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Twin Disc (NASDAQ:TWIN)

F2Q08 Earnings Call

January 22, 2008 2:00 pm ET

Executives

Michael Batten - Chairman, President and Chief Executive Officer

Christopher Eperjesy - Vice President of Finance, Chief Financial Officer and Treasurer.

Analysts

Shawn Bailey – THM Holdings

TJ Carter – Outpoint Capital

Shawn Fing – Northpoint Capital

Joe Norton – Singular Research

Wi Lee – Whitebox Advisors

Jeffrey Matthews – Ram Partners

Scott Archer – Oaks and Palms LLC

Operator

Welcome to the Twin Disc’s 2008 second quarter financial results conference call. (Operator Instructions) I would now like to turn the call over to Andrew Berger, please go ahead, sir.

Andrew Berger

Thanks, Joshua. On behalf of the management of Twin Disc, we are extremely pleased that you have taken the time to participate in our call, and thank you for joining us to discuss the company’s fiscal 2008 second quarter financial results and business outlook.

Before I introduce management, I would like to remind everyone that certain statements made during the course of this conference call, especially those that state management’s intentions, hopes, beliefs, expectations or predictions for the future are forward-looking statements. It is important to remember that the company’s actual results could differ materially from those projected in such forward-looking statements.

Additional information concerning factors that could actual results to differ materially from those in the forward-looking statements is contained in the company’s annual report on Form 10-K, copies of which may be obtained by contacting either the company or the SEC.

By now you should have received a copy of the news release which was issued this morning before the market opened. If you have not received a copy, please call Eileen Collins at 262-638-4000 and she will send a copy to you.

Hosting the call today are Michael Batten, Twin Disc Chairman, President and Chief Executive Officer; and Christopher Eperjesy, the company’s Vice President of Finance, Chief Financial Officer and Treasurer.

At this time, I will turn the call over to Michael Batten.

Michael Batten

Thank you, Andy. Good afternoon everyone and welcome to our second quarter conference call. I will start with a brief statement and then both Chris Eperjesy and I will be available to answer questions.

Sales for the quarter improved 10.3% to $81.9 million from $74.2 million in the same period last year. Sales for the first six months rose 11.1% to $155.5 million from $140 million reported in the first half of 2007. Favorable foreign currency translation represented $5.1 million of the $7.7 million increase in sales for the first quarter, while the same factor represented $7.5 million of the $15.5 million increase in sales for the first half.

The remainder of the increase in sales for both the quarter and six months was mainly the result of strong sales of marine and propulsion products to the commercial marine and navy markets, as well as continued demand for land-based transmission products for airport rescue and firefighting and military markets.

Gross margins in the fiscal 2008 quarter increased 2.0 percentage points from 32.9% to 30.9% compared to the same quarter a year ago. Year-to-date gross margins declined modestly from 31.9% to 31.6% compared to similar periods last year.

Second quarter profitability was negatively impacted by reduced sales of higher margin products, higher sales of lower margin products and higher material costs, partially offset by higher pricing, expanded outsourcing and lower pension expense.

The fiscal 2007 second quarter and first six months included the impact of unfavorable purchase accounting adjustments to inventory in the amount of $489,000 and $1.223 million before tax, respectively. Further, second quarter results were impacted by higher marketing, engineering and administrative expenses which as a percentage of sales rose to 21.2% from 19.6% for the same three months a year ago.

The higher ME&A expenses were due to approximately a $1 million increase in stock-based compensation, primarily the result of the increase in the price of the company’s stock. The impact of foreign currency translations from overseas operations, and expenditures related to a new global ERP system. Year-to-date, ME&A expenses rose more modestly to 20.6% from 20.1% a year ago.

As a result, net earnings for the fiscal 2008 second quarter declined to $4.2 million, or $0.37 per diluted share compared to $5.7 million or $0.48 per diluted share for the equivalent three months a year ago.

Year-to-date earnings of $9.3 million were equal to the same period last year, although earnings per diluted share improved to $0.81 compared to $0.79 as a result of the repurchase of shares in the first fiscal quarter.

For the second three months, EBITDA totaled $9.6 million down from $12 million reported in the same period a year ago. For the first six months, EBITDA was $20.4 million compared to $20.1 million for the first half last year.

