calls, we continue to experience high legal costs relating to the pending acquisition of EPC. In the second quarter of 2011, we expensed $3.3 million of costs, an increase of $1.3 million from the second quarter of 2010, but $3 million lower than in the first quarter of 2011. Our effective tax rate was 28.6% in the second quarter, lower than our previous guidance for 2011 of 31% to 32%. Second quarter tax provision decreased due to the incremental warranty expense, which reduced our taxable income in the U.S.

Turning to the balance sheet, our second quarter end cash position was $275 million, increasing $44 million from the year-end level due to our strong cash flow from operations. Our balance sheet remains strong with excellent liquidity.

Turning to Slide 8. We previously announced the closing on 2 important financings in the last 60 days. We were pleased with both financings, as we increased our financial flexibility and arranged attractive permanent financing for the pending EPC acquisition.

First closing was on June 30, 2011 when we refinanced our $500 million unsecured revolving credit commitment for an additional 5 years. Second closing was a private placement of unsecured notes with an average term of 10 years and an average interest rate of 4.74%.

On July 14, we took the initial funding of $423 million and expect to take the final funding in August for a total new debt issue of $500 million. This financing represents the permanent financing for the pending acquisition of EPC. We were fortunate in our timing in accessing the long-term debt market to raise this capital at a competitive interest rate, but the timing of the financing is a few weeks ahead of the closing on the EPC acquisition. This additional financing is forecasted to increase our interest expense in the third quarter of 2011 by $4.4 million.

For the third quarter of 2011, we expect earnings to be in the range of $1.11 to $1.17 per share. Our third quarter guidance does not include any impact from the pending EPC acquisition. In comparing our third quarter guidance to the second quarter, we expect to see a decline in sales volume and increased commodity cost inflation, principally steel. As I highlighted on the previous slide, we will incur higher interest expense on the new long-term debt, which will reduce our third quarter earnings by $0.07 per share. We also expect our third quarter income tax rate to revert to our normal effective tax rate estimated at 31.5%. This increase in the income tax provision from the lower second quarter tax rate will reduce our third quarter earnings by $0.05 per share.

And lastly, we compared our third quarter guidance to the analyst consensus. Several estimates include an earnings contribution from EPC that may add up to $0.05 in earnings per share to the third quarter estimates. Again, our third quarter guidance does not include any EPC results. When we close on the EPC acquisition, we will provide updated guidance on the EPC results.

Now I will turn the call over to Jon Schlemmer.

Jonathan Schlemmer

Thanks, Chuck, and good morning, everyone. During the second quarter of 2011, we experienced strong double-digit sales growth over the prior-year period in our Mechanical businesses, our North American Commercial and Industrial business and also on our Asia businesses. Our Mechanical businesses, which compete in later-cycle segments continued their strong rebound in the quarter with 15% sales growth. The strength that we have seen in the prior 5 quarters in our North America Commercial and Industrial businesses continued through the second quarter with sales up 20%.

As expected, demand for the more energy-efficient NEMA Premium products increased and now represents the majority of our interval horsepower motor sales. Sales in our global generator business grew 34%, driven by growing demand in emerging markets, the recovery in Japan and primary power plants adding standby power for risk mitigation. Driven by strong growth in the emerging markets and our acquisition strategy, sales outside the U.S. grew by 35% and represented 37% of our total sales for the quarter. Sales in Asia were up 14%, driven by robust economies and new products.

In HVAC, the strong start to the year in the first quarter slowed in the second quarter. There are several factors at play here. First, the U.S. housing market and consumer confidence continue to struggle; second, we did experience a cool spring weather season throughout much of the U.S.; and finally, the combination of the reduction of the federal stimulus, plus the shift back to outdoor condensers utilizing R-22 refrigerant, impacted both demand and also the mix of energy-efficient products sold in the quarter.

As you may recall, we announced 2 price increases in the last 9 months. With those 2 increases and our continued drive for productivity, we were able to offset current quarter commodity inflation. We have not yet been, however, able to offset the margin we lost to inflation in 2010.

Last quarter, I mentioned the acquisition of Ramu, Inc., a small R&D company focused on switched-reluctance or SR technology. We continue to be excited about the Ramu team and technology as an energy-efficient alternative to Permanent Magnet Motors. The first new product development using Ramu's switched-reluctance technology is already underway. During the quarter, we also closed on the acquisition of AFMC, the Australian Fan and Motor Company. AFMC designs, manufactures and distributes a wide range of blowers, fans and motors for sales in Australia and New Zealand. Combined with our motor and air-moving manufacturing and technology, AFMC strengthens our ability to bring new energy-efficient products to our customers throughout the Southeast Asia-Pacific region.

As you know, we continue to focus our engineering development efforts on energy-efficient products. During the last call, we previewed a new permanent magnet AC motor product line and a new Genteq high-speed ECM motor.

