Kaydon Q3 2007 Earnings Call Transcript

Oct.29.07 | About: Kaydon Corporation (KDN)

Kaydon Corporation (NYSE: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 - BarringtonResearch

Peter Lisnic - Robert .W. Baird

Steve Barger - KeyBanc Capital Markets

Ian Fleischer - FBR Capital Markets

Operator

Welcome to the Kaydon Corporation Third Quarter 2007 EarningsCall. Before the conference begins, the company would like to make the legaldisclaimer that certain information in this formal discussion and that may beincluded in the question-and-answer session is forward-looking within themeaning of the Federal Securities Laws.

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

The company does not undertake and expressly disclaims anyobligation to update or alter its forward-looking statements whether as aresult of new information future events, or otherwise except as required in theapplicable law.

During this conference call, Kaydon spokespersons willreference certain GAAP measures. To assist in understanding such non-GAAPmeasures as well as to comply with SEC requirements, the company has includedin their press release, reconciliations of non-GAAP measures to their mostdirectly comparable GAAP measures.

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

James O'Leary

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

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

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

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

During the quarter, we had record third quarter order entryof $117.3 million up almost 26% year-over-year, leaving us with a record quarterend backlog of $211 million going into the fourth quarter. Reflecting continuedstrength across most of our businesses. Assuming this trend continues, thisposition does extremely well for the remainder of 2007 and into 2008. Duringthe 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 ofrelocation and ramp up costs equaled $24.5 million or 22.8% of sales ascompared to $24.9 million or 25% of sales in last year's third quarter. Lastyear's quarter benefited from about $800,000 in one time operating incomebenefits, while this year suffered some one time determents mostly associatedwith the ramp up in Mocksville and our wind energy expansion.

Now to provide you with an apples-to-apples comparison, I'llbriefly discuss some non-GAAP information. On a non-GAAP basis backing the $1million 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% thisyear as compared to 24.1% last year. Remember, last year was an extremelyrobust performance in what's usually a slow quarter.

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

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

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

Gross profit for the third quarter was $43.3 million or40.3% of sales as compared to $40.9 million or 41% of sales during last year’sthird quarter. Comparisons, again affected by the pretax items just discussed.In particular gross margin was impacted by about $600,000 of costs to ramp upour wind energy business and to relocate certain sealing product businesslines. During the fourth quarter we anticipate that these items will negativelyimpact gross margin by about $1 million and this is discussed in prior quartersand that should complete most of these charges for investments and relocation.

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

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

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

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

Operating income in the Friction Control Product segmentdecreased to $15 million, impacted by the ramp up costs and the absence of$500000 insurance refund recorded in the third quarter of last year. Ascompared to the current period the third quarter of 2006, benefited fromextremely strong performance in our military business, obviously it wasnegatively impacted by what should be a timing issue and with some shipmentsswept 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 delayedoutside vendor deliveries.

Operating margins equaled 25% as compared to 29.3% at theend of last year. The lower operating margin driven by a higher proportionategrowth of lower margin but still high margin split roller bearings and lowersales in our military business, which was exceptionally high in last year'sthird quarter.

The wind energy ramp up and the absence of the $500000refund last year also creates some static in making clean comparisons. Again,applying the same logic to the items just reviewed resulted in anapples-to-apples non-GAAP comparison of about 26% this year, compared to about28.4% last year.

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

Now moving to the Velocity Control segment, third quartersales of velocity control products increased $1.9 million to $16.5 million or13% over the prior third quarter, with strong sales by both our German and U.S.operations.

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

In Sealing Products, sealing products sales increase $1.7million to $12 million or 16.4% higher than the third quarter of 2006.Operating income in the Sealing Products segments increased 32% to $2.2million, with operating margin rising to 18.2% from 16% last year. Thisimprovement was driven by leverage from higher sales and extremely strongmarket conditions in both our Hydro-Carbon Processing and Aerospace segments. Ordersduring 2007 totaled $9.8 million as compared to $12.4 million in the prior yearand 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 favorof multiple shorter-term orders. For example, in the prior quarter a customerplaced a single large long-term order, which is now being replaced by smallershort-term orders impacting clean quarter-to-quarter comparisons.