As indicated in our press release, while demand for many of our products remains at a historical high, we have begun to experience a shift in our sales mix. Most notably, we have begun to see a slowdown in demand for our oil and gas transmissions. In addition, our industrial markets continue to experience a cyclical softening. However, despite a slowdown in these sectors, our commercial and segments of the marine market and our airport rescue and firefighting and military markets continue to grow.

Looking ahead, we continue to expect that fiscal 2008 will be another good year for Twin Disc. Our backlog of orders to be shipped over the next six months stands at $121 million, up 8% from $112 million reported a year ago, and up 10% from $110 million at the fiscal 2007 year end.

That concludes the prepared remarks for today. Chris and I are prepared to take questions at this point. Josh, I will hand it back to you to start the Q&A period.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Shawn Bailey – THM Holdings.

Shawn Bailey – THM Holdings

I know you don’t generally give forward-looking guidance, but the stock is having its worst day in its history, down 55 points, 6%. How do you feel about ’08?

Michael Batten

Actually, I am encouraged by the prospects for the second half of the year. As I have indicated in our general outlook in the press release and my remarks right now, we are seeing, obviously as reported, some slowing down of activity in oil and gas and in industrial. But our volume did increase despite that year over year and quarter over quarter; we see that continuing for the balance of the year.

Our marine markets, represented by propulsion products and marine transmissions going into commercial applications, and our transmissions going into military and [ARF] applications are still going and we are comfortable about our outlook for the balance of the year.

Shawn Bailey – THM Holdings

How much do you have left on the repurchase? Is it accretive at this level?

Michael Batten

I am sorry, I didn’t understand the question.

Shawn Bailey – THM Holdings

How many shares are left on your repurchase authorization?

Michael Batten

140,000 shares are available under the repurchase authorization that we have.

Shawn Bailey – THM Holdings

Do you expect to go to the board to increase that?

Michael Batten

At this point in time we will work with the 140,000 and to the extent that we need to go to the board or want to, we have that capability.

Operator

Your next question comes from TJ Carter – Outpoint Capital.

TJ Carter – Outpoint Capital

Can you give more color on the oil and gas transmission weakness that you are seeing? Is that any particular region or is that across the board?

Michael Batten

The oil and gas market during the second quarter did see some softening and it was largely here in North America that we saw it, both Canada and in West Texas. Some rescheduling or in some cases some cancellations of transmissions. We do see that activity does continue; not everybody was involved in that activity and we have customers that are hanging on to their schedules and we are planning to ship more in the second half.

The activity seems to have moved to Russia and to China. We are active in selling transmissions directly. So in that regard, we do supply our good North American customers but we are also involved in supplying and have shipments going out this quarter to a new Chinese customer that we have acquired for application on their Chinese-built rigs. We are also supporting the population that has gone into Russia and see opportunities in that market area as they are prepared to spend a lot of money to develop their oil and gas markets as well.

Yes, we hit a bump in the road in the second quarter, but that does mean that we still have orders and backlog for oil and gas transmissions going forward.

TJ Carter – Outpoint Capital

You had outsourcing initiatives to help improve the margin. Could you give a bit more color on progress there and how much more you could do?

Michael Batten

Regarding our global outsourcing effort, we are actually doing two things. One is – we say global, but part of it is resourcing both here in the U.S. and in Europe where we can get a total cost that is lower. But we are also putting a heavy emphasis on our expansion into India and China for sourcing activities.

We have two offices in China. We have one office in India staffed with people who are engineers, manufacturing engineers, quality and purchasing for the people as well as we are staffing up in the design engineering as well in the office in India.

The activity is more in the third inning, so to speak, in a baseball game. We have got our feet on the ground, we are actively sourcing parts from these locations and we have plenty of room to grow in this area to improve our margins and/or offset; I mean granted, we did see some material increases occurring but our outsourcing is working on that.

TJ Carter – Outpoint Capital

My final question. Could you update us on your acquisition pipeline and how you view acquisitions versus share buyback, given where your stock is now?

Michael Batten

Good question. The acquisition pipeline has candidates in it at various stages of the process. Not that I am being definitive or predicting when we might do something, but we are actively in discussions and something could materialize or not materialize; you know how that works. We are active on the acquisition front.