Today, I'd like to talk about 2 new energy-efficient products. First, our Commercial and Industrial business has expanded the permanent magnet AC product line into the 3- to 10-horsepower industrial-sized motors. These new high-efficiency industrial motors are being sold through the Marathon Motors business under the SyMAX brand, and the Leeson Motors business under the Platinum e brand. The new motors utilize permanent magnet technology and deliver energy efficiency levels that not only exceed the NEMA Premium requirement, but also exceed the European IE4 efficiency levels.

Other features include the capability to achieve higher torque levels and increased power density. Our team has worked extensively to test this new product with many of the major drive manufacturers. This robust drive compatibility allows users an option for high performance, where expensive servo motor performance is not required.

While our standard industrial motors now meet the new NEMA Premium energy efficiency levels, this new product gives us the ability to help our customers achieve even higher efficiency levels. Our customers are showing strong interest in this new line of motors and a wide range of industrial applications.

Next, our Unico team has launched yet another new product for the oil and gas industry, the heavy-duty LRP, or Linear Rod Pump. The LRP is a great example of our strategy to develop custom-integrated solutions combining our mechanical components with electronics and applications-specific software. The heavy-duty LRP was developed and introduced for more demanding oil and gas wells. The new LRP is a scaled-up version of Unico's very successful original LRP system.

The original LRP artificial lift system was limited to wells with depths of less than 7,000 feet. The new heavy-duty LRP extends the lift capacity by 50% and nearly doubles the stroke length, giving us the ability to handle wells up to 12,000 feet in depth. The new technology makes Unico's LRP platform capable of handling the vast majority of oil and gas wells.

Unico LRP systems have been accepted by numerous oil and gas producers, including some of the super majors, as an attractive alternative to conventional pumping units. LRP technology offers improvements in safety, aesthetics and production, as well as reduction in downhole failures, installation time and transportation logistics. The oil producers get all these benefits at a significantly lower cost, and that's why our Unico business is experiencing very strong growth in demand.

Our team is on pace to deliver a record year of new products with the majority focused on energy efficiency. In terms of our outlook for the third quarter, we're anticipating that we will see continued strength from our Commercial and Industrial and Mechanical businesses and continued softness in the HVAC business. We're still hopeful that the recent heat waves will help offset some of the HVAC headwinds, but we've not yet seen a change in order patterns. And finally, we expect that the combination of price and productivity to continue to offset commodity inflation.

The real excitement for the third quarter is the prospect of closing the EPC transaction within the month. We've made great progress on preparing our functional operations for eventual integration. There's still a significant amount of commercial integration and synergy activities that we can't begin until we receive DOJ approval of the transaction. We look forward to starting that process upon closing.

We feel great about the talent we're getting with the transaction, and the cultural fit seems to be right on target. From A.O. Smith’s public release, you can also see that the EPC team is performing very well, and that makes it even more exciting to join ranks. Our team will -- our focus will be to combine our talents within our teams so that we can add incremental, long-term value for our customers.

Overall, except for the incremental warranty expense, we had a great quarter. The balance of industries that we serve allowed us to outperform our second quarter guidance even as HVAC slowed. We feel great about the performance in the quarter of our Commercial and Industrial and International businesses. At some point in time in the future, the residential market will return. And what it does, we believe we will be well-positioned. Until it does, we believe our diversified set of businesses and our diversified footprint will continue to drive growth.

With that, I'll turn it back over to Mark.

Mark Gliebe

Thanks, John. Now I'll just summarize -- again, we want sincerely communicate that we regret the -- any inconvenience we caused our customers or that our customers are experiencing due to the flaw in our motors. We will learn from the event and be stronger and better for it in the future.

Excluding the incremental warranty expense, we felt great about the quarter and our performance in the quarter, especially given the weakness of our residential HVAC business. Between our pricing actions and productivity actions, we were able to cover the second quarter inflation. And our string of new products continue to roll out with exciting technology for the Commercial and Industrial motor margin business, as well as for Unico's oil and gas business.

Our third quarter guidance reflects continued softness in HVAC and continued strength in most of our other businesses. Further, the A.O. Smith EPC transaction is not reflected in our estimate, even though the interest expense for the acquisition financing is included.

And finally, we have our new financing arrangements in place, and we are more optimistic than ever about the pending closing of the EPC transactions. We believe will close the transaction within the month.

With that, we will take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Steve Sanders of Stephens Inc.

Stephen Sanders - Stephens Inc.

Maybe just first, Chuck, I think you indicated the third quarter sales would be below 2Q. And you've given some color on that. So should we think about that as HVAC down sequentially, moderating growth in C&I and the emerging markets staying fairly robust, but also maybe moderating? Can you just put a little more color on that?

Charles Hinrichs

Yes, I think that's a good summary, Steve.

Stephen Sanders - Stephens Inc.

