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Executives

Mike Olsen - Executive Vice President and Chief Financial Officer

Mike Sutherlin - President and Chief Executive Officer

Analysts

Ann Duignan - JPMorgan

Henry Kirn - UBS

Vlad Bystricky - Barclays Capital

Seth Weber - RBC Capital Markets

Schon Williams - BB&T Capital Markets

Charles Brady - BMO Capital Markets

Robert Wertheimer - Vertical Research Partners

Robert McCarthy - Robert W. Baird

Joy Global Inc. (JOY) F1Q2012 Earnings Conference Call May 31, 2012 11:00 AM ET

Operator

Welcome to the Joy Global Second Quarter 2012 Earnings Release Conference Call. Today's conference is being recorded.

Now at this time, I would like to turn the call over to Mr. Mike Olsen, Executive Vice President and Chief Financial Officer. Please go ahead, sir.

Mike Olsen

Thank you, Jake. Good morning and welcome, everyone. Thank for participating in today's conference call and for your continued interest in our company. Joining me on the call this morning is Mike Sutherlin, President and Chief Executive Officer, and Sean Major, Executive Vice President, General Counsel and Secretary.

This morning, I will begin with some brief comments, which expand upon our press release and which provide some additional background on the results for the second quarter of our 2012 fiscal year. Mike Sutherlin will then provide an overview of our operations and our market outlook.

After Mike's comments, we will conduct a question-and-answer session. During the session, we ask you to limit yourself to one question and one follow-up question before going back to the queue. This will allow us to accommodate as many questioners as possible.

During the call today, we will be making forward-looking statements. These statements should be considered along with the various risk factors detailed in our press release and other SEC filings. We encourage you to read and become familiar with these risk factors. We may also be referring to a number of non-GAAP measures, which we believe are important to understanding our business. For reconciliation of non-GAAP metrics to GAAP, as well as for other investor information, we refer you to our website at www.joyglobal.com.

Now, let's spend a few moments reviewing the second quarter results. As a reminder, operating results include performance of our legacy surface and underground mining equipment business units combined with the results of the LeTourneau and IMM acquisition. Both acquisitions contributed favorably for the results for the quarter. Additionally, there is considerably less noise than the acquisition of IMM during the current quarter compared to our first quarter. During the second quarter, we increased our ownership of IMM to approximately 99%, and expect to settle the remaining outstanding shares during our third quarter. We also anticipate that Hong Kong Exchange will approve our request to de-list IMM during our third quarter.

During the second quarter, IMM recorded bookings of $98 million, while recognizing $87 million of revenue and $21 million of operating profit before excess purchase accounting charges. The excess purchase accounting charges related to the amortization of the write-up of acquired inventory and totaled $17 million in the current quarter. We also expect to record an additional and final $5 million of excess purchase accounting charges related to IMM during our third quarter based on our current acquisition valuation estimate. Despite the economic slowdown in China, the IMM second quarter results were substantially in line with our expectation.

With regard to LeTourneau, their performance rebounded nicely from the product quality issue and the divested business distractions experienced in our first quarter. LeTourneau recorded bookings of $128 million during the second quarter while recognizing $133 million of revenue and $26 million of operating profits before excess purchase accounting charges. These charges were related also to the write-up of acquired inventory and backlog and totaled $6 million. During our third quarter, we expect to record an additional and final $2 million of excess purchase accounting amortization related to LeTourneau acquisition.

Turning to the legacy surface and underground mining equipment businesses, strong financial results were tempered by moderation in our bookings for the quarter. Bookings of $1 billion in the current quarter were down 34% from a year ago and below the $1.3 billion recorded last quarter. The decrease in new order bookings was comprised of 20% decrease for surface mining equipment and a 38% decrease for underground mining equipment. The 20% decrease in surface equipment bookings in the current quarter was primarily made up of a 42% decrease in original equipment orders as after-market bookings remained flat.

Original equipment orders continue to be strong for copper customers in South America and for coal and iron ore customers in Australia, but were more than offset by decreases in original equipment orders in North America, South Africa and Russia. Surface after-market orders in the current quarter increased in South America and Australia, but were offset by a decrease in after-market bookings in China, India, Russia and South Africa.

The 38% decrease in the second quarter in underground mining equipment bookings was attributable to a 62% decline in original equipment orders and a 12% decrease in after-market bookings. The original equipment bookings declined compared to the second quarter of last year is attributable to weak U.S. coal market and high comparables due to a major longwall system order received in Australia in 2011.

The decrease in after-market orders was due to the reduced underground coal produce production in the United States, which is the result of a mild winter and low natural gas pricing and a larger impact due to the unusually high level of service orders received in Australia in the second quarter last year which were associated with the longwall system orders previously mentioned and which were not repeated in the current quarter.

The backlog of the legacy businesses was $2.8 billion at the end of the second quarter, compared to $3.3 billion at the end of the first quarter. In addition to lower bookings recorded during the quarter, we have removed $119 million in underground equipment backlog scheduled for U.S. market as we believe there is a reasonable risk of deferral or cancellation of these orders.

It is important to note that these orders have not been cancelled, but we believe the reduction in backlog to be prudent given current market conditions. Backlog attributable to the IMM and LeTourneau businesses remained at $300 million, the same level as of the end of the first quarter. Despite the soft bookings recorded in the second quarter, the company expects the book-to-bill ratio for the 2012 fiscal year to exceed 1.0 for the legacy businesses.