As it relates to stock buyback, at this point in time if we were to have an acquisition come our way I think I would prefer to put the cash into an acquisition because of the long-term growth in revenues and earnings possibilities that an acquisition would offer. But that doesn’t mean that along the way we might not have some repurchase activity going forward. It isn’t going to be an either/or situation. I think what we are going to see is possibly some of both.

Operator

Your next question comes from Shawn Fing – Northpoint Capital.

Shawn Fing – Northpoint Capital

Could you comment on the luxury built mega yacht market? Can you tell us what the composition for the backlog is as far as what percentage is from oil and gas and what percentage is from boats, et cetera.

Michael Batten

The mega yacht market continues to do very well for us. Activity continues to be strong. The yards are optimistic about their outlook for the balance of this year and into next, so there is a lot of activity and we are very encouraged by it.

With respect to our backlog, we don’t break out the numbers by market, but the composition of backlog in our transmission business has been healthy. It is a combination of both oil and gas and military and [ARF] transmissions. The marine backlog, both for mega yachts and commercial applications, that would be offshore oil both here domestically as well as overseas, is very strong.

Operator

Your next question comes from Joe Norton – Singular Research.

Joe Norton – Singular Research

Thank you, good morning. I am trying to get a sense of why the disconnect or why are we seeing continued strength or such good strength on the marine side and such a slowdown on the industrial and the oil and gas. Is that just a matter of where you are geographically? What do you think is accounting for that difference?

Michael Batten

In part, they are entirely different marketplaces. I am sure you understand in just phrasing the question. The industrial markets, by and large, that we serve are domestic though we do have global exposure with our Italian company as well. They are facing some of the slowdown that the U.S. economy has been experiencing along with some of the other markets – housing and automotive.

The marine market that we serve is unique. Most of the press that one would read about the pleasure craft market here in the U.S. deals with the lower horsepower segment of boating and that, of course, is depressed and reflects some of the same issues of high fuel prices and interest rates, at least up until today, in that marketplace for buyers without a great deal of discretionary income.

Now when you talk about the mega yacht market, you are talking a completely different story in terms of geography and disposable income availability. These yachts are multi-million dollar yachts and a recession here in the U.S. or even elsewhere is not going to play as much a factor, if any at all, in the purchase of these yachts.

The other thing, in terms of geography that is interesting, is that many of these yachts are being purchased by people coming out of the non-industrialized countries that are making huge amounts of money from whatever they are doing. For example, there is a huge influx of wealthy Russians that are in effect taking a great deal of the product that is being built in Italy or along the Mediterranean yacht market. That kind of wealth isolation and new money coming from Russia, China, in addition to the Middle East and others, continues to drive the yachting market.

Joe Norton – Singular Research

Historically, is it normal that you would see the slowdown in the industrial business first and then marine is just lagging? Or do you really just not think that there is any correlation between these two?

Michael Batten

The markets that respond to interest rates such as the industrial and the lower horsepower pleasure craft do tend to be more leading cycle product market segments than some of our other product lines and marketplaces. So historically yes, the industrial markets have tended to be a leading indicator.

However, the factors that continue to support us are, in some cases, exogenous to the normal rule. That is, the wealth factor that we just talked about in the high end boat segment, that doesn’t necessarily mean that it has to follow any cycle at all.

The military markets have been very good for us and that outlook continues to be healthy from our perspective. And then of course the oil and gas, while we hit a bump in the road in the second quarter, as was mentioned previously, the longer term outlook for oil and gas is unlike what we have seen before and I have been through the boom and the bust of the 70’s and 80’s and even though there is, as I say, a bump in the road, the underlying demand cycle for oil and gas, given the demand from China and India, the long-term demand suggests to us at Twin Disc that this cycle is going to have some cycling but that it isn’t going to be a boom and bust kind of cycling. It is going to be more of a moderation and then a continued acceleration as these countries are industrializing and using more and more oil as the U.S., Europe and Japan are using.

Joe Norton – Singular Research

On the oil and gas business, you made a comment about the geographic moving of that business. Are you well-penetrated in those markets, or are you saying that is an opportunity for you to go where that business is moving?

Michael Batten

We are already in China. We are getting more active in Russia. We understand that we have to be there. We are doing two things. One is that our good customers are taking our product over into these markets. Those need to be supported in terms of repair, if need be, or additional trucks or fracturing rigs for demand expansion in those marketplaces.