Okay. And then what have you seen in July overall in some of your primary businesses and specifically in HVAC? And then is there any way for you to quantify the dry ship impact for either the second quarter or kind of your thinking for the year?

Mark Gliebe

The HVAC in the third quarter is normally below our second quarter. It was an anomaly last year because we had an especially strong season last year, and we went into Q3 last year with a rather substantial backlog. So as we go into July right now, the HVAC business is not seeing the kind of demand it would have typically seen. It's somewhat softer than we had expected, and that shouldn't be a surprise given the communication from -- the public communication from many of our customers. And a lot of that is driven by the 3 or 4 things that John mentioned earlier. In terms of the specific impact of R-22, it's -- there's so many things and so many variables. It's difficult for us to pinpoint exactly what contribution the R-22 is having on the business.

Stephen Sanders - Stephens Inc.

Okay. And then 2 quick ones, and I'll get out of the way. With the probabilities of a double-dip going up, can you just talk generally about opportunities you might have to accelerate some of the margin enhancement initiatives if we do end up there? And then the final question is just on the China facility relocation, should we think about that as a working capital and margin headwind in the near term? And then we start to get the payback in '12? Or how should we think about that?

Mark Gliebe

Certainly, there are no shortages of opportunities to mine synergies given the acquisitions that we've done. And so we'll be aggressively pursuing those, I would say, somewhat regardless of what happens with the economy. So there will be opportunities there to pursue those synergies. I'm sorry. Can you repeat the second half of that question?

Stephen Sanders - Stephens Inc.

Yes, just China. You're doing a facility relocation. So do you need to build some inventory? And are there some inefficiencies on the margins side that we'll have to absorb until we start to get some benefits next year?

Mark Gliebe

I think -- well, certainly, any time you do a plant relocation, there are some inefficiencies that you'll experience. So we have 2 of them to do. And then obviously, we'll be spending the CapEx ahead of the transition. And I do believe when we come out of the other end, the plants will be running more efficiently.

Operator

The next question comes from Jeff Hammond of KeyBanc Capital Markets.

Jeffrey Hammond - KeyBanc Capital Markets Inc.

So you guys gave a lot of detail on EPC, and it seems like it's a done deal. I mean, is there any risk that it does push beyond August?

Mark Gliebe

Well, any time you're dealing with a situation like this, where -- you're never 100% sure, but obviously, for us to have come out and say we're going to close within the quarter, we are feeling more optimistic than ever that we've made tremendous progress.

Jeffrey Hammond - KeyBanc Capital Markets Inc.

Okay. And then you said no material change to the original deal. Are there any changes to the original deal?

Mark Gliebe

Well, I'm not going to comment on anything in specific just because we're still going through the process. But I think the right way to say it is the way we have said it, which will be that there will be no material change to the transaction that we signed with A.O. Smith.

Jeffrey Hammond - KeyBanc Capital Markets Inc.

Okay, great. And then just back on HVAC, I mean, any indication that weather in July helped? And what are your customers telling you about inventory and their production plans relative to normal into 3Q?

Jonathan Schlemmer

This is Jon. I'll take that question. Obviously, we are seeing some heat right now. We've seen that across much of the U.S., and it's been going on now for a couple of weeks. We're not yet seeing a change in order patterns from our customers due to that heat. We think there is probably a couple of factors at play there. One is the heat came rather late in the season, and it could be that distributors are using that as an opportunity to work down inventory levels. And there could also be an impact of just how much capacity there is with the contractor base to deal with the heat and replacement and repair of units. But as of right now, we're not seeing a change in order patterns. But obviously, in general, heat is usually good for this business.

Operator

The next question comes from Mike Halloran of Robert W. Baird.

Michael Halloran - Robert W. Baird & Co. Incorporated

So back to the first question, just on the sequential trends that you guys are talking about, obviously down 2Q to 3Q. When you think about that relative to, say, normal sequential patterns, are you guys really seeing much difference from that normal sequential pattern?

Mark Gliebe

Well, I would say, just -- the HVAC business is certainly less robust than we would have expected. So that's point one. Relative to our Commercial and Industrial businesses, it doesn't have the seasonality that our HVAC business has. So there's nothing to take note of there.

Michael Halloran - Robert W. Baird & Co. Incorporated

No, no, no. I certainly agree on the second point. I guess what I'm trying to drive to on the first point though is you saw weak trends in 2Q. It sounds like -- or I'm curious, if 2Q is the right base to build off of it if I think about kind of a normal HVAC sequential trend. So I mean, are you seeing weakening on the HVAC side, 2Q to 3Q relative to normal? It sounds like you're saying continued weakness at a comparable level.

Mark Gliebe

Yes, I would think that, that's the right way to characterize it. It's -- relative to Q2, it's kind of a normal seasonality. Now the other thing to take note of is that we do have tough comps in Q3 on a year-over-year basis simply because we carried a backlog in the Q3 that we're not carrying this year.