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

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

The improvement in absolute and marginal profitability camelargely from the benefits of a client consolidation in our liquid filtrationbusiness and the absence of consolidation costs associated with it that wereincurred in the third quarter of last year.

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

Ken Crawford

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

Interest expense during both the third quarters of 2007 and2006 was $2.4 million with the only long-term debt outstanding being our $200million of convertible debt. The effective tax rate for the third quarter 2007was 36.1%, which is expected to be the rate for all of 2007.

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

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

EBITDA is a non-GAAP liquidity measure that we consider animportant indicator of financial health. During the quarter, EBITDA was $29.3million as compared to EBITDA during the third quarter a year ago of $29.1million. 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 September30th of 2006 of a $111.5 million.

Free cash flow is another non-GAAP liquidity measure that weconsider to be an important indicator of the company's health, as it reflectsour ability to generate cash in excess of both growth and maintenance capitalinvestment. 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 ourqualified pension plans.

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

Capital expenditures were $9 million higher during thisyear's third quarter, as we continued our investment in capacity expansionsannounced in prior quarters.

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

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

Cash and cash equivalents plus short-term investmentstotaled $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 $200million, equal to 30.2% of total capitalization.

During the third quarter of 2007, the company paid dividendsof $3.4 million. That dividend payment was at a rate of $0.12 per share, andthe 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 295,800shares of company common stock for $15.4 million and invested a total of $16.8million in net capital expenditures.

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

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

That said, we are obviously very pleased with our thirdquarter 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 tobacklog of a $155 million at the end of last year's third quarter.

As discussed in previous conference calls, it's worth areminder 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 beingapproximately 50% during the next subsequent quarter, approximately 35% to 40%during the next two subsequent quarters and 10% to 15% over the final threesubsequent quarters, to being approximately 40% during the next subsequentquarter, 35% the next two and the final 25% over the final three subsequentquarters. This shift in timing is tied to both demand and to when we expect ourcapacity under construction for large diameter bearings to come on line.

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

As I mentioned in our last conference call, the seasonalslowdown and the approximately $600,000 of expenses related to wind energyexpansion ramp-up and the relocation costs incurred in our sealing productsbusiness was expected to ended result in third quarter margins that are lowerthan our normal run rate.

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

Finally, I would like to remind everyone that last year'sfourth quarter effective tax rate of 32.7%, reflected $8,000 of reductions tothe tax provision related to deductions recognized for financial reportingpurposes after examinations by taxing authorities or after the expiration ofapplicable 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 quarterconference call, 2007 is an important investment year for Kaydon, as we lay thegroundwork for future profitable growth. We've continued to accelerateinvestments in a major growth initiative, supporting our specialty bearingsbusiness, servicing the rapidly growing wind energy market.

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

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

This will result in a significantly more efficientmanufacturing process and substantially higher profitability which will make ussignificantly 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 shouldbring that to a conclusion.

I'd like to talk a little about capital allocationinitiatives. As noted last quarter, we are confident in the ability of ourbusinesses to generate high levels of cash flow in excess of CapEx required forboth growth and maintenance. This, and our strong balance sheet, will allow usto prudently return capital to our shareholders in form of both sharerepurchases and periodical increase dividends, while driving profitable organicgrowth.

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

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

Avon is expected to addapproximately $30 million to Kaydon's fiscal 2008 sales. Headquartered in Ohio, Avon is a leadingcustom designer and manufacturer of high precision large diameter turntablebearings. Avon also remanufactures bearings,sells replacement bearings and is known globally for its focus on engineeringsupport, product quality and proprietary manufacturing capacities.

