Kaydon Q3 2007 Earnings Call Transcript

Kaydon Corporation (KDN)

Q3 2007 Earnings Call

October 29, 2007 11:00 am ET

Executives

James O'Leary - Chairman and CEO

Ken Crawford - SVP and CFO

Peter DeChant - SVP of Corporate Strategy and Development

Analysts

Joel Tiss - Lehman Brothers

Walt Liptak - Barrington Research

Peter Lisnic - Robert .W. Baird

Steve Barger - KeyBanc Capital Markets

Ian Fleischer - FBR Capital Markets

Presentation

Operator

Welcome to the Kaydon Corporation Third Quarter 2007 Earnings Call. Before the conference begins, the company would like to make the legal disclaimer that certain information in this formal discussion and that may be included in the question-and-answer session is forward-looking within the meaning of the Federal Securities Laws.

These forward-looking statements are only predictions based on the company's current expectations about future events. While the company believes that any forward-looking statements may be reasonable, actual results could differ materially since the statements are based on the company's current expectations and are subject to risks and uncertainties beyond the control of the company. Listeners are cautioned to refer to the company's Form 10-K for a list of factors that could cause its results to differ from those anticipated in any forward-looking statements.

The company does not undertake and expressly disclaims any obligation to update or alter its forward-looking statements whether as a result of new information future events, or otherwise except as required in the applicable law.

During this conference call, Kaydon spokespersons will reference certain GAAP measures. To assist in understanding such non-GAAP measures as well as to comply with SEC requirements, the company has included in their press release, reconciliations of non-GAAP measures to their most directly comparable GAAP measures.

Today's conference is being recorded and I would like to turn the call over to Mr. James O'Leary, Chairman and Chief Executive Officer of Kaydon Corporation. Mr. O'Leary, please, go ahead.

James O'Leary

Thank you very much Dalia. Good morning and thank you all for joining us today. I'm pleased to be reporting on a healthy quarter. The one which requires a lot more heavy lifting than usual when making comparisons to last year's extremely strong third quarter.

This is principally due to investment spending and a number of discrete ups and downs, which we will take you through later. But again, we apologize, there is a bit more heavy lifting this quarter, but we'll do our best to walk you through in a regrettably painstaking detail.

We are extremely excited and pleased to be discussing our progress on several longer term initiatives aimed at acceleration long-term shareholders value. Notably, the acquisition of Avon Bearings Corporation which was announced this morning and the acceleration of share repurchase program, which is aimed at optimizing our approaches to both capital allocation and the use of free cash flow.

I am joined this morning by Ken Crawford, Senior Vice President and Chief Financial Officer and Peter DeChant, Senior Vice President responsible for Corporate Strategy and Development.

During the quarter, we had record third quarter order entry of $117.3 million up almost 26% year-over-year, leaving us with a record quarter end backlog of $211 million going into the fourth quarter. Reflecting continued strength across most of our businesses. Assuming this trend continues, this position does extremely well for the remainder of 2007 and into 2008. During the quarter, Kaydon had record third quarter sales of $107.4 million up $7.7 over last year's strong third quarter.

Operating income, which included about $1 million of relocation and ramp up costs equaled $24.5 million or 22.8% of sales as compared to $24.9 million or 25% of sales in last year's third quarter. Last year's quarter benefited from about $800,000 in one time operating income benefits, while this year suffered some one time determents mostly associated with the ramp up in Mocksville and our wind energy expansion.

Now to provide you with an apples-to-apples comparison, I'll briefly discuss some non-GAAP information. On a non-GAAP basis backing the $1 million of ramp up and relocation costs incurred this year and adding back the $800,000 of one time benefits last year, our margins would have been 23.7% this year as compared to 24.1% last year. Remember, last year was an extremely robust performance in what's usually a slow quarter.

Again, that comparison was non-GAAP. The slight dip on an apples-to-apples basis of about 40 basis points was largely attributable to a challenging comparison with an extremely strong performance by our higher margin Military segment last year, which was not fully repeated into this year's third quarter.

In addition, we saw some shipments slip from the end of this year's third quarter into this year's fourth quarter because we had some challenges in receiving customer supplied raw materials and delayed outside vendor deliveries. These items in particular are timing and should be caught up early in the fourth quarter.

Net income equaled $17.1 million or 16% of sales as compared to $17.6 million or 17.6% of sales last year. Diluted EPS equals $0.54 compared to $0.55 in last year’s third quarter and again the comparison to the prior year third quarter was affected by the expenses just mentioned and by a one-time tax benefit totaling $500,000 in the third quarter of 2006, which was related to the disposition of an idle facility which gave us a non-repeatable tax benefit.

Gross profit for the third quarter was $43.3 million or 40.3% of sales as compared to $40.9 million or 41% of sales during last year’s third quarter. Comparisons, again affected by the pretax items just discussed. In particular gross margin was impacted by about $600,000 of costs to ramp up our wind energy business and to relocate certain sealing product business lines. During the fourth quarter we anticipate that these items will negatively impact gross margin by about $1 million and this is discussed in prior quarters and that should complete most of these charges for investments and relocation.