Michael Halloran - Robert W. Baird & Co. Incorporated

Absolutely. No, that makes a lot of sense. And then on the margin side, could you talk about the price cost curve and whether you've got steel moving a little bit more against you in 3Q, but you've also got probably more full realization of the pricing side in 3Q? Could you talk about the price cost curve and whether it's comparable to 2Q or a little bit better than 2Q when you hit 3Q?

Charles Hinrichs

Mike, we think we're balanced going into the quarter. As you said, the realization of the last price increase for the full third quarter and our productivity initiatives that will continue to build momentum in the year. So we're feeling okay going into the third quarter on that balance.

Michael Halloran - Robert W. Baird & Co. Incorporated

And then last one for me. On the acquisition side, from a cost perspective, you had $3 million and change of acquisition expenses in this quarter. What are your expectations at this point for 3Q? And obviously, that would be excluding a lot of the one-time oriented costs that would be associated with the actual close of the EPC acquisition itself.

Charles Hinrichs

Yes, I guess, we're seeing some reductions in third quarter versus the 2Q expense level. But until we get it over the finish line, it's kind of hard to estimate that.

Operator

The next question comes from Mark Douglass of Longbow Research.

D. Mark Douglass - Longbow Research LLC

Just talking again about HVAC and your ability to get cost. This quarter was -- the second quarter was good. But is there a mix shift also working against you in HVAC on the resi side is -- on the dry ship side of things, is there less content of higher efficiency motors? How is that playing into your margins right now?

Jonathan Schlemmer

This is Jon. We did -- we have seen a shift in mix towards more standard efficiency products for the reasons that I explained. There is a combination of factors at play here. One is the reversion back to the R-22 outdoor condensers when there is a failure with the consumer and the product is replaced. And then you combine that with the lack of consumer confidence and also the reduction in the federal stimulus. All 3 of those factors combined are creating a dynamic we believe that's causing a mix shift back to more standard efficiency products. Clearly, there is still demand for high-efficiency products in the business. But from a year-to-year comparison, that is a change that we're seeing in the business. Saw that as we went through the second quarter, and we expect to see that in the third quarter as well.

D. Mark Douglass - Longbow Research LLC

So right now, would you say that C&I for high-efficiency motors is kind of carrying the water at this point for high-efficiency motors?

Jonathan Schlemmer

We have definitely seen an increase in high-efficiency product on a year-over-year basis in our other businesses. And C&I is a notable segment of our business where we're seeing that kind of increase in demand for high-efficiency products, absolutely.

D. Mark Douglass - Longbow Research LLC

Sure. And then some of that's certainly due to the -- having to go up to NEMA Premium. Can it be quantified how much of the 20% growth in C&I was due to the shift in NEMA Premium?

Mark Gliebe

We don't have the breakout of that right now, but we'll ask Chuck and Jon to take a look that and provide it after the fact.

D. Mark Douglass - Longbow Research LLC

Okay, great. And one last question for Chuck. And so what are your CapEx expectations for the year?

Charles Hinrichs

Mark, it's kind of tough to forecast when that spending will be on the plants. But if you'll recall, we started with an initial estimate for 2011 of $90 million. And that would probably be some 25 -- excuse me, $50 million above our normal run rate. So those 2 factories are probably going to be in the $20 million to $30 million range in total.

D. Mark Douglass - Longbow Research LLC

Okay, but it’s still TBD if it’s being spent in '11 or 12?

Charles Hinrichs

Sure.

Operator

The next question comes from Christopher Glynn of Oppenheimer.

Christopher Glynn - Oppenheimer & Co. Inc.

Mark, I had a question about the Reynosa snafu there. Just -- are you concerned about any risk of mix shift and how the customers allocate the share?

Mark Gliebe

Sure. Well, obviously, customers are going to be disappointed in the fact that we have this issue. So no surprise, and we're making it very clear that we regret any inconvenience. But I would say this: We have absolutely had a sense of urgency around this issue that I think our customers have recognized. We've stepped up and stood behind the obligations to our customers, and it's evident by the announcement that we made on Wednesday. So my hope is that our customers recognize that and also recognize the fact that not every motor manufacturer in the world could stand behind their obligations the way that we are. So time will tell. But we certainly are doing right by the customer.

Christopher Glynn - Oppenheimer & Co. Inc.

Okay. And then from a bigger-picture perspective, what are your longer-term thoughts about potential for OEM risk of diversification to international suppliers?

Mark Gliebe

I think there’s always risk that you'll have competition from international suppliers. We've had it in every one of our businesses. But I think we're well-positioned, given our own international footprint. And also, when you add EPC to the mix, we'll have an even stronger international footprint that will be able to compete with anybody anywhere.

Christopher Glynn - Oppenheimer & Co. Inc.

Okay. And then just on the 20% C&I growth, could you break out the organic piece of that?

