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Executives

James O’Leary - President and Chief Executive Officer

Kenneth Crawford - Senior Vice President and Chief Financial Officer

Analysts

John Householter – Robert W. Baird

Walter Liptak – Barrington Research

Holden Lewis – BB&T Capital Markets

Ian Fleischer – FBR Groups

Nigel Coe - Deutsche Bank

Michael Hamilton – RBC

Steve Barger - Keybanc Capital

Kaydon Corp., (KDN) Q4 2007 Earnings Call February 21, 2008 11:00 AM ET

Operator

Before the conference begins, the company would like to make the legal disclaimer that certain information in this formal discussion and that may be included in the question-and-answer session as forward-looking within the meaning of the federal securities laws. These forward-looking statements are only predictions, based on the company’s current expectations about future events. While the company believes that any forward-looking statements that are made are reasonable, actual results could differ materially since the statements are based on the company’s current expectations and are subject to risks and uncertainties beyond the control of the company.

Listeners are cautioned to refer to the company’s Form 10-K for a list of factors that could cause its results to differ from those anticipated in any forward-looking statement. The company