SG&A expenses included 300,000 related to the wind energy ramp up and were $18.8 million or 17.5% of sales, during the third quarter. This compares to $16 million or 16.1% of sales during the third quarter of 2006. During last year’s third quarter, an insurance refund and a reduction in environmental reserves contributed about $800,000 of favorable SG&A impact. In the fourth quarter of this year we expect additional SG&A of about $500,000 related to the wind energy ramp up.

Operating income during the third quarter of 2007 was $24.5 million or 22.8% of sales and again the non-GAAP apples-to-apples operating margin comparisons are roughly $23.7 million this year as compared to 24.1% of last year.

Now let's spend a little bit of time in our business segment performance starting first with Friction Control Products. Sales of friction control products increased $2.5 million to $60 million or 4.3% when compared to the third quarter of 2006. This increase was driven by strong sales of split roller bearings in almost every market we sell into. But notably, what we term, distant markets, which is driven principally by China and India.

This segment was also positively affected by increased demand for specialty bearings utilized in the machinery, wind energy, and wind and medical equipment markets; offset by lower sales to military, non-wind, heavy equipment and semiconductor markets. All relative levels achieved last year's third quarter. Remember, last year's quarter enjoyed particularly strong business in our Military segment.

Operating income in the Friction Control Product segment decreased to $15 million, impacted by the ramp up costs and the absence of $500000 insurance refund recorded in the third quarter of last year. As compared to the current period the third quarter of 2006, benefited from extremely strong performance in our military business, obviously it was negatively impacted by what should be a timing issue and with some shipments swept from the end of this year's third quarter to this year's fourth quarter. Due to the delays in receiving customer supplied raw materials and delayed outside vendor deliveries.

Operating margins equaled 25% as compared to 29.3% at the end of last year. The lower operating margin driven by a higher proportionate growth of lower margin but still high margin split roller bearings and lower sales in our military business, which was exceptionally high in last year's third quarter.

The wind energy ramp up and the absence of the $500000 refund last year also creates some static in making clean comparisons. Again, applying the same logic to the items just reviewed resulted in an apples-to-apples non-GAAP comparison of about 26% this year, compared to about 28.4% last year.

Third quarter orders in this segment increased $22 million or 44% to $72 million. Our wind energy orders almost tripled while the non-wind orders in this segment experienced strong 20% growth. As we have noted before, we typically received extremely large discrete orders for specialty bearings utilized by the wind energy industry, resulting in an uneven order of flow when orders are booked.

Now moving to the Velocity Control segment, third quarter sales of velocity control products increased $1.9 million to $16.5 million or 13% over the prior third quarter, with strong sales by both our German and U.S. operations.

Operating income from velocity control products, increased to $4.5 million, were 28.8% when compared to the third quarter of 2006, while operating margin rose from 23.8% to 27.1%, primarily as a result of the strong operating leverage experienced on higher incremental sales. Orders increased more than 18% over the prior third quarter, with double-digit growth achieved by both the U.S. and the German operations.

In Sealing Products, sealing products sales increase $1.7 million to $12 million or 16.4% higher than the third quarter of 2006. Operating income in the Sealing Products segments increased 32% to $2.2 million, with operating margin rising to 18.2% from 16% last year. This improvement was driven by leverage from higher sales and extremely strong market conditions in both our Hydro-Carbon Processing and Aerospace segments. Orders during 2007 totaled $9.8 million as compared to $12.4 million in the prior year and the decline was principally due to the timing of when orders are received.

On a year-to-date basis, segment order activity has grown. Recently, certain customers have reduced their larger long-term orders in favor of multiple shorter-term orders. For example, in the prior quarter a customer placed a single large long-term order, which is now being replaced by smaller short-term orders impacting clean quarter-to-quarter comparisons.

In our Other Product segments, sales in other businesses equaled $18.8 million during the third quarter, an increase in the third quarter of 2006 of $1.6 million or 9.3%, principally due to higher demand in our liquid and air filtration businesses.

Operating income for the company's remaining businesses improved to $2.2 million in the third quarter compared to $800,000 during the third quarter of 2006. Third quarter operating margins for these businesses equaled 11.5% as compared to 4.6% last year.

The improvement in absolute and marginal profitability came largely from the benefits of a client consolidation in our liquid filtration business and the absence of consolidation costs associated with it that were incurred in the third quarter of last year.

Now I'll turn it over to Ken to cover some additional financial items.

Ken Crawford

Thanks Jim. We earned 5.2% on average cash and short term investments of $362.5 million during the third quarter of 2007, generating $4.8 million of interest income. Last year we earned 5.1% on average cash investments of $342.9 million, generating $4.4 million of interest income.