Avon's going to be an excellent addition to our marketleading bearings business and will add immediate capacity to our growing windenergy platform, while strengthening both existing customer relationships andadding others. This acquisition complements Kaydon's current and expandingmanufacturing capabilities. Combined with the previously announced capitalinvestment programs, it will enable Kaydon to become the largest manufacture ofslewing 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 certainlong-term initiatives as evidenced both by the Avonacquisition and our enhanced activity in the share repurchase program. The$211.4 million quarter end backlog positions us well for the remainder of 2007and beyond, as we expand our internal capabilities to service segments enjoyingstrong secular growth.

This position combined with our strong balance sheet andtremendous financial flexibility provides us with the resources to driveinternal growth while selectively evaluating external opportunities. Our strongfinancial position and free cash flow generation also allow us to prudentlyreturn capital to our shareholders in the form of both share repurchase andenhanced dividends.

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

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

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

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

Finally we’re very pleased to have the Avon Bearings Corporationpeople join the Kaydon team. Avon’sstrengthens areas we were already strong and provide us with many complementaryrelationships and capabilities going forward. We’re excited about welcoming theAvon management team and their devotedemployees to the Kaydon family while we will expect it'll be an extremelyexciting future.

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

Question-and-AnswerSession

Operator

Thank you so much. (Operator Instructions)

First question is coming from Joel Tiss with Lehman Brothers.

Joel Tiss - LehmanBrothers

Good morning. How are you doing?

James O'Leary

Hi, Joel. How are you?

Joel Tiss - LehmanBrothers

Alright. I wonder if you could give us a little bit moreflavor of the change in the military business. I mean, you mentioned toughcomps, 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 toughcomps are largely due to extremely favorable absorption we had last year in thethird quarter. One of our facilities in Sumterwas 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 worthnoting that our backlog in the military business is up today as compared tolast year. But, some unexpected orders were booked and shipped particularly inthe third quarter really benefit us with respect to absorption. Butyear-over-year our backlog is up in our military segment and replacementprograms, particularly MRAP are coming on now.

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

Joel Tiss - LehmanBrothers

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

James O'Leary

Well, there is absolutely nothing in this quarter thatreflects a strategy of lower pricing. I think what we have said is in certainsegments, and as we expand internationally, we may be willing to acceptsomewhat lower margin. But, that is not reflected in this quarter. There is nolower pricing. The only issue that I think stems from lower pricing per se, isa mix issue.

Splitroller 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 highalmost 20% operating margin this year. But the bottom line is split rollerbearings, which are experiencing unbelievable growth, particularly in thedistant market segment which is Chinaand India,has being growing faster than our traditional custom bearing business. And partof 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 todo with this quarter. It's a question of mix timing and phenomenal growth inour 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 - LehmanBrothers

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 threekind of product categories in friction, semiconductor, heavy equipment anddefense. Of those three product categories, which ones were down the mostyear-over-year?

James O'Leary

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

In heavy equipments, it's not down materially. That's abusiness 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 thebusiness of Manitowoc, Terex, a lot of heavy equipments producers who areshipping cranes all over the world with backlogs going out to 2009 and 2010, wethink we're pretty well positioned in the Avon acquisition, positions us to doeven 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, Imean, 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 theorders in the backlog were up year-over-year, so that's not slowing. But theMRAP, that's a huge spending program. Are there other orders that are not inbacklog that you expect, what could we look at, you know, when would you startshipping for MRAP related product?

James O'Leary

Yeah. That will be next year. And they're absolutely ourorders 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 aboutour bearings business with respect to wind energy, because we only includethings that are 18 months in and out, it might not necessarily reflect our fullposition there.

Walt Liptak - Barrington Research

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

James O'Leary

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

But, unfortunately that does impact us a little bit oncertain of the forgings and certain of the things we outsource. And our supplychain guys, our forging guys are just like some of our customers scrambling allover the world to offset that. That's largely a timing item. It should comeback next quarter.