Net sales for the legacy businesses increased by 24% in the first quarter, with surface mining equipment shipments up 27%, while underground mining machinery revenue increased 23%. OE shipments of surface equipment increased 57% while the underground mining equipment, original equipment increased 43%. After-market shipments of surface mining equipment increased 12% and shipments of after-market underground mining equipment increased 10% compared to the second quarter last year, primarily driven by strong part sales in the current quarter.

Legacy business operating profit of $311 million in the current quarter exceeded last year by $75 million with both, the surface and underground mining equipment units having return on sale percentages in excess of 24% and an overall incremental profitability percentage of 29%. The increase in operating profit was primarily due to the increase in net sales. Income from continuing operations in the current quarter were $2.04 per fully diluted share compared to $1.52 per share last year. The table included in the press release and on our website provides the summary of a various items which impacted the current quarter.

The most significant item, which was new in the current quarter was the $14.8 million or $0.14 per share decrease in net income due to the excess purchase accounting amortization associated with IMM previously mentioned. The second quarter also included a $14 million increase in net interest expense compared to last year due to the financing of the LeTourneau and IMM acquisitions.

The effective tax rate in the current quarter was 31.1% compared to 29.8%, last year. The increase in the effective tax rate is attributable to a non-recurring tax planning benefit net of discrete items realized in the second quarter last year. The full year effective tax rate for this year is expected to be between 30% and 31.5%.

On a final note, the revised guidance included in the press release includes all of the actual results reported through the second quarter and assumes full year fully diluted weighted average outstanding shares of $108 million.

Now, let me turn the discussion over to Mike Sutherlin

Mike Sutherlin

Thanks, Mike, and let me add my welcome to those on the call. This quarter extends the pattern of uncertainty in our end-markets overshadowing the exceptional performance that we continue to deliver.

It was a record quarter for revenues margins and earnings. Our legacy Joy underground and P&H surface businesses delivered exceptional performance by using cycle time reduction to accelerate machine deliveries and high operating leverage translated into record levels of profitability.

Both LeTourneau and IMM made strong contributions with their combined margins over 21%, excluding excess first year purchase accounting charges. We are proud of these results but I think the strong base performance prepares us to better deal with the uncertainty in our end markets. The extended duration of the uncertainty weighs on the market and both data and messages can be inconsistent and confusing. I will provide our views of our end markets and our customer activities and then how we expect that to impact our business.

The U.S. coal market is at the epicenter of the market corrections, so let's address that first. A winter that did not come reduced power generation in the U.S. by about 5.5% below last year, which is beyond the decline experienced in 2009. About 65 million tons of annual coal production was taken offline in the first quarter and the accelerating trend reached over 100 million of annual production by April. However coal utilities have increased over 200 million tons resulting in 40 million to 50 million tons of stockpiles deficiency that will become headwinds in the late coal production recovery.

We estimate that up to 40 million tons of the overall reduction is a result of accelerated compliance with regulations that will require closure of the oldest, unscrubbed coal-fire units. The remaining reduction is driven by combinations of the significant decline in electricity demand and the loss to dispatch to natural gas as its price remains in the mid-$2 per 1 million BTU range.

Shale gas drilling programs require $4 to $5 gas to return the cost to capital and coal should begin to regain lost tons as gas prices move above $3. However, natural gas storage is at all time highs and this must be worked through before drilling for dry gas increases. This is reflected in the forward strip for natural gas which gets to $4 but not until 2014. In the meantime, upside in the U.S. coal market will come from exports and met coal. Upside will also come from increased electricity demands since most of the unutilized excess generating capacity is in coal-fired units.

We expect after-market demand from the U.S. underground coal to be reduced by about 12% in line with production reductions. After market orders in the U.S. underground could drop more than that for the next quarter or so as inventories held at mine site are depleted. Orders for underground original equipment are expected to be depressed until the market stabilizes, which may not be until next year. Then we expect to return to normal replacement cycle for underground equipment, plus upgrades as new technology improves productivity and reduces cost.

Although U.S. coal will become a structurally smaller market, it will continue to provide a strong base from which to leverage our investments into the international markets. International coal markets are dominated by demand from China and India and imports for both are running well ahead of last year on an annualized basis. Electricity demand in China has slowed from 12% last year to 7%. Although demand for thermal coal has slowed as well, current pricing provides an advantage to import it over domestic coal and imports are increasing, while domestic stockpiles are reaching historically high levels.

The import tonnage for April is estimated at 21 million tons close to a record set last November and up on a run rate basis from the 58 million tons imported in the first quarter. With most of China's new production coming from the western provinces increased rail transportation costs will keep seaborne coal demand strong and growing.

Although, China's economy continues to show signs of slowing, the central government has started to take steps to simulate growth by cutting interest rates and lowering the banks' required loan reserve ratio and further steps in both areas are expected. The nation will also start, and I quote here, “a series of key infrastructure projects that are vital to the overall economy and can facilitate growth” and therefore, we expect to China to bottom in the near term and return to higher growth.

Seaborne coal demand is growing at even faster rate in India which continues to struggle to increase its domestic coal production. India's largest power producers increased in imports had a 33% rate over last year. Although just over half of India's power is generated from coal today almost 85% of the 76 gigawatts of planned capacity increases will be coal-fired.

Global steel production continues at a 6% growth rate over last year and steel production in China has recovered and is running 20% above its low last November. Although steel production is expected to remain flat for the rest of this year it should provide support for both met coal and iron ore. China steel mills had de-stocked met coal and iron ore and both raw materials are anecdotally at about a month of supply on hand. Restocking should provide additional support to the steelmaking raw materials. In addition, steelmaking and other met coal importing countries excluding China is up 12% from a low point late last year.