Interest expense during both the third quarters of 2007 and 2006 was $2.4 million with the only long-term debt outstanding being our $200 million of convertible debt. The effective tax rate for the third quarter 2007 was 36.1%, which is expected to be the rate for all of 2007.

The effective tax rate for the third quarter of last year was 34.6% primarily because of a $500,000 tax benefit related to the disposition of an idle facility.

Net income for the third quarter was $17.1 million or $0.54 per share on a diluted basis as compared to the third quarter of 2006 net income of $17.6 million or $0.55 per share on a diluted basis.

EBITDA is a non-GAAP liquidity measure that we consider an important indicator of financial health. During the quarter, EBITDA was $29.3 million as compared to EBITDA during the third quarter a year ago of $29.1 million. EBITDA for the last 12 months ended September 29th of '07 totaled a $123.1 million as compared to EBITDA for the last 12 months ended September 30th of 2006 of a $111.5 million.

Free cash flow is another non-GAAP liquidity measure that we consider to be an important indicator of the company's health, as it reflects our ability to generate cash in excess of both growth and maintenance capital investment. Free cash flow during the third quarter of this year was a negative $6.7 million due to the company's $23.2 million contribution to fully fund our qualified pension plans.

The net after tax impact to this contribution was a $14.9 million use of cash from operating activities. This contribution will substantially eliminate future contributions and should be modestly accretive to future periods.

Capital expenditures were $9 million higher during this year's third quarter, as we continued our investment in capacity expansions announced in prior quarters.

Free cash flow was $9.6 million during the third quarter of last year. Free cash flow for the last 12 months ended September 29th of 2007 totaled $34 million as compared to free cash flow for the last 12 months ended September 30th of last year of $44.3 million.

The third quarter pension contribution along with the higher capital expenditures associated with our capacity expansion programs more than offset our improved cash generation from other operating activities. Again, EBITDA and free cash flow should be viewed as supplemental data rather than as substitutes or alternatives to the GAAP measures. We've included in our earnings release a reconciliation of these two metrics to the most comparable GAAP measures for your reference.

Cash and cash equivalents plus short-term investments totaled $350.3 million at the end of the third quarter of 2007 as compared to $370.8 million at the end of 2006. Long-term debt remains unchanged at $200 million, equal to 30.2% of total capitalization.

During the third quarter of 2007, the company paid dividends of $3.4 million. That dividend payment was at a rate of $0.12 per share, and the latest dividend which we paid early in this fourth quarter was at a rate of $0.15 per share and equals $4.2 million. We also purchased a total of 295,800 shares of company common stock for $15.4 million and invested a total of $16.8 million in net capital expenditures.

In the third quarter of 2007, the company invested $90 million net in auction rate securities, a short-term investment vehicle offering superior interest rates to cash and cash equivalent investments. These assets are considered available for sale, and the purchase and sales activity are shown in the Investing section of our Statements of Cash Flows.

As Jim mentioned earlier, order entry was strong during the third quarter of 2007, achieving a third quarter record of a $117.3 million, an increase of 25.9% over last year's third quarter. The variability and size of orders of large diameter bearings for the wind energy market affects quarterly year-over-year comparisons and creates challenges in assessing a normalized run rate.

That said, we are obviously very pleased with our third quarter order entry and the resultant backlog at the end of the third quarter, which equaled a record $211.4 million. This is a 36.4% increase compared to backlog of a $155 million at the end of last year's third quarter.

As discussed in previous conference calls, it's worth a reminder that our wind energy orders will ship later than our typical pattern. The overall timing of when we expect our backlog to ship has changed from being approximately 50% during the next subsequent quarter, approximately 35% to 40% during the next two subsequent quarters and 10% to 15% over the final three subsequent quarters, to being approximately 40% during the next subsequent quarter, 35% the next two and the final 25% over the final three subsequent quarters. This shift in timing is tied to both demand and to when we expect our capacity under construction for large diameter bearings to come on line.

In addition to sales shipped from backlog, the company also generates approximately 25% to 40% of its quarterly sales on a book-and-ship basis, for both the order and the sale occur in the same quarter. Because of summer shutdowns at several of our customers, particularly in Europe, during the long end-of-summer holidays, our book-and-ship business is historically the slowest during the third quarter of each year.

As I mentioned in our last conference call, the seasonal slowdown and the approximately $600,000 of expenses related to wind energy expansion ramp-up and the relocation costs incurred in our sealing products business was expected to ended result in third quarter margins that are lower than our normal run rate.

In addition, we do not experience the benefit of some of the profitable large military business that we recorded in the prior third quarter. Therefore, we experienced our normal seasonal debt in the third quarter, and expect margins to recover in the fourth quarter which is seasonally a stronger quarter.

Finally, I would like to remind everyone that last year's fourth quarter effective tax rate of 32.7%, reflected $8,000 of reductions to the tax provision related to deductions recognized for financial reporting purposes after examinations by taxing authorities or after the expiration of applicable review periods.