We also see the opportunity, the Chinese for example have come to us, we have gone to them, to develop their own fracturing rig business. They see while they can produce the trucks, they don’t have the pumps and the transmissions and the engines or the horsepower required to do the fraccing. So they come to us and others to provide that part of the truck, but they will develop and assemble the undercarriage and the cab and so on for the basic truck. We are actively developing multiple players in both markets.

Joe Norton – Singular Research

Finally, I don’t think I saw this in the press release but usually in your Q you tell us domestic versus international sales. Can you just give me those figures?

Michael Batten

We would disclose it at the time of the Q so we haven’t disclosed it yet. I don’t know if there is a significant shift off of what you would have seen in the 10-K from last year.

Joe Norton – Singular Research

Anecdotally, as a growth rate, are you seeing a slowing in growth rates in both of these regions? Just trying to get a sense of how the international markets are doing relative to the U.S.

Michael Batten

The international markets are relatively doing better off of their own bases than the U.S. The reason for that being is that much of our industrial business is U.S.-based and that is softening. The oil and gas has largely been a U.S. sold activity. The units may be going offshore, but it is our customers who are doing that. We would record it as a U.S. sale in that activity.

So those are the two areas that have seen some softening. The marketplaces, the products and markets that are growing, are generally the mega yacht, the commercial marine, and the military and [ARF] markets. The military is a combined offshore and domestic business, as is the [ARF]. We are penetrating Europe very well, as well as the Far East with our [ARF] transmissions.

Operator

Your next question comes from Wi Lee – Whitebox Advisors.

Wi Lee – Whitebox Advisors

On the slowdown in demand for oil and gas transmission in the U.S., we are seeing oil right now at a historic high and there is certainly a little bit of a disconnect there. Are you saying there is an oversupply of rigs out there right now?

Michael Batten

What is happening is the North America – just to start with a little bit of a broader view – the North American market is seeing a bump in the road in that the market has reached the point where costs of equipment have accelerated and there is more competition occurring at the price levels, the rental levels of these rigs. So the margin for the investor to invest and get a return has been narrowing. That is the factor that is being dealt with here.

However, the markets in China and Russia continue to grow and some of the North American frac companies have been moving equipment, unutilized equipment, over into these overseas markets to take advantage of the opportunities in those territories. We still see that some of our domestic customers are still ordering and buying oil and gas. It is not like demand has dried up 100%. But we have seen moderation occurring in the form of either, in some cases cancellations; in other cases, pushing out the order board.

Overall, the market continues to exist both on a domestic and an overseas basis.

Wi Lee – Whitebox Advisors

What is the mix right now between U.S. and overseas revenue?

Michael Batten

That we just discussed, and it is not too different. We don’t publish it until the Q and that won’t be for at least a couple more weeks. In the 10-K the mix was roughly, a little less than 60/40 so a little less than 60% domestic and a little more than 40% international. I wouldn’t expect that to change significantly.

Wi Lee – Whitebox Advisors

With the U.S. dollar going still down against major currencies right now, would that be a net benefit for you going forward?

Michael Batten

In terms of translation, it is a negative. In terms of stimulus for U.S. product overseas it is a positive. We have one foot in each canoe, so to speak. We are conflicted there. But on a net basis in the financial statements are positive for a weaker dollar.

Operator

Your next question comes from Joe Norton – Singular Research.

Joe Norton – Singular Research

On the growth margin, is the 31% the barometer we are looking at now? Is there anything you can do to get that back to prior-year levels in the second half?

Michael Batten

We are working real hard on that, Joe, and that is an area that has our attention as well, to find ways to do that.

Now, we anticipate shipping more higher margin products in the second half, but we are also experiencing issues of material cost increases. Steel prices have gone up, surcharges are at very high levels relative to where they were even just a few months or a year ago.

We are doing everything we can to expand our outsourcing efforts to offset what is happening there and have a net addition to margin. We are also accelerating pricing activity to make sure that we are covering the increases that we are experiencing. We are working very hard on that, to get those margins back up.

Operator

Your next question comes from Jeffrey Matthews – Ram Partners.

Jeffrey Matthews – Ram Partners

I want to make sure I understand the nature of the order cancellations in the U.S. The type of company that is canceling an order is what type of company? They are canceling because costs have run up too high or they are cutting their budgets in response to cost increases? I am not quite sure I understand the link.