Charles Hinrichs

Well, Chris, it would be a combination of volume growth and price growth. And then we'd also, of course, see the shift from the standard to the NEMA Premium. And that has a higher average selling price. So it would be those 3 factors [indiscernible] a volume number.

Christopher Glynn - Oppenheimer & Co. Inc.

That didn't include acquisitions?

Charles Hinrichs

It did not include acquisitions.

Operator

The next question comes from Josh Pokrzywinski of MKM Partners.

Joshua Pokrzywinski - MKM Partners LLC

Just wanted to follow up on an earlier question about the acquisition costs in the quarter, that $3.3 million. How does that compare to that original expectation of $7 million that you guys called out last quarter? Was -- is there another $3.7 million somewhere else buried in the numbers not related to A.O. Smith? Or was that just lower than anticipated?

Charles Hinrichs

That second quarter did -- I'm sorry, the first quarter did have some other projects included in that number. And then the number I quoted for second quarter was a pure EPC number. And so we would expect to see some decline on that going into the third quarter.

Joshua Pokrzywinski - MKM Partners LLC

Okay. But just to be clear, your guidance into -- your original 2Q guidance had $7 million in it, give or take, and you guys came in a little bit wider than that?

Charles Hinrichs

Yes.

Joshua Pokrzywinski - MKM Partners LLC

Okay. Just looking out into the third quarter, maybe back half of the year, any changes on that -- the recent spike in steel from your guys' perspective? Any changes that happens on the LIFO line?

Charles Hinrichs

LIFO was not a material change for the quarter, Josh. And steel, as I mentioned, is starting to trend down a little bit, but we'll still see an increase in the third quarter. But we've got that built it into our guidance.

Joshua Pokrzywinski - MKM Partners LLC

Okay. And then any quantification or feedback you're getting from the channel about what this bonus depreciation is doing? Is it kind of a blip or a non-event, or is that something that you feel like is picking up demand a little bit this year?

Charles Hinrichs

We have not heard anything from our sales and marketing teams that would suggest that it's any kind of a benefit to the business.

Joshua Pokrzywinski - MKM Partners LLC

Got you. And then one final one, just on inventory. With the ISA standard and pretty strong demand on the C&I side near term, any fits in the channel on inventory levels? Is premium inventory too low, standard inventory too high? Any dynamics there that we should be aware of?

Mark Gliebe

I would just say in general, we're well-positioned. Things are rolling out pretty much the way they thought they were, and that is that over time, we would burn down any remaining EPACT inventory -- that is the less efficient product that we had in the interval horsepower business. That's moving away over time and being replaced by the NEMA Premium product. And that's what we see happening with our other competitors as well.

Operator

The next question comes from Scott Graham of Jefferies.

R. Scott Graham - Jefferies & Company, Inc.

I was wondering if you could unbundle for us some of the strengths, the markets in particular, in C&I and Electrical and Mechanical overall.

Mark Gliebe

I would say overall -- generally speaking, in both the Commercial and Industrial and Mechanical and generator businesses, those tend to be later-cycle businesses. And so we've seen overall general strength across all segments that we saw in Q2. And going forward, we're assuming that we'll see that same behavior in Q3.

Jonathan Schlemmer

And I would add to that, Scott, that we've seen particular strength in Ag with industrial equipment and also the oil and gas.

R. Scott Graham - Jefferies & Company, Inc.

That's helpful. Would you call those 3 markets really the leaders in each of those business? Or is it maybe a little bit of a different set for one versus the other?

Jonathan Schlemmer

No, I wouldn't call those necessarily leaders for us. We do participate with several of our businesses in each of those segments. But that -- they're not necessarily the largest segment. Now industrial equipment is a pretty important sector for our Commercial and Industrial businesses.

R. Scott Graham - Jefferies & Company, Inc.

Okay. Now you guys have obviously a big leadership position in HVAC in the high-efficiency area. And I know that you're trying to move this leadership position, leverage it more to C&I. I was just wondering if you could kind of us a bit of an update there on -- I see some of the new products, of course, but where do you see traction? I mean, motors are pretty much as ubiquitous as it gets in industrial. And so it would seem to be a nicely leveraged position. So I was just wondering, are you seeing good successes there? Is it just new products? Is it distribution? Just maybe give us a good idea of how that strategy is rolling out.

Jonathan Schlemmer

Scott, you're right. It's a great question. I think that we're excited about what we're seeing so far in our Commercial and Industrial businesses with our strategy to take the ECM technology, if you will, and the dynamics behind that product development and how to fit it into the Commercial and Industrial business. We've been on that path for a long time. And that the -- one of the products that I mentioned today, the permanent magnet AC industrial motors is a great example of that. Essentially, if you look at the motor, it's very similar to an ECM motor. It uses permanent magnet technology, offers higher-efficiency levels and standard products, as well as other features and benefits. In that particular case, we've done a lot of work to make sure that product's compatible with drives that are available on the market today so customers can take advantage of those benefits. Last quarter, I mentioned a smaller frame, Permanent Magnet Motor, which has very similar technology, but that gives us the ability to take the high-efficiency technology into a wide variety of Commercial and Industrial applications. And we're on just a constant path to do that, to keep taking this type of technology, making it suitable for Commercial and Industrial applications and just expanding it. So I -- there's a lot of excitement in the team right now, and we feel very good about the path we're on.