As a result, we believe met coal is in the deficit. For example one of our customers has indicated that met coal demand is running ahead of its annual guidance and another brought a met coal mine back into production after being idle for only a few weeks. Production challenges and project delays will keep copper supply in deficit this year. For example one of the major Chilean miners saw its production down 10% in the first quarter and this is in line with the general trend of producers routinely missing production targets by 5% to 6%.

We entered this year expecting our order rate to moderate from the exceptionally strong growth in orders last year. If you remember, our regional equipment orders last year were up over 70% and our total orders were up over 40% and this was because last year had a catch-up factor as customers rushed to get equipment booked for projects that were put on hold in 2008 and restarted in 2010. However, with strong momentum from projects underway and a stagnating global economy, our customers no longer have a great sense of urgency to bring new projects forward.

Although some of the largest diversified mining companies have indicated they are slowing CapEx and reevaluating their large greenfield projects, that is not a broad trend. In fact, we continue to see new projects added to our prospect list, but at a slower rate. Customers are focusing their resources on completing the projects actively underway and on brownfield expansions that have lower risk and a shorter time horizon. We expect this condition to continue until our customers see demand improvement that was justify acceleration of projects.

We see the commodity markets of copper, iron ore and met coal to be solid with risk to the upside. Seaborne thermal coal had supply surplus that is considered near-term and longer-term view still justifies capacity expansion. The U.S. coal market should stabilize later this year but has to reduce excess coal stockpiles and deplete high natural gas storage levels before it can expect a meaningful improvement. We expect this to translate into slowing order rates and flattening revenues for the next few quarters with this comparison made to our first half run rate rather than per second quarter.

Despite this expectation we are preparing for a wide range of possible outcomes. In addition to trimming and focusing our costs, the efforts we made over the past several years to streamline our processes and reduce cycle times will allow us to adapt to market conditions faster and more effectively. We are also taking steps to increase the alignment of our surface and underground businesses to better leverage common processes and overlapping cost structures through an initiative we call One Joy Global. These are all directed at making us a more efficient business and they will allow us to prepare for slowing market growth, while maintaining key investments in selected R&D programs and in the rollout of our service excellence program.

We are adjusting this year's guidance for two factors. The combination of backlog reduction and the impact of reduced mine volumes on aftermarket orders for U.S. underground coal market will begin to be felt in our second half. Despite earlier expectations, the slowing in the international markets will no longer enable them to fully offset the reductions in the U.S. coal market. That reduces our net revenue expectations for 2012 by about $100 million. This $100 million reduction in revenues will reduce earnings per share for 2012 by $0.18 after some cost mitigation.

In addition prior guidance excluded the excess per share purchase accounting charges for IMM. These have now been determined to be $0.17 per share for 2012 of which $0.14 was reported in our second quarter. The combination of these two factors reduces 2012 revenues by $100 million and our top end earnings per share by $0.35. Therefore our update guidance for 2012 is for revenues to be between $5.5 billion and $5.7 billion and for earnings per fully diluted share to be between $7.15 and $7.45.

So, with that, I will turn the call back over to Jake for questions.

Question-And-Answer Session

Operator

[Operator Instructions]. We do ask that you limit yourself to one question and one follow-up question to allow maximum participation in Q&A. You may re-enter the queue after that. [Operator Instructions].

We will take the first question from of Ann Duignan with JPMorgan.

Ann Duignan - JPMorgan

Mike, could you talk a little bit about what would have to happen, in what scenario could you envision revenues being down year-over-year in fiscal 2013 and in what scenario would revenues be up? What has to happen between now and the end of the year in your mind?

Mike Sutherlin

Based upon the experience of 2009, we have got a pretty good feel for what to expect in U.S. coal markets. The downside and upside all translates into the international markets and we have customers that are growing a little bit more cautious. They feel they have enough stuff in the pipeline and they have time to ramp up and therefore are waiting to see a little bit more certainty out of the global economy.

So downside would occur if we continue to see slowing in the international markets and upside would come from that as well. Right now, though, we continue to see signs and evidence that there is some strength in the international markets.

Like I said, steel production is up and we will go through a restocking phase for met coal and that will create some upside demand there. Iron ore imports look really good. China production costs are exceptionally high and iron ore, in fact, despite some really high levels of iron ore imports, the stockpiles at the ports in China are starting to come down.

So, we believe that there is more risk in the international markets to be upside than there for the downside. I think the variable here is the timing. Is the upside going to be later or is it going to be near in and that's the unknown. But certainly, we believe that the international markets have more upside than downside at this point.

Ann Duignan - JPMorgan

So in your view we could perhaps have a quarter or two of bit of a vacuum based on whatever the macro data signals send us?

Mike Sutherlin

Yes, the international markets tend to be lumpier with original equipment demand just on the timing of projects. We saw that in our second quarter order rate. It wasn't projects that were put on hold or indefinite deferral. It was just permitting delays and other kind of things, infrastructure build delays and they were just a little bit behind on the projects.

As those projects are still moving forward, we expect those to become orders in the second half for example. So we are not seeing this put-on-hold kind of mentality among customers. We have seen that with some of the major diversified mining houses but those are mega greenfield projects.

If you look at the economics those didn't have overly compelling economics and slowing those things down is different than what we see in most of our other markets. Most of our customers are continuing with their projects. We don't see any evidence of slowing and some of the stuff we are hearing from the major diversified is a little bit to appease shareholders that they want some returns rather than spending all the money on this mega greenfield projects.