Michael Batten

We are talking about oil and gas and we are talking about specifically the fracturing rig market. What we do is we sell our transmissions to fracturing rig builders and they in turn sell them to operating people who rent or lease their vehicles to oil companies to do the fracturing. There is a day rate associated with that activity. That leasing day rate activity.

What is happening in the industry, the feedback that we are getting is that part of the slowdown is due to the fact that the cost of the rigs themselves, along with the other costs associated with doing the fracturing have risen over the last several quarters to squeeze the margins of those people who are renting out the vehicles for fracturing. Given that situation, they are saying we are not going to invest in new vehicles because we are not getting our rates of return. That is the issue.

There is another factor and that is with more vehicles out there, there is more competition on the day rate. Those are the things that are happening in the marketplace.

Operator

Your next question comes from Scott Archer – Oaks and Palms LLC.

Scott Archer – Oaks and Palms LLC

On your website in your description of the company it makes the statement that the company has become a major player, if not a market leader, in each of its market segments and has added new technologies.

Given the businesses that you are in, I thought it was surprising; I am relatively new to the story. I am surprised that your overall revenue base wouldn’t be a lot bigger, given you are international and all the big markets that you serve. Can you comment on t hat?

Michael Batten

Sure, Scott. I think that in the markets we are serving, which is largely the marine-based markets behind diesel engines and the transmission markets, again behind diesel engines but in vehicles that are high horsepower and specialty vehicles; and then industrial products which are largely clutches and disconnect products for off-highway, heavy duty, industrial applications, while the names like transmissions and marines might suggest much larger markets, we have a fairly significant share of market in each of the activities that we are in.

We aren’t in huge global markets, at least as we define them. We are looking at our served segment. We participate in marine, for example, in pleasure craft, in commercial and military. We have excellent shares of market in all three of those areas of the marine market.

In the transmission market, we are the Pluto of the universe because so many transmissions are built around the world, but our segment is 300 hp up to 3,000 hp. That reduces the size of the market available to us and we have very good representation in that off-highway, 300 plus horsepower market.

Then in the industrial markets, again, it is how you cut the cookie, but the industrial products that we sell are largely heavy duty disconnect products and we have a major share of market here in the U.S. and an excellent share overseas.

I don’t know if that answers your question, but that is how we look at it.

Scott Archer – Oaks and Palms LLC

Yes it does. Then as you define, clarify your segments a little bit more, do you have an overall market size target in terms of dollars? If you add all those markets that you feel are really yours together, how big that market is and what your penetration to-date is?

Michael Batten

We tend to look for markets that may not be billions of dollars, but rather more in the low hundreds of millions of dollars, because we think that our potential competition are the Allistons or the ZF’s of the world or people that have got much more critical mass than we do.

So while we tend to be the standard of the market in marine and industrial in the segments that we serve, we also recognize that for us to succeed, we have to be able to be more nimble and design flexible to compete in the market areas that we serve. That is our approach, to be more niche-oriented or smaller market oriented than larger market oriented.

Scott Archer – Oaks and Palms LLC

But you’ve never really sat down and added all of those up to say, here is the size of a potential market in terms of dollars that we are looking at?

Michael Batten

We look at that, yes we do.

Scott Archer – Oaks and Palms LLC

But you don’t disclose the number?

Michael Batten

That’s correct.

Scott Archer – Oaks and Palms LLC

Is there anything new on the competitive scene, either domestically or overseas?

Michael Batten

What is new on the competitive scene –

Scott Archer – Oaks and Palms LLC

Or should I say any new threats in terms of market share competition?

Michael Batten

There is one thing that is occurring in the marine area which is presently in the lower horsepower segment; they are called pods. One is being introduced by Volvo and the other is being introduced by Mercury. Volvo is called the IPS system and the Mercury is a Zeus system. They are starting out in the sub-500 segment of the market. We are watching that closely and looking at what our competitive response will be there.

Scott Archer – Oaks and Palms LLC

Thank you.

Operator

At this time, gentlemen, there are no further questions. Please continue with any closing remarks.

Michael Batten

We would like to thank you all for joining us today. We appreciate your interest in Twin Disc and we are eager to continue the job that we are doing and look forward to discussing our results at the end of next quarter. Thank you.

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