R. Scott Graham - Jefferies & Company, Inc.

So we're really seeing both customer content and new customers gains off of the strategy?

Jonathan Schlemmer

When we have a technology like this, one, there's interest from our existing customers. And two, it absolutely opens the doors up for new customers. No question about that.

Operator

The next question comes from Wendy Caplan of SunTrust.

Wendy Caplan - SunTrust Robinson Humphrey, Inc.

Can we talk about working capital, Chuck? Looks like it was up -- on a year-over-year basis, it was up 35% double kind of what your sales increase was. Inventory seemed to be the biggest challenge. And is that generally related to China? Are there other factor -- in terms of redundancies, or are there other factors that would be helpful for us to know?

Charles Hinrichs

Wendy, probably the biggest driver would just be the seasonal change. As we build up inventories, that would be at the end of the second quarter.

Mark Gliebe

I'll just add, Wendy. If you recall last year, in the quarter, our HVAC business saw an enormous demand surge. And we brought our HVAC inventories down significantly in the second quarter of last year. This year, we have a more normal inventory position.

Wendy Caplan - SunTrust Robinson Humphrey, Inc.

Okay. So are we in the "right" inventory position at this point?

Charles Hinrichs

I think it's generally balanced. I think, clearly, a lot of it will be determined by future sales trends. But we're comfortable with our working capital levels at the end of the quarter.

Wendy Caplan - SunTrust Robinson Humphrey, Inc.

Okay. And can you comment on hiring? What are you -- are you hiring? Where are you hiring? Who are you hiring? Can you give us some of that information, please?

Mark Gliebe

Sure. It's going to depend very much on the specific manufacturing facilities, which is where the majority of our hiring would be, obviously, at the production facilities. And so when we start talking about our generator business being up 35% -- I think [ph] that was the exact number or our C&I business being up or our Mechanical business being up, now those facilities would obviously have been increasing on our level of staffing in order to support that demand. And in our HVAC business, to the extent that there is weakness, we would be removing production workers.

Wendy Caplan - SunTrust Robinson Humphrey, Inc.

So on a net basis, are we kind of flat? Or what would you say, Mark?

Mark Gliebe

Yes, I would say probably through the second quarter, we would have been up on a year-over-year basis. Going forward, it's probably moderating.

Wendy Caplan - SunTrust Robinson Humphrey, Inc.

Okay. And Mark, your degree of confidence that $28 million is the right number to cover these warranty issues and the fact that it's -- can be -- it will be corrected this quarter and we won't hear -- we'll be looking back on it next quarter. Can you tell us about that, please?

Mark Gliebe

Sure. We've done a tremendous amount of work -- analysis to get that this. We’ve worked closely with our customers and looking at every point in the distribution channel to make sure that we understood it. This is after a lot of analysis. This is the correct number right now, and we feel as good that we have captured it all.

Wendy Caplan - SunTrust Robinson Humphrey, Inc.

Okay. And one last question on the price cost equation. You -- last quarter, you talked about price increases lagging the cost inflation. And in this quarter, it's covered both on -- you said on pricing and productivity. If -- should we worry that if 3Q revenue growth is slowing and volumes decline a bit sequentially that productivity gains are going to be harder to get? Or do you have a strong -- you didn’t mention the kind of nature of the price increases, but should they, given what you know today, should they be covering costs going forward into the third quarter?

Mark Gliebe

Our guidance right now includes us having a similar performance in the third quarter that we had in the second quarter, which is that our -- the combination of both price and productivity will allow us to offset third quarter inflation.

Operator

Our next question comes from Bill Dezellem of Tieton Capital Management.

William Dezellem - Tieton Capital Management

We have a couple of questions. The first one, generically speaking, with EPC, if that transaction were to close in the month, would you anticipate that it would be beneficial or a drain to Q3 earnings on an operating basis, including the -- any restructuring charges and then secondarily, excluding restructuring charges?

Charles Hinrichs

Bill, we look forward to providing that information immediately after the closing on EPC. And we'll schedule a conference call for that purpose.

William Dezellem - Tieton Capital Management

Okay. And even just generically, directionally, whether it will be favorable or unfavorable in the quarter is not something that you're prepared to talk about now?

Charles Hinrichs

Yes, it won't be very far off. So we'll just provide that information at that time.