Walt Liptak - Barrington Research

Okay. I understood the second part of what you said, but yousaid 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 salesthat 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 ordernumber 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 yearthird 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 windis, 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 outsales 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 theydo with timing and largely they do with where we are positioned. I mean, some otherbusinesses that are doing extremely well in a particularly claim, we just -- we'renot 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 havedone as well with some of the consolidation going on there. We are still doingwell. It’s just a little bit off relative to last year. I don’t know if wenecessarily have enough business to say or into Avon,I don’t know if we necessarily had enough business to say. We’ve represented anyweaker 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 ofwhat Avon’s end-market exposure is like incomparison to yours? And what I specifically wonder is, how much wind exposurethey have now?

James O'Leary

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

Just the issue here is thus is Avonwas small family-business, run extremely well by three, very good guys, who wehope 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 atraditional family business where, you know, a little bit resource constrained.But they have invested well. They have invested in a great reputation therepair/refurbishing market worldwide. But they’re in a position really wherethey’ve been taking orders for the last few years. You know, we expect to have muchmore robust marketing effort around that business, particularly, repair/refurbishment.And we are expecting to be globally oriented. Because as we mentioned beforewith the crane business and I read the other data non-metallic has backloggoing out to 2009, large cranes on a Chinaand India.

That’s where we expect a lot of our efforts to be focused inthe long-term, as we change Avon really from being in a position to wait forthe orders to come in to, you know, one of the Walsh’s who is responsible forthat. 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 notin the $40 million. So, we think it’s considerable outside there over the longerterm.

Peter Lisnic - Robert.W. Baird

Okay. And then, the financialquestion would be upside or kind of what the profitability profile the businessis now?

James O'Leary

Yeah. It will beconsistent 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 accountingand the other reason is that immediately accretive on an EPS basis based onwhat we’re entering at. And I think, you know, we’re entering at a price-to-salesand if you impose our margins over the longer term. The only reason that’s accretiveto earnings immediately is products accounting, where you mark-up the backlog, andtake away some of the immediate benefits on a cash-flow accretion basis. It’spretty much immediately accretive out of the box.

Peter Lisnic - Robert.W. Baird

Okay. Can you put abox around the accretion?

James O'Leary

No, since we don't give forecast. And I don’t know if thatwould 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 thereoverlap 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 CapitalMarkets, 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 Avona little bit. Previously, you thought you could get to a $100 million run ratefor wind by the end of FY'08, this should accelerate the process, but how areyou thinking about that. How much business you can support now towards the endof '08?

Ken Crawford

Well, that will be about, we would be on a run rate of above115.

Steve Barger -KeyBanc Capital Markets

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

Ken Crawford

It is on track, with what we talked about, externally westill expect we’re shipping in December. You know we are into a little bit of ourown internal contingencies. We would have liked of being shipping a bit soonerbut nothing ever works out perfectly. Ithink, again, the dark side of business being so darn good in that sector inparticular is, you know, we have seen some delays in forging and componentsthat are important for us. So I can't tell you that, you know, you won’t haveanother couple of week of slippage, but right know we don't expect it to do. Weexpect to be shipping in December, and we should be at that $100 million plusrun rate, now, so 110 to 115 plus with the addition of Avonby 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 ismore 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 currentlyselling 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 aregoing to have two of the major top tier wind energy people, and again at somepoint, we have to address the fact that it will become a meaningful enoughnumber we will have some discloser issues. But today, we're still bound byconfidentiality. 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 Commercewould be that next level of people who are not quite in the and I will just tryall the names, investors [Commissure] GE, Suzlon kind of notch below thatvolume, but we'll be very well positioned with them to service their needs. Andthe reason why we kind of have to stratify and take a very strategic approachto how we allocate our capacity is, we want the top guys, the bigger volumeguys who we already have commitments on to be extremely happy if not ecstaticwith our performance because that's our lifeblood. We also want to be with afew growing guys Commerce that we can add some value to and also keep themequally happy. So unfortunately, we can't be all things to everybody, but wecan do the best we can for the limited number of forces that are willing toselect us.