Now, I would like to turn the call back over to Jim.

Jim O'Leary

Okay. Thanks, Ken. As I noted in our second quarter conference call, 2007 is an important investment year for Kaydon, as we lay the groundwork for future profitable growth. We've continued to accelerate investments in a major growth initiative, supporting our specialty bearings business, servicing the rapidly growing wind energy market.

Our capacity expansion is proceeding. We'll provide Kaydon with substantially increased manufacturing capacity to satisfy the rapidly growing wind turbine demand for advanced custom specialty bearing assemblies, up to 11 feet in diameter for new, large wind turbines, up to three megawatts of capacity. This is supplemented by the Avon acquisition which we believe gives us the capability to make the largest bearings in North America.

For 2007, Kaydon now expects total CapEx to approximate $61 million as compared to $26.3 million in 2006. Also, the relocation of our manufacturing capacity or portion of our manufacturing capacity in sealing products from a higher cost facility in Baltimore to a lower cost facility located in Mocksville, North Carolina is in progress.

This will result in a significantly more efficient manufacturing process and substantially higher profitability which will make us significantly more competitive in competing for new business going forward. We've incurred additional costs related to severance, recruitment, training, duplicative labor and operating expenses of $500,000 in the second quarter, a $1 million in the third and about a $1.5 million in the fourth which should bring that to a conclusion.

I'd like to talk a little about capital allocation initiatives. As noted last quarter, we are confident in the ability of our businesses to generate high levels of cash flow in excess of CapEx required for both growth and maintenance. This, and our strong balance sheet, will allow us to prudently return capital to our shareholders in form of both share repurchases and periodical increase dividends, while driving profitable organic growth.

Our fourth quarter dividend paid earlier this month was $0.15 per share and increased to 25% over the prior dividend. In addition, as Ken just noted, we repurchased approximately 295,000 shares for $15.4 million during the quarter, with year-to-date share repurchases totaling 455,000 shares for $22.6 million, reflecting our commitment to an ongoing robust program of returning capital to our shareholders.

I am very pleased with our acquisition of Avon Bearings Corporation which we announced this morning. The acquisition was a cash transaction valued at about $55 million and is expected to be accretive to Kaydon's earnings within the first full year of ownership.

Avon is expected to add approximately $30 million to Kaydon's fiscal 2008 sales. Headquartered in Ohio, Avon is a leading custom designer and manufacturer of high precision large diameter turntable bearings. Avon also remanufactures bearings, sells replacement bearings and is known globally for its focus on engineering support, product quality and proprietary manufacturing capacities.

Avon's going to be an excellent addition to our market leading bearings business and will add immediate capacity to our growing wind energy platform, while strengthening both existing customer relationships and adding others. This acquisition complements Kaydon's current and expanding manufacturing capabilities. Combined with the previously announced capital investment programs, it will enable Kaydon to become the largest manufacture of slewing ring bearings in North America.

In summary, we are pleased with our third quarter results, but more importantly we are extremely pleased with our progress on certain long-term initiatives as evidenced both by the Avon acquisition and our enhanced activity in the share repurchase program. The $211.4 million quarter end backlog positions us well for the remainder of 2007 and beyond, as we expand our internal capabilities to service segments enjoying strong secular growth.

This position combined with our strong balance sheet and tremendous financial flexibility provides us with the resources to drive internal growth while selectively evaluating external opportunities. Our strong financial position and free cash flow generation also allow us to prudently return capital to our shareholders in the form of both share repurchase and enhanced dividends.

Three final notes, first I'd like to welcome a new Director to Kaydon's Board, Bill Gerber. Bill joins us from Kelly Services a Fortune 500 Company, where he has been Chief Financial Officer for almost ten years. Bill has recently announced his plans to retire from Kelly Services, effective December 31, of this year to form a private investment fund and to focus on directorship assignments.

Prior to joining Kelly, Bill held several senior financial positions at The Limited. Bill is a CPA and has previously held financial positions at Arthur Andersen, Gould Incorporated, and Caterpillar. He also serves on the Board of Directors of AK Steel and we’re extremely excited to add Bill to our Board.

His broad experience makes him and excellent addition and his extensive financial experience at Kelly Services, during the period of domestic and international expansion will serve us particularly well. I am confident that he will play an important role and make meaningful contributions as an independent member of our Board and, most notably, its Audit Committee.

I would also like to thank each of our Kaydon employees for their efforts this quarter. Our most valued and valuable assets are our many employees throughout Kaydon and I would like to thank them for the great work done this quarter and positioning us for strong results in the near future and prospectively for their efforts ahead.

Finally we’re very pleased to have the Avon Bearings Corporation people join the Kaydon team. Avon’s strengthens areas we were already strong and provide us with many complementary relationships and capabilities going forward. We’re excited about welcoming the Avon management team and their devoted employees to the Kaydon family while we will expect it'll be an extremely exciting future.