William Dezellem - Tieton Capital Management

All right. And then the second question is relative to the economy, there are a number of questions out there, I suppose especially after yesterday. But what is your sense with the North American economy, whether it's shifting backwards or not? And then would you please also address the Asian and European regions? But I'm actually -- not only do we have the question about the economy but are also interested in the implications of your answer about the economy in those 3 regions for acquisitions.

Mark Gliebe

Yes. Well, obviously, the best indication for us is going to be order patterns. And we reflected our thinking in our third quarter guidance. And the comments that we've made is that, obviously, we see a weakening in HVAC, and it's kind carrying over from the second quarter. In our Commercial and Industrial, in our Mechanical businesses, which tend to be later-cycle businesses, we still see strength in those markets, and they tend to cover many, many different industries. But -- so far, through the third quarter, we still feel strength in those businesses. From an Asia perspective, our -- both our Asia-Pacific business, which for us includes Australia, Thailand and Singapore, still going strong. Our India business, similar, still going strong. However, we have seen a deceleration in our China orders.

William Dezellem - Tieton Capital Management

And the European market?

Mark Gliebe

From a Europe standpoint, it's -- we don't have a tremendously big footprint in Europe. So we may not be the best indicator. But what we're seeing is a little bit stronger in the northern part of Europe and somewhat weaker in the southern part of Europe.

William Dezellem - Tieton Capital Management

And when you put all this together, what implications, if any, do you believe this has for future acquisitions for you?

Mark Gliebe

Well, the M&A markets, as you know very well, are still very strong, at least going -- coming out of the second quarter. I would say that it's a little bit frothy relative to the valuations. In terms of our own pipeline, we continue to feel good about the pipeline that we have, and we're still looking at a number of opportunities, and we will continue to do so.

Operator

The next question comes from Jamie Sullivan of RBC Capital Markets.

Jamie Sullivan - RBC Capital Markets, LLC

Most of my questions have been answered. Just figured I'd ask one on HVAC. With some of the moving parts, you had some pricing helping, mix hurting. So I'm wondering if you could talk about just kind of unit volumes and whether there was any additional impact in that business compared to last year due to maybe some changing competitive dynamics as you go down into the lower efficiency end of the market.

Mark Gliebe

Well, 2 comments. Number one, from a year-over-year basis, as I mentioned earlier, it was difficult comps because we had a very strong second and third quarter, particularly third quarter. But second quarter as well last year, we had surging demand. The second point I'll make is that as you go into the lower-efficiency products, it tends to be more competitive.

Jamie Sullivan - RBC Capital Markets, LLC

Okay. All right. And then are your customers -- are they saying anything about their expectations around this mix trend towards R-22? Are you hearing anything about closing the loopholes? Just wondering what you're hearing about...

Mark Gliebe

Number one, there is -- one, there's a few of the customers who don't like the situation, what's going on and, in fact, I believe are pursuing -- are trying to pursue the closing of that loophole. I don't know the specifics. I don't know their chances of being successful. But some people don't like what's happening. In terms of the impact on mix, they are seeing it as well. They are seeing the impact on mix as well. And therefore, we are seeing it.

Jamie Sullivan - RBC Capital Markets, LLC

Okay. And maybe for Chuck. Just wondering if you have a breakout after the price increases over the last 9 months. How much did price contribute to the sales growth in the quarter overall?

Charles Hinrichs

Jamie, we typically don't release that information, just for competitive reasons.

Operator

The next question comes from Walt Liptak of Barrington Research.

Walter Liptak - Barrington Research Associates, Inc.

I realize that we'll be talking in a month, hopefully, after A.O. Smith gets closed. But I wondered if -- I think you may have mentioned that there's likely $0.05 in the analyst estimates, and I put A.O. Smith in there. And I wonder how you came up with that number. Is that based on what the other analysts came up with? Or is it based on your own accretion model?

Charles Hinrichs

It's purely based on our estimate of it and looking at the different models, Walt. So there’s no science to it. We could be off by $0.05 either way on that number.

Walter Liptak - Barrington Research Associates, Inc.

Okay. A.O. Smith, their revenue and profits have been running ahead of, I think, what most people thought they would be doing 6 months ago. Have you adjusted your accretion models? I know we've got the pro forma on that at $702 million. They’re already running at $424 million in revenue. I mean, can you talk at all about where your accretion models are?

Charles Hinrichs

We'll be updating that on our call after the closing, Walt.

Walter Liptak - Barrington Research Associates, Inc.

Okay. And then integration plan, you've had more time now, I guess, to maybe not dig in to A.O. Smith, but at least to consider what you're going to do. Can you give us an idea of how quickly you'll be able to get in there and start taking costs out? And basically, can you get costs out once the deal closes like within the first month or 2?

Mark Gliebe

We’re going to stand behind the numbers we've given before in terms of our synergy targets still in the $30 million range. We have spent a tremendous amount of time with the team in terms of integration planning, but only on the functional side. We've not been able to discuss the commercial aspects of the integration, and we're looking forward to doing that as soon as the transaction closes. But as Jon mentioned, we feel great about the talent, and we feel great about the cultural aspect of the transaction.