Steve Barger -KeyBanc Capital Markets

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

James O'Leary

Longer-term, but that would be galloping into some of thecontractual 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 withFBR Capital Markets.

Ian Fleischer - FBRCapital Markets

Hi, good morning.

James O'Leary

Hi and how are you?

Ian Fleischer - FBRCapital Markets

Good. Can you provide some color to quantify the assetsstep-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 theexisting backlog. The asset step-ups will probably take -- I don't want tospeak of it, it's somewhere between 90 days, it will be into our first quarterbefore you know, look it's allocated to fixed assets, look it's allocated togoodwill.

I think in our next call, you will be a little bit moreconversant in that because that requires to workup appraisers that reallycouldn't start until today. Most of the step-up immediately goes againstbacklog, that's why you have these diversions between cash accretion and EPSaccretion.

Ian Fleischer - FBRCapital Markets

Okay, and just turning to your seal segment, can you providesome color on the timing and impact on margins of the seals facilityrelocation?

James O'Leary

Sometime by the middle of next year, that'll be whollycompleted. We'll have most of our sealing products relocated and it will be a100 plus basis points of improvement.

Ian Fleischer - FBRCapital Markets

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

James O'Leary

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

Friday, I'd expect we would be more aggressive on debts overthe next several months, but in the absence of acquisitions, nobody asked mewas about the acquisition pipeline and I would have told we have no comment onit. If Avon hadn't closed this weekend, Iwould still have had no comment on that. I don't think it's really appropriateto talk about an acquisition pipeline until deals get done. Well, Avon came along, it was opportunistic, it fits usperfectly, 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 ourcapabilities, do all the things that Avondoes. And the second type of acquisition we'd like to do, I think that we canbolt into some of our standalone segments that need critical mass and productbreadth, like ceiling products and velocity controls, and we are looking for asecond leg. That will come as the market presents itself, we have to beopportunistic, but before I start thinking about big share repurchase programsin the absence of acquisitions, I’m very pleasantly surprised we are talkingabout an acquisition today. And I am hoping to be very pleasantly surprisedover the next couple of quarters.

I think what you should be looking to us, and again I thinkthis 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 cashflow and eat into the cash balance if deals don't present themselves as rapidlyas 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 anannual basis we will look at a dividend, as a way of keeping us on a budget andproviding some return to our shareholders who value our dividend through thickand thin.

So, I think on all three points, share repurchase stepped upmeaningfully this quarter and I think you’ve heard an articulated commitmentfrom management to continue doing that. Last quarter, but evidence by paymentthis quarter, we are going to continue to look at our dividend and as evidencedby 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 bitmore operationally intensive, what we think we are going to add a lot of valueto, is operations beyond our standalone criteria historically. So, I think onall three fronts of capital allocation, coupled with the growth aspect of Avon this quarter kind of embodies that, it’s a littlebit of messy quarter in terms of the ins and outs and the margin issue, whichwe 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 andmilitary. I think when you look through this static there is a lot more goodsthan bad, and I think more importantly for our long-term shareholders, grow ourbiggest business, position in the sector that, I have to yet to hear anythingin fact today there is a great article on Suzlon in the [fpage] I'd encourageyou guys to take a look at, we have positioned ourselves well.

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

Ian Fleischer - FBRCapital 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 - FBRCapital Markets

Yeah. On your Friction and Motion Control segment, when Ithink about the operating margin, there is a lot of moving pieces there. Is it29% that you did in 2006, should I think about that as your high water point orcan you do better than that in '08?

James O'Leary

I think for the foreseeable future, I'm at the high waterpoint. 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 inanother quarter or so when and we see how wind and how the other segments ofthe business. I think we got to keep an eye on as we go into '08, and we'rejust starting our budget process now in a global economy that shows no sign ofslowing down.

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

Ian Fleischer - FBRCapital Markets

Thanks, I appreciate it.

James O'Leary

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

Operator

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

James O'Leary

Bye, bye.

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