That concludes the formal presentation of the conference call. Dalia, I would like to turn it back to you to moderate Q&A.

Question-and-Answer Session

Operator

Thank you so much. (Operator Instructions)

First question is coming from Joel Tiss with Lehman Brothers.

Joel Tiss - Lehman Brothers

Good morning. How are you doing?

James O'Leary

Hi, Joel. How are you?

Joel Tiss - Lehman Brothers

Alright. I wonder if you could give us a little bit more flavor of the change in the military business. I mean, you mentioned tough comps, but can you just give us a little bit of flavor of what the trends are, so that we can start to frame out 2008 as well.

James O'Leary

That is a very good question. I am glad you asked. The tough comps are largely due to extremely favorable absorption we had last year in the third quarter. One of our facilities in Sumter was up and running on all cylinders during what is usually a somewhat slower quarter.

As far as the trends in the business, I think it’s worth noting that our backlog in the military business is up today as compared to last year. But, some unexpected orders were booked and shipped particularly in the third quarter really benefit us with respect to absorption. But year-over-year our backlog is up in our military segment and replacement programs, particularly MRAP are coming on now.

So, we view this as more as an absorption and a timing issue, not a commentary on the health of the military business. Again, still strong, up year-over-year, and we feel very good about our position there.

Joel Tiss - Lehman Brothers

Okay. And as the follow-up question, I'm going to try to glue two together here .Can you explain a little bit more for us your changing your strategy for lower pricing to be able to get more volume? And related to that, can you also give us a sense if this growth in backlog is coming part and parcel with the lower pricing, like is the backlog going to be as profitable as the current business you have today, less or more that's what I'm trying to get at? Thank you.

James O'Leary

Well, there is absolutely nothing in this quarter that reflects a strategy of lower pricing. I think what we have said is in certain segments, and as we expand internationally, we may be willing to accept somewhat lower margin. But, that is not reflected in this quarter. There is no lower pricing. The only issue that I think stems from lower pricing per se, is a mix issue.

Split roller bearings in our Friction Control segment have inherently a lower margin, although, I will tell you they were up from low to mid teens last year to high almost 20% operating margin this year. But the bottom line is split roller bearings, which are experiencing unbelievable growth, particularly in the distant market segment which is China and India, has being growing faster than our traditional custom bearing business. And part of that has to do with the fact that wind energy isn't up and running.

So, it isn't a strategy of lower pricing that has nothing to do with this quarter. It's a question of mix timing and phenomenal growth in our split roller bearing business, which at a high teens and twenties, I think, a great many of our competitors would kill for margins like that.

Joel Tiss - Lehman Brothers

I would too. Thank you.

James O'Leary

You are welcome. Thank you.

Operator

And next with the question from Barrington, we have Walt Liptak.

Walt Liptak - Barrington Research

Hi, thanks. Good morning, Jim.

James O'Leary

Good morning, Walt. How are you?

Walt Liptak - Barrington Research

Good. I wonder if you could, you know, you called up three kind of product categories in friction, semiconductor, heavy equipment and defense. Of those three product categories, which ones were down the most year-over-year?

James O'Leary

I think the only one, I'd say, that is genuinely weak, is semiconductor. Military, again, I think is largely timing. Backlog is up year-over-year. And a lot of the impact that business can have on your absorption, which does drive margins to a significant extent, has to do with the timing of when a very robust program last year hit us and carried through to the second and a little bit into the third quarter this year, then tailed off, and when that will be replaced principally by programs such as MRAP.

In heavy equipments, it's not down materially. That's a business actually that we think will be benefited significantly by the Avon acquisition. There are many sizes of bearings, considerably higher than what we do, even in what we do in wind energy, where Avon is uniquely positioned. And if you look at the business of Manitowoc, Terex, a lot of heavy equipments producers who are shipping cranes all over the world with backlogs going out to 2009 and 2010, we think we're pretty well positioned in the Avon acquisition, positions us to do even better in the heavy equipment segment.

Walt Liptak - Barrington Research

Okay.

James O'Leary

I think semiconductor being the only truly weak segment.

Walt Liptak - Barrington Research

Okay. Could you quantify that head win in semiconductor, I mean, in millions of dollars?

James O'Leary

Let me come back to that, Walt. We will dig that up for you. It's not significant but we'll get that for you.

Walt Liptak - Barrington Research

Okay. And then the on the defense part, you said that the orders in the backlog were up year-over-year, so that's not slowing. But the MRAP, that's a huge spending program. Are there other orders that are not in backlog that you expect, what could we look at, you know, when would you start shipping for MRAP related product?

James O'Leary

Yeah. That will be next year. And they're absolutely our orders that probably would not be in inventory, although I can tell you that a PO has been cut. Our position on the program, even if a PO were cut for the entire thing, and if you think about our bearings business with respect to wind energy, because we only include things that are 18 months in and out, it might not necessarily reflect our full position there.