Some of that is rhetoric to deal with the increased cost pressures coming from Australia from taxes in different forms and fashions. So at first that looks more like an exception to the norm than the trend in the international markets.

Ann Duignan - JPMorgan

Okay, and just as a quick follow-up, could you talk a little bit about the One Joy program that you mentioned. Could you give us a little bit more color on what you are doing there and what kind of savings we might anticipate?

Mike Sutherlin

That program is to recognize the fact that running two business units that operate in the same region with the same customer base you incur some duplication of costs and it results in inefficient service and support levels to our customers. So we are realigning our focus there to get more focused on delivering better service, more consistent levels of service to our customers.

It will translate in some cost savings. Right now in the early stages we are focusing more on performance improvement, better service support, better parts availability, those kinds of things. Through time we expect the savings in costs to occur by a more leverage than the growth as we see revenues pick up.

We have got a cost structure that will support a higher revenue base at existing cost structure levels. So, we are not expecting a lot of costs to come out here in the near term, but we are expecting more leverage to the upside as a result of what we are doing.

Ann Duignan - JPMorgan

Okay, and was that undertaken as a direct result of the new competition between capping (inaudible) and then I will get back in line.

Mike Sutherlin

This has been a program that we have been working on in concept in developing the foundation for some time. It goes back a couple of years. We have been waiting a little bit. We have wanted to get further through our operational excellence program before we took this on and we have done that.

We have sort of transitioned more recently from operational excellence which is focused more on our factories to service excellence which is focused on our service centers. That was a natural progression for us and as we get into the service center excellence program, the alignment with customers and their minds operating in regions around the world becomes a focal point.

So this is sort of the normal evolution of a program we have had underway. It's just now getting at the part where we are ready and prepared to take on some of the alignment issues in the regions.

Ann Duignan - JPMorgan

Okay, thanks very much, Mike. I will get back in line.

Mike Sutherlin

Yes, thanks, Ann.

Operator

We will now move to the next question, one moment. We will now take a question from Henry Kirn with UBS.

Henry Kirn - UBS

Good morning, guys.

Mike Sutherlin

Good morning, Henry.

Henry Kirn - UBS

Could you talk a little bit more about the orders in Surface? How much of order weakness there was PRB?

Mike Sutherlin

Well, PRB for our surface business is, from an original equipment standpoint, PRB is not a big market. It's typically like a shovel a year or something like that on average. So, it hasn't been a big market for the original equipment. It does provide some reasonable market for us in the aftermarket support of the equipment. We have been working out there.

Then we did see decline in that aftermarket business in the PRB in our second quarter. At the same time, a number of those customers see the current conditions as opportune to do some major outages for draglines which are major rebuild and repair programs and the same for shovels. So, we are talking to them about better use of their time while demand is not strong to get machines ready for the future.

So, there are some pluses and minuses here in the near term. We have seen a little bit of a decline in the aftermarket out of PRB but we think that that will pick up a little bit as we get into these major machine outages and rebuilds.

Henry Kirn - UBS

That’s helpful and with the backlog, do you see any deferral or cancellation risks, orders in the backlog outside of underground U.S. coal?

Mike Sutherlin

Let me finish on one thing on the PRB. Our surface revenue from U.S. coal is only about 3%. So, you've got to factor, when I give you those comparisons, that in and that's mostly PRB.

So the cancellation risk. We looked that that our backlog and we looked at what's in backlog for Central Appalachia underground where we see probably the highest risk. We have had discussions with customers. We all know in the press that some customers are struggling more than others to get their financial balance sheets in order but in the meantime we think there is going to be some deferral of equipment deliveries going into Central Appalachia.

Some of that is stuff that we had in backlog. The uncertainty around all that was just that we felt it was better to recognize that now when we did a risk assessment. It's not necessarily equipment for any one customer. We just looked at customers' applications, thermal versus met coal, a lot of different factors and we believe that that represents what we believe is the risk we have for the U.S. underground.

Other markets we tested, we just don't have the risk in the other markets. We continue to deliver machines. We don't see any pushback and we have pretty tight contracts, particularly in the international markets. The issue with the Central App, we have long-term relationships with customers, so we try to work with them and in some cases they may or may not have the wherewithal to take the deliveries that they have on schedule.

So, we are trying to be rationale and prudent about that, but we are also trying to get ahead of the curve with this issue rather than letting it slip up and create headwinds later in the year.

Henry Kirn - UBS

That’s very helpful. Thanks a lot.

Mike Sutherlin

Yes, thanks, Henry.

Operator

Now we will hear from Andy Kaplowitz with Barclays.

Mike Sutherlin

Hi, Andy.

Vlad Bystricky - Barclays Capital

Hi, guys, this is Vlad Bystricky on for Andy. Good morning.

Mike Sutherlin

Okay.

Vlad Bystricky - Barclays Capital

A quick question on IMM. It looked like the results from IMM were very strong and in line with your expectations. We have heard some reports of weakening demand for road headers in China. Can you talk about if you are seeing any of that or what you are seeing on forward for IMM?

Mike Sutherlin

The road header market in China has been a really good market for IMM. It's one of their core based markets but one of our Chinese competitors has been a new entrant into the market primarily a construction equipment company that's moved into mining. They have been very, very aggressive over the last couple of years. They have taken market share and they have been aggressive in a way they have gone to market and structured deals.

What we are seeing in IMM is more stability than what we are hearing out of the competitor reports. Some of that gets back to base level performance. The machines at IMM do a great job. They are well recognized. They are like our continuous miners. They are the standard of the industry.