Operator

The next question comes from Holden Lewis of BB&T.

Holden Lewis - BB&T Capital Markets

Just to, I guess, close to the loop [ph] on a couple of things. First, with regards to the price cost curve, I guess you indicated that you felt like in Q2, you had sort of recaptured the dollars net that you had lost earlier. Are we to sort of assume then that by Q4, if materials stay where they are, by then you're sort of recapturing the actual margins? So price costs, going forward, could actually begin to be a margin boon at that current level as we sort of work through the direction?

Charles Hinrichs

Well, just to be clear, Holden, we said that we were balanced in the second quarter between price and productivity offsetting the inflation and that we would expect to continue that balance into the third quarter. But again, we're only speaking about the year-to-date cost inflation. And we are still behind on recovering the 2010 cost inflation. So of course, there'll be other factors impacting the margin for the full year. The volume would have a big driver to that as well. But purely on the balance between price, productivity and cost inflation, we feel we're balanced on a year-to-date basis.

Holden Lewis - BB&T Capital Markets

Okay. And that's really just assuming the 2011 changes when you say year-to-date?

Charles Hinrichs

That's correct.

Holden Lewis - BB&T Capital Markets

Okay. So just taking Q2 as a base line, going forward, if raw materials stay where they are, are you getting more price to still bleed in, whether it be from more contract accounts or what have you, that means that if we've captured -- recapture the dollars through the first half, by the end of the second half, you start recapturing the margin and the productivity begins to actually contribute to margin rather than just being -- playing defense with that?

Charles Hinrichs

Yes, it's difficult to answer that question with those assumptions because we know that are -- we're still experiencing some cost inflation into the third quarter. Now our prices, that will receive full realization for the entire third quarter, so that will benefit us.

Holden Lewis - BB&T Capital Markets

Okay, okay. And I guess, just hitting back on sort of the HVAC trend as we go through the rest of the year, I guess the way that we've seen this play out so far is you feel like Q1 is relatively strong. Customers built up inventories and then they sort of worked down those inventories in Q2 because of a relatively cool season. And I guess, you think that at least to begin Q3, they are continuing to work down those inventories because despite the heat, you're weren't seeing any pop up. I think you noticed maybe some capacity issues around contractors who all seem to be saying that their demand is up pretty significantly. I mean, does this feel like as you get it later into Q3, those inventories should be just -- rationalized enough that they start to build? And maybe there's a capacity issue? Maybe then you have a better Q4 than is seasonally normal? I mean, does that feel like it -- that's how it plays out, or do we feel like whatever revenues we kind of lost in Q2 due to the weak seasonal -- or weak weather are just lost?

Jonathan Schlemmer

This is Jon, Holden. We certainly would hope that, that dynamic would hold true, that the heat that we experiencing right now, even if we're not seeing the impact on orders today, that we would see the benefit of that as we go through the third year and into the fourth quarter. As I mentioned earlier, heat is generally good. It's going to drive more demand for the air conditioning equipment. It's going to drive increased demand due to replacement products. So that's certainly what we would hope to see. As I mentioned also at this point, we haven't seen the -- an uptick in orders though.

Holden Lewis - BB&T Capital Markets

Okay. And then lastly, I guess, could you give us sort of an update on SG&A? It seems like -- I mean revenues were up nicely in Q2, but it seems like the overall SG&A dollars are actually down versus Q1. So volumes went up, SG&A dollars went down. Is that productivity? Is it something else? If it's productivity, what major initiatives do you have in place right now that it is driving some of that?

Charles Hinrichs

Holden, I guess the only number that we've called out would have been the lower legal expenses related to EPC in the second quarter over the first quarter.

Holden Lewis - BB&T Capital Markets

And how much are those, I'm sorry?

Charles Hinrichs

They were $3 million in the second quarter. And with respect to the EPC part of it, they were over $6 million in the first quarter.

Holden Lewis - BB&T Capital Markets

Okay. So, even accounting for those, that can explain the $3 million. But it still kind of went down in a rising volume environment. Is that just productivity you're doing? I guess I'm also just trying to get a sense of what big productivity initiatives do you have in place right now that could not only drive that result but continue to drive results going forward?

Charles Hinrichs

Yes. Maybe we can go over some of the specifics later, Holden. But there were no other big-dollar changes quarter-to-quarter for -- we continue to, of course, focus on controlling all of our costs.

Mark Gliebe

Okay, well I think that's the end of the questions.

Operator

Yes, it's the end of the questions.

Mark Gliebe

Thank you very much. Before we close, one special note. Please mark your calendars for our second annual Analyst Day event, which will be December 6, 2011, in New York City. Thank you for joining the call, and thank you for your interest in Regal Beloit.

Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.

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