Walt Liptak - Barrington Research

Okay. And then the last one. You mentioned the vendor related issues. Can you quantify the kind of sales that you couldn't ship this quarter because of the vendor issues?

James O'Leary

It's less than 10. It is 5ish or so, probably around that. I guess that's the other edge of we're in a great position as far as being a component supplier to something that has taken off like nobody envisioned a few years ago, even a few quarters ago with respect to wind energy. There were supply chain shortages all throughout the supply chain.

But, unfortunately that does impact us a little bit on certain of the forgings and certain of the things we outsource. And our supply chain guys, our forging guys are just like some of our customers scrambling all over the world to offset that. That's largely a timing item. It should come back next quarter.

Walt Liptak - Barrington Research

Okay. I understood the second part of what you said, but you said less than 10. Did you mean less than $10 million?

James O'Leary

Less than $10 million of sales, yeah.

Walt Liptak - Barrington Research

So, there might have been $5 million to $10 million in sales that got pushed out from this quarter to just the fourth quarter of '08?

James O'Leary

Yes.

Walt Liptak - Barrington Research

Okay. Alright. Thank you.

James O'Leary

Okay. You are welcome.

Operator

And next up from Robert .W. Baird, we have Peter Lisnic.

Peter Lisnic - Robert .W. Baird

Good morning, gentlemen.

James O'Leary

Good morning, Pete.

Ken Crawford

Good morning.

Peter Lisnic - Robert .W. Baird

Jim, I may have missed this, but did you give the wind order number for the quarter?

James O'Leary

I did not. And I will turn you over to Mr. Crawford.

Ken Crawford

Yes. $18 million in the quarter, this quarter and last year third quarter it was $5 million.

Peter Lisnic - Robert .W. Baird

Okay. 18 million.

James O'Leary

Yes.

Peter Lisnic - Robert .W. Baird

All right. So that puts your orders non-winded up like 6.5%, if I am doing the math right.

Ken Crawford

On a consolidated basis, within the segment though were wind is, it was up more than that.

Peter Lisnic - Robert .W. Baird

Okay. Yeah, that’s fine.

James O'Leary

It always 20%...

Peter Lisnic - Robert .W. Baird

Okay. I guess, I know on the heavy equipment side in friction, I was some what surprised that it was down. Was last year such a strong year, or was that where, or was that the end-market where a lot of this pushed out sales may have occurred?

James O'Leary

Remember, heavy equipment is not among our biggest segments. So when we say down, I doubt it’s more than $5 million. I think as largely they do with timing and largely they do with where we are positioned. I mean, some other businesses that are doing extremely well in a particularly claim, we just -- we're not well positioned, who have not done until the acquisition of Avon. You know where we are positioned well, (inaudible) orders were expected maybe not to have done as well with some of the consolidation going on there. We are still doing well. It’s just a little bit off relative to last year. I don’t know if we necessarily have enough business to say or into Avon, I don’t know if we necessarily had enough business to say. We’ve represented any weaker trend there. I think it’s a timing of shift.

Peter Lisnic - Robert .W. Baird

Okay. All right. And then, can you give us some sense of what Avon’s end-market exposure is like in comparison to yours? And what I specifically wonder is, how much wind exposure they have now?

James O'Leary

Sure. Next year, we think its going to be about $30 million of total sales. About a third of that, you should think would be wind. Longer term, we think it's about $40 million, and lets say that’s a run rate that annuities in near two, three plus years. And if it’s about $40 million, half is wind with a split between two to three customers and with the balance been heavy equipment. That would be representative of where they are today on a $40 million run-rate. But that doesn’t reflect to some other things. We think we can do with it, particularly, with Avon and the position is carried in the repair and refurbishing market.

Just the issue here is thus is Avon was small family-business, run extremely well by three, very good guys, who we hope will stay with us for a while. And that we expect at least two of them will, the Walsh Brothers. They have been taking orders as a comics has been a traditional family business where, you know, a little bit resource constrained. But they have invested well. They have invested in a great reputation the repair/refurbishing market worldwide. But they’re in a position really where they’ve been taking orders for the last few years. You know, we expect to have much more robust marketing effort around that business, particularly, repair/refurbishment. And we are expecting to be globally oriented. Because as we mentioned before with the crane business and I read the other data non-metallic has backlog going out to 2009, large cranes on a China and India.

That’s where we expect a lot of our efforts to be focused in the long-term, as we change Avon really from being in a position to wait for the orders to come in to, you know, one of the Walsh’s who is responsible for that. So maybe we are -- had been working on our behalf’s on out and kind of, travel the globe, helping that business come to us more proactively, that’s not in the $40 million. So, we think it’s considerable outside there over the longer term.

Peter Lisnic - Robert .W. Baird

Okay. And then, the financial question would be upside or kind of what the profitability profile the business is now?