Sometimes you try other people you find out that the machine performance isn't as good and you get back to the core equipment that that you have always had. Then we believe that that's one of trends we are getting to right now is that, the mine production in China is slowing, and we expect the coal production in China to grow at somewhere like half or two-thirds of the rate we have seen historically.

We see stockpiles building up right now and if the prices grow $100 a metric ton we are seeing that imported coal continue to have price advantage. So, there is some slowing in the market in China but we also believe that share issues, particularly around road headers are stabilizing and we will provide a more effective base for us to grow back to that market for IMM.

So, a lot of things are moving there, but we are not seeing the same issues at IMM that we hear from other competitors, and in some cases we think that some of those are opportunities for us and we are starting to see some impact to that as well.

Vlad Bystricky - Barclays Capital

That’s very helpful, thanks and then just as a follow-up, can you talk about your visibility on aftermarket outside of the U.S.? I mean it seems like, at the strong levels of OE delivered in the past few years that we should be coming into some big good rebuild cycles here soon. Can you talk about your visibility on that and whether you think customers will stick to those three-year rebuild schedules?

Mike Sutherlin

We have the same visibility on the international aftermarket as we do on the U.S. We run life cycle management programs in those mines. We are close with customers. What we see out of the international markets that we don't see out of the U.S. is there's more of a tendency to buy a large amount of parts with some original equipment orders. They sort of carry higher levels of mine stocks.

So, we get a little bit more lumpiness as a result of that, and in some areas, particularly out of places like China and India will get their parts demand for those markets will come in three or four large orders a year rather than monthly or weekly. So we do get more lumpiness in the international markets but certainly as we look at the equipment, the typical shovel will start to go into the first year to most of the parts that are required or limited because the machines use some of those that are covered under warranty, but by year three we start to see significant parts demand and in the first major rebuild clears it in year five.

So we are getting up to the point where year three and year five come into play for the machines we have delivered in 2009 and '10 and '11 for sure. For underground the rebuild cycle is a little bit quicker but it's typical to rebuild a miner every couple of years and the shearing machines come in after every panel for sometimes a minor, sometimes a major rebuild. So, those will drive higher levels of aftermarket activity, parts and labor in the aftermarket activities and we have that modeled in.

Some of that will come in lumpy form because some of the parts they're delivered with the projects upfront. Some of it gets lumped by the nature of some of the larger international companies and how that business gets translated in areas like China and India, for example. So more lumpiness in the aftermarket out in the international markets and less predictability on the quarter-by-quarter basis and that's just one of the things we will have to work with you guys on getting a little bit more granularity around.

Vlad Bystricky - Barclays Capital

Okay, thank you. That’s very helpful.

Operator

Now we will move to Seth Weber with RBC Capital Markets.

Seth Weber - RBC Capital Markets

Hey, good morning, guys.

Mike Sutherlin

Good morning.

Seth Weber - RBC Capital Markets

I guess, just to start, a clarification. Did I hear that book to bill for the core legacy business over 1 for this year? It looks like, by my math, that would suggest that orders are going to improve more than what they were in the second quarter. Is that correct?

Mike Sutherlin

We think the second quarter represents a downside to the normal order pattern and in our underground business, for example, we booked one longwall order this year which is part of it below where we normally do. That longwall order was a U.S. longwall smaller equipment and a smaller price point.

We do have some things on the table in Australia that are the bigger longwall systems, a lot bigger, a lot more complex and then a lot of redundant. They are buying multiple shearing machines and multiple AFCs to facilitate their longwall move.

So we see some of that in the pipeline ahead of us and second quarter didn't have any of that and the second quarter shovel bookings were the lowest we have seen since probably the early first quarter of 2011 and again that's the timing of the number of projects and just the timing of how orders come in. So that's why we have noted the comparisons of softening orders and flattening revenues.

We want to compare that to the first half because we think that's a better base for that comparison in the second quarter. So we translate that out. The second half should look a little like the first half and therefore that would get us to a book-to-bill of 1 for the year and if you translate out to the second quarter you are not going to get there. So there is a definite influence in that.

Seth Weber - RBC Capital Markets

Okay, well that’s helpful, thank you. I guess my question is, in past periods when we have seen the slowdown in orders, the end result has been some lower-priced backlog or lower-priced orders that go into backlog or more competitively priced. Is that something that we should anticipate going forward? Or do you feel like people are staying more disciplined on pricing this time versus a few years ago?

Mike Sutherlin

Is it okay if I thank you to that you asked this one?

Seth Weber - RBC Capital Markets

Me?

Mike Sutherlin

Yes. We have been really I think extremely disciplined on pricing and with our customers we really had a real strong effort around being very predictable and we tell them upfront what we are going to do and why we are going to do it. We don't play games. We don't go into a project and then cut our discount deeply at the end to try to bag the order.

In 2009 when it's only like five shovels all of 2009 and yet we raised parts price in 2009 because we were trying to catch out from getting behind the curve in 2007, 2008, and that went down okay. We explained it to our customer. We explained why we are doing it and they accepted that.

So we have been pretty disciplined about keeping price, positive price realization in our equipment. Having said that, in an up market you have the ability to get a little bit above neutral on positive price realization, in a soft market those increments are going to get squeezed. So we don't see any significant reduction in the margins.

We think that the margins will hold, they may not see strong margin growth year-over-year but we think we definitely plan the margins to hold and we look at margins in backlog, we look at margins in the quotations and we continue to compare those. We want each one of those increments to be positive sometimes by a small number, sometimes by a bigger number but we have been pretty good about maintaining those margins through difficult times as well as better times and we think we will do the same thing now. We have no expectation that we are going to see margin erosion in our equipment pricing.