James O'Leary

Yeah. It will be consistent with our exciting business, Pete.

Peter Lisnic - Robert .W. Baird

Is that consistent right now?

James O'Leary

It won’t be right away, largely because of the products accounting and the other reason is that immediately accretive on an EPS basis based on what we’re entering at. And I think, you know, we’re entering at a price-to-sales and if you impose our margins over the longer term. The only reason that’s accretive to earnings immediately is products accounting, where you mark-up the backlog, and take away some of the immediate benefits on a cash-flow accretion basis. It’s pretty much immediately accretive out of the box.

Peter Lisnic - Robert .W. Baird

Okay. Can you put a box around the accretion?

James O'Leary

No, since we don't give forecast. And I don’t know if that would be something we do probably add a penny or so to next year.

Peter Lisnic - Robert .W. Baird

All right. Well, at least I can try. And, then last question, on Avon, wind customer exposure, is there overlap or are they brand new customers for you?

James O'Leary

Both.

Peter Lisnic - Robert .W. Baird

Okay. Thank you.

James O'Leary

You are welcome.

Operator

And our next question now comes from KeyBanc Capital Markets, Steve Barger.

Steve Barger - KeyBanc Capital Markets.

Hi, good morning.

James O'Leary

Hey Steve, how are you?

Steve Barger - KeyBanc Capital Markets

I am doing alright. Back to Avon a little bit. Previously, you thought you could get to a $100 million run rate for wind by the end of FY'08, this should accelerate the process, but how are you thinking about that. How much business you can support now towards the end of '08?

Ken Crawford

Well, that will be about, we would be on a run rate of above 115.

Steve Barger - KeyBanc Capital Markets

Okay. So it’s fair to say that your capacity expansion x-Avon is on track or are you seeing any puts or takes there?

Ken Crawford

It is on track, with what we talked about, externally we still expect we’re shipping in December. You know we are into a little bit of our own internal contingencies. We would have liked of being shipping a bit sooner but nothing ever works out perfectly. I think, again, the dark side of business being so darn good in that sector in particular is, you know, we have seen some delays in forging and components that are important for us. So I can't tell you that, you know, you won’t have another couple of week of slippage, but right know we don't expect it to do. We expect to be shipping in December, and we should be at that $100 million plus run rate, now, so 110 to 115 plus with the addition of Avon by next year. And I think if you took 40 -- you know 50% that being wind by the end of two years’ plus out, the 125 is more or like 145 to 150.

Steve Barger - KeyBanc Capital Markets

Excellent. And for customer negotiations in the wind market, I think you were talking to a couple of people that you weren't currently selling to, could you update us on where you are in any negotiations?

James O'Leary

We are highly confident by the end of this year, we are going to have two of the major top tier wind energy people, and again at some point, we have to address the fact that it will become a meaningful enough number we will have some discloser issues. But today, we're still bound by confidentiality. We will be with two of the major global guys. We'll be with -- what we think are a healthy representation of the Commerce and the Commerce would be that next level of people who are not quite in the and I will just try all the names, investors [Commissure] GE, Suzlon kind of notch below that volume, but we'll be very well positioned with them to service their needs. And the reason why we kind of have to stratify and take a very strategic approach to how we allocate our capacity is, we want the top guys, the bigger volume guys who we already have commitments on to be extremely happy if not ecstatic with our performance because that's our lifeblood. We also want to be with a few growing guys Commerce that we can add some value to and also keep them equally happy. So unfortunately, we can't be all things to everybody, but we can do the best we can for the limited number of forces that are willing to select us.

Steve Barger - KeyBanc Capital Markets

Sure, okay. And last one, I am sure it's a competitive market but is there margin expansion opportunities for that second tier of wind customers over what you get with your primary and large volume customers?

James O'Leary

Longer-term, but that would be galloping into some of the contractual stuff that probably wouldn't be appropriate on this call.

Steve Barger - KeyBanc Capital Markets

Okay. Very good, thanks.

James O'Leary

You are welcome, Steve. Thank you.

Operator

(Operator Instructions) Next, we go to Ian Fleischer with FBR Capital Markets.

Ian Fleischer - FBR Capital Markets

Hi, good morning.

James O'Leary

Hi and how are you?

Ian Fleischer - FBR Capital Markets

Good. Can you provide some color to quantify the assets step-ups to go to the P&L in the fourth quarter?

James O'Leary

I probably can't, I hope -- it's largely associated with the existing backlog. The asset step-ups will probably take -- I don't want to speak of it, it's somewhere between 90 days, it will be into our first quarter before you know, look it's allocated to fixed assets, look it's allocated to goodwill.

I think in our next call, you will be a little bit more conversant in that because that requires to workup appraisers that really couldn't start until today. Most of the step-up immediately goes against backlog, that's why you have these diversions between cash accretion and EPS accretion.

Ian Fleischer - FBR Capital Markets

Okay, and just turning to your seal segment, can you provide some color on the timing and impact on margins of the seals facility relocation?

James O'Leary

Sometime by the middle of next year, that'll be wholly completed. We'll have most of our sealing products relocated and it will be a 100 plus basis points of improvement.

Ian Fleischer - FBR Capital Markets

Okay. And turning to your capital allocation, in the absence of acquisitions, how should we think about a share buyback, are you in a position where you would buy back a large of piece of stock like 5 million shares, something like that. Am I thinking about that right in the absence of acquisitions?

James O'Leary

I think over time that would be right if you had a absolute drought of acquisitions for a long period. We are not going to go out and do a big Dutch auction. I think we will evaluate opportunistically things in the market. When I walked away from the Bloomberg a little while ago, it was a better deal today than it was.

Friday, I'd expect we would be more aggressive on debts over the next several months, but in the absence of acquisitions, nobody asked me was about the acquisition pipeline and I would have told we have no comment on it. If Avon hadn't closed this weekend, I would still have had no comment on that. I don't think it's really appropriate to talk about an acquisition pipeline until deals get done. Well, Avon came along, it was opportunistic, it fits us perfectly, it fits I think is one of the three tiers of our acquisition program.

We'd like to add bolt-ons to our flagship bearings business, if they can be again accretive within 12 months, add value, add to our capabilities, do all the things that Avon does. And the second type of acquisition we'd like to do, I think that we can bolt into some of our standalone segments that need critical mass and product breadth, like ceiling products and velocity controls, and we are looking for a second leg. That will come as the market presents itself, we have to be opportunistic, but before I start thinking about big share repurchase programs in the absence of acquisitions, I’m very pleasantly surprised we are talking about an acquisition today. And I am hoping to be very pleasantly surprised over the next couple of quarters.

I think what you should be looking to us, and again I think this quarter demonstrates what we’ve been talking about for several months is, in the absence of acquisitions we'll devote a substantial amount of free cash flow and eat into the cash balance if deals don't present themselves as rapidly as we would like. I think over the longer term you should expect at least 50% of free cash flow to be devoted to share repurchase and I don’t think on an annual basis we will look at a dividend, as a way of keeping us on a budget and providing some return to our shareholders who value our dividend through thick and thin.

So, I think on all three points, share repurchase stepped up meaningfully this quarter and I think you’ve heard an articulated commitment from management to continue doing that. Last quarter, but evidence by payment this quarter, we are going to continue to look at our dividend and as evidenced by Avon, we are being a little bit more broad on the types of acquisitions, this is absolutely not a turnaround, but this is something it's a little bit more operationally intensive, what we think we are going to add a lot of value to, is operations beyond our standalone criteria historically. So, I think on all three fronts of capital allocation, coupled with the growth aspect of Avon this quarter kind of embodies that, it’s a little bit of messy quarter in terms of the ins and outs and the margin issue, which we flagged for your last quarter.

But, I think when you stand back and look at record orders, record backlog, strengthen two securely strong segments, particularly wind and military. I think when you look through this static there is a lot more goods than bad, and I think more importantly for our long-term shareholders, grow our biggest business, position in the sector that, I have to yet to hear anything in fact today there is a great article on Suzlon in the [fpage] I'd encourage you guys to take a look at, we have positioned ourselves well.

And we’re in a position with our liquidity and our debt capacity, where I am not saying we’re going to be all things to all people, but for at least to foreseeable future, we can be a lot of things to many people.

Ian Fleischer - FBR Capital Markets

That's helpful. One final quick one…

James O'Leary

I thought I would also like 10 minutes be a fast little.

Ian Fleischer - FBR Capital Markets

Yeah. On your Friction and Motion Control segment, when I think about the operating margin, there is a lot of moving pieces there. Is it 29% that you did in 2006, should I think about that as your high water point or can you do better than that in '08?

James O'Leary

I think for the foreseeable future, I'm at the high water point. There was unbelievable absorption before the capacity really got going, no investment cost. That's a tough one to replicate. I think once we're in another quarter or so when and we see how wind and how the other segments of the business. I think we got to keep an eye on as we go into '08, and we're just starting our budget process now in a global economy that shows no sign of slowing down.

What's the impact of raw material is going be and what's the impact of further supply chain issues. Now right now, we think what hit us this quarter is discreet but, I listen to a lot of the same calls that you guys do as far as industrial peers and the one thing I'm kind of holding my breath on and I don't if you will move to where a little bit further into next year is the impact of raw material pricing in a robust global economy on domestic manufacturers. Let’s say to be visited on probably on our next conference call

Ian Fleischer - FBR Capital Markets

Thanks, I appreciate it.

James O'Leary

You are welcome. Operator, other than to say thank you very much and thank you all for listening to us. And thank you Kaydon employees and welcome to Avon employees, I think we are pretty much done.

Operator

That does conclude today's conference call. Thank you for your participation and have a good day.

James O'Leary

Bye, bye.

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