Seth Weber - RBC Capital Markets

Okay, that’s good to hear, thanks, if I could get a follow-up in to Mike Olsen? Mike, is there a range that you are thinking about for free cash flow this year? You gave us your CapEx number but should free cash flow, do you think, be relatively steady?

Mike Olsen

We would expect that the free cash flow after depreciation would be in that $400 million range. Once again keep in mind that that $400 million range is net of about $180 million worth of discretionary contributions to our pension plans. So we are taking a very aggressive position to eliminate that under-funded status of those plans and for the U.S. plan in particular where those discretionary contributions are running at about $130 million a year our expectation is that that plan will be fully funded by mid 2013 but for this year that free cash flow should be in that $400 million range.

Seth Weber - RBC Capital Markets

Okay, very helpful, guys. Thanks very much.

Mike Sutherlin

Okay, thanks, Seth.

Operator

Now we will move to a question from Schon Williams with BB&T Capital Markets.

Schon Williams - BB&T Capital Markets

Hi, good morning. I wonder if you can just help me out here. You are talking about cutting $100 million out of the guidance because of the weakness you are seeing on U.S. aftermarket coal but then you are talking about $120 million essentially of backlog being at risk because of U.S. I am just trying to get a sense of why is $100 million cut enough if we are already looking at $120 million net that maybe at risk, and that $120 million I would assume that that's more OE related. So just help me get my head around those numbers and why the $100 million is enough here?

Mike Sutherlin

Well, one comment I will give you, Mike will give you more granularity, but the $100 million is a net number between upside we see in the international markets and downside we see in the U.S. underground coal market but Mike can give you more specifics on some of those puts and takes.

Mike Olsen

Yes. In fact I think you partially alluded to is, what's the adjustment to the backlog that we were referencing to the $119 million. About $100 million of that was in fact associated with original equipment shipments with about $18 million associated with the aftermarket, really complete machine refurbishment. A chunk of that backlog would in fact be scheduled for deliveries outside of this fiscal year.

So, it would not have impacts on the current year revenue. The aftermarket, the $100 million reduction is baked into the guidance. A big chunk of that really is associated with softness that we had in the guidance that we issued at the end of the first quarter. At that time, we indicated that we expected that the U.S. may have as much as 4% to 6% impact on our business but at that point in time we felt that that softness would in fact be mitigated by strengths outside of the U.S.

What we are seeing now is that a portion of that softness will still be mitigated by activity levels we are seeing outside of the U.S. but won't be able to offset all of it and that's the reason for the additional guidance reduction of the $100 million.

Schon Williams - BB&T Capital Markets

Okay, and then as a follow-up, I would like to talk about the cost cutting initiatives. Can you give us any further detail on what actions you have actually put in place or are we really just talking about kind of laying out a couple of different scenarios in case we see things get worse. Have you actually put anything into place already?

Mike Olsen

Yes, we have. As we have talked really down through the years and we first started talking about that back in really the fourth quarter of 2008, we consistently work through scenario planning where each of the businesses are taking a look at cost structures, taking a look at various scenarios of volume levels and we in fact have various tiers of cost reduction initiatives.

Some of those initiatives are really just belt tightening where you are eliminating discretionary expenditures and then they accelerate all the way up if the markets get extraordinarily soft to the point where we begin to close some of the higher cost facilities and begin to put more volume into our lower cost facilities.

The first phase, the belt tightening phase has been underway really for a couple of quarters now but at the same time what we want to make sure of is that we don't take costs and resources away from those projects that really are going to be driving our future. So those projects associated with our service excellence initiatives, those projects that are associated with our new product developments, those in fact are sacred.

So we will in fact find additional cost in order to maintain our spending levels for those activities but to answer your question, that was probably more information than you were looking for, but to answer your question, we have begun the cost reduction initiatives and during the third quarter we will actually step those up a bit and move a bit further along the spectrum of our cost reduction scenarios.

Mike Sutherlin

Schon, scenario planning is has been very important to us, but we do see the U.S. to be a structurally smaller market. We have always expect the U.S. to be a flat market but some of the pressures that are going on right now we got to be prepared for that to be a structurally smaller market and we will be taking actions in the second half to address that.

We do expect the savings to cover the cost of the things we will do in the second half of the year. The other thing to note is that as the cycle matures we did increase the amount of outsourcing we do particularly around structural fabrications which tend to be more skewed to the cycle, less replacement demand for those.

In 2008, outsourcing had gotten to around 35% of our production hours. Today that number is just a little bit over 30% but as we did in 2009 we are pulling that work back in-house there is a significant amount of cost mitigation for us and it maintains overhead absorption. So, we have that as part of our plans as well.

We want to maintain our network of outsource suppliers that we use but we did leverage that down in 2009 and if we need to we can leverage that down which is a big part of the overall cost reduction plans we have.

Schon Williams - BB&T Capital Markets

All right, thanks for the update, guys.

Mike Olsen

Yes, thanks.

Operator

Next question is from Charlie Brady with BMO Capital Markets.

Mike Sutherlin

Hi, Charlie.

Charles Brady - BMO Capital Markets

Hi, good morning, guys. Good morning, Mike. Just back on the $119 million, on the underground equipment at risk that you pulled out of backlog, your determination that that could be deferred or at risk, what's the genesis of that? Is that a customer coming to you? Is that you just looking at the market?

Mike Sutherlin

It is not customer is coming to us. It is our assessment of, in some cases customer risk and in some cases, we will look at things, we did look at things like are the machines going into a met coal or thermal coal mine, and we look at cutting conditions and whether it's in low seam conditions with a lot of rock cutting which increases production costs. We look at operating costs for different mines. We look at thermal versus met and what the cost structure looks like.

The net realizable pricing on the stuff out of those mines and we came up with our own assessment of where we think the risk is. We talk to customers all the time but we didn't really go back to them and say, are you going to take this or not because they are going through their planning process right now. If anything we try to get ahead of that and we probably have been a little conservative in the number making sure that we caught everything that we think is there with us now.

Some of that may not be cancelled. It hasn't been canceled yet, and some of them may not be canceled, but I think that there is a significant risk that that equipment could be put on an indefinite deferral until market conditions improve.

Charles Brady - BMO Capital Markets

Okay, thanks, and just back on the prior question of the outsourcing percentage, can you tell us, how low did the outsourcing get down to at the trough?

Mike Olsen

The outsourcing got down to around 20% but all of it wasn't driven by the trough. Some of it was in fact driven by new manufacturing capacity being brought online. The 35% was what existed in 2008. As you look at our volumes over '09 and '10, our volumes really didn't change that much, but what we did do is, we brought some additional capacity online in Tianjin, with some additional capacity for transmissions for the surface business.

So that was a natural decline in outsourcing, and then as the business volumes ramped up in 2011, we began to do more outsourcing. So we are now in a position somewhat similar to 2008 where that outsourcing variable cost element is up around that 30% level which gives us an opportunity to allow those costs to flex with any softness in volume that we might see going forward.

Charles Brady - BMO Capital Markets

As you look at your capacity utilization today and I guess, more importantly, kind of where you see it going over the next six or 12 months given the market conditions, do you think the flexibility in reducing outsourcing is enough to absorb what I would imagine would be a lower capacity utilization?

Mike Sutherlin

As we look at our capacity utilization right now we are still booking equipment out. Surface equipment, for example, shovels are still booking out in that 12-month range. We like that because it allows us to not have deliveries become an impediment to market share and booking orders but it also keeps us from having to deal with escalation and other kind of clauses because we can lock in our supplies over that period of time.

So, capacity is effectively fully utilized right now. We don't have a lot of excess capacity. We do a little in underground in some machinery but it is really not very significant. As we look forward, we look for our business to flatten and we do have some more capacity coming online in China that will be ready to come online sometime early next year.

So, the capacity utilization, as we look at right now the excess capacity is going to come out of that additional investment in factory capacity in China rather than declines to the market at this point. So that's where our planning is, as we haven't gone into the outsourced that we just talked about but we will be prepared to if we needed to but right now, we think we can hold the bunch pretty steady.

We are moving some things around to get better utilization. For example, we are moving some machines that would have otherwise being built in Australia. We just don't have the capacity there. So the lead times that are extended, we are moving that production back to the U.S., so we are using that to backfill some of the delays we expect to have at Central Appalachia. So we are doing a number of things. The net result is, we don't see a lot of reduction in capacity utilization with the current outlook that we have.

Charles Brady - BMO Capital Markets

Great, thanks.

Mike Sutherlin

Thank you.

Operator

Now moving to a question from Rob Wertheimer with Vertical Research Partners.

Robert Wertheimer - Vertical Research Partners

Hi, good morning, guys. I just wanted to ask just generally outside of the U.S. underground market, in what way things have gotten more negative? I have obviously understand the things you alluded to with Australia and the pressure to get back capital but are you having conversations about pushing off replacement about just not taking part orders for a while and the greenfield quote you made, is there any greenfield mine that would touch your revenues in '13 or '14 or is that all beyond, we always debate the timing of mining CapEx versus machinery CapEx?

Mike Sutherlin

That’s a good question and right now, what we, in our discussions with our customers, I think that we have not seen any negatives in the international market. Mine delays that we are seeing are normal stuff, like permitting delays or other kind of things that are fairly normal with major projects. We are not seeing people just starting to get cautious and flowing back on their plans.

What we do see is a focus on completing what they have in the pipeline. We do see them looking at brownfield expansions which are quicker and more predictable. What we do see slowing down is their rush to bring the next big greenfield project into the pipeline. Some of that allows them to work within their existing resources which are more efficient than subcontracting out engineering and more cost effective.

So with the view of the global economy right now, our customers feel more comfortable they have enough stuff in the pipeline at the rate that they're going. If they could maintain the pace that they are going, they will be fine. They won't open dual projects, they won't get ahead of themselves and they will be able to do that more cost efficiently because they will be working mostly within their own internal resources.

So\ there is a more satisfaction that they're going at the right pace, less of a rush to step it up a notch or two, less opportunistic like that, I need to get my mine on production now so I can take advantage of market opportunities. A lot of that rush and timing issues have sort of worked their way out of the system.

So we see a lot of stability in the international markets. We do see upside. Some of the major headlines we get comes from a couple of our major customers but some of that is fairly large CapEx plans around some really large projects that are multiyear projects, time horizon the first production is.

We have been talking about one of the Australian projects now for four or five years and they are still probably six or seven years from production. So I think there is a lot more concern about those big mega projects.

Most of our other customers are continuing with the projects as they have planned. We see new projects coming into the pipeline. They are not mega projects. They are not four draglines and 12 shovels there, like five shovels here and then three shovels there. We continue to see those things come into the pipeline.

Certainly longwalls in Australia for underground coal we see those coming into the pipeline as well. So the smaller more manageable projects are okay. The brownfield projects are a priority and things that are underway are in fine shape. We don't see any pressure on those but we do see the pressures on the big mega greenfield projects but those are further out and we have never put those too much in our plans because those have always had timing issues and permitting delays. So they are generally off our prospect list and out of the horizon for that anyhow.

Robert Wertheimer - Vertical Research Partners

Well, that's what I would say. Like the nearest term of the greenfield projects that maybe feel a little softer, a little more shuffled around, that the earliest you could have envisioned delivering for that stuff, would it even be 2014 or is it out past that?

Mike Sutherlin

Well, we have delivered slots right now for 2013. We are booking about year on surface equipment. We really don't like to have slots booked out for multiple years. It just creates a lot of problems for us with escalation clauses and how we place that in. So, we are more inclined to get the initial lot of shovels with options for other shovels later on and we price those when the customer gets ready to put those on order.

So, we don't really have the multiyear backlog. We did that in 2008 but those were some more letters of intent. They weren't locked down. Everything we have in backlog right now is under contract and lockdown on our service side.

Robert Wertheimer - Vertical Research Partners

I am sure and I understand that. I apologize if I wasn’t clear but just like of the things you are thinking about that are greenfield, that are maybe getting a little bit de-prioritized, is that something that would have turned into a sale in '14 or '15?

Mike Sutherlin

We have some things that we are working on that are coming in. Our prospect list goes out for 12 months. So we look at things that we think are going to turn to orders for us in the 12-month period but we see some of those projects moving into that horizon time, both surface and underground. So, we are seeing projects continuing to move forward, and at the way we are look at it right now, that would translate to 2013 bookings and 2014 deliveries.

Robert Wertheimer - Vertical Research Partners

Okay, I will stop there. Thanks very much.

Mike Sutherlin

Yes, thanks. Jake, we probably have time for one more call, so we can finish on the hour.

Operator

Okay, and that question will come from Robert McCarthy with Robert W. Baird.

Mike Sutherlin

Hi, Robert.

Robert McCarthy - Robert W. Baird

Hi, Mike. How are you? I just wanted to make absolutely sure that I understood exactly what you were saying about first half and second quarter being representative outlook for the balance of the year. You were talking about bookings specifically when you made that comment, right?

Mike Sutherlin

Yes.

Robert McCarthy - Robert W. Baird

So, if we are talking about a number in the second half of the year is going be $1.3 billion, $1.4 billion a quarter, in a sense you are talking about going back to more or less, I think, 2010 demand levels then adjusted for the acquisitions that you have made since then?

Mike Sutherlin

I don't have those numbers in front me, but that seems 2010 probably seems a low comparison.

Robert McCarthy - Robert W. Baird

You are running about $1 billion of bookings per quarter in 2010 in recovery, right?

Mike Olsen

We wouldn't expect that those run rates would drop to $1 billion, because if you looked at the legacy business, the second quarter had bookings of $1 billion. So we are not expecting that those bookings levels will settle in at that level.

Robert McCarthy - Robert W. Baird

Okay, very good. I appreciate the clarification. Are you still comfortable with a $300 million revenue contribution for IMM this fiscal year?

Mike Sutherlin

In our reviews of that business we still think that that's good. There are some upsides. They have struggled with some of their products and we think that we have the experience and the technology to make those products perform at much better levels for them at levels that would be industry-leading performance.

So we think there is upside, near-term as well as longer-term through some of the technology that we can apply to those products. So, right now, we feel pretty good. Their focus of the customer base and we see a little bit of slowing in the China market but the mechanization process of safety drives, those things continue on and that's been a little large focus where IMM has been working.

Most of the areas were in those mid-tier mines. Most of those markets are local markets. Where we see the buildup in stockpiles is cleaning out now and the port and that stuffs out of Shaanxi and Inner Mongolia that's railed to the Qinhuangdao Port, and then barged down to Shanghai. Markets that IMM serves are generally local markets where local production goes and local power burns so they're less affected by those swings and the larger producers out west.

Robert McCarthy - Robert W. Baird

Very good and if just a short follow-up to that, really, for Mike Olsen. I just want to make sure I understand the purchase accounting affect going forward at IMM. I'm not talking about the excess related to inventory write-up but the ongoing. You recognized $4.7 million in the quarter but that included according to the release, $1.1 million catch up from the first quarter. So can we use the difference or $3.6 million per quarter as the ongoing rate?

Mike Olsen

Yes. Now, the one caveat that I will put in there is that we will be finalizing the review by our external auditors of the asset valuation of IMM. So there could in fact be some tweaks but based on the best information we have today, that $3.6 million is a good number.

Robert McCarthy - Robert W. Baird

Okay, great, all right, thank you.

Mike Sutherlin

Okay, thanks, Rob. With that, I think we will finish our call here on the hour. Just a quick comment in closing. First of all I appreciate everybody's participation and interest on the call. I just want to reiterate that we continue to look at ourselves as an operationally and financially efficient business. I think we saw that in our second quarter results.

We are also a business that continues to be focused on growth, strategy and execution, and we think that that combination has surfaced well over the last several years. We think it will continue to serve us well and particularly important as we deal with the uncertainty that we see in our markets until that stabilizes.

So, we think that that we have the right kind of business and the right business model and the right focus to continue to deliver good value for our shareholder. So thank you again for your participation and we will look forward to the call at the end of our third quarter. Thanks very much.

Operator

Ladies and gentlemen, that will conclude your call for today. Thank you for your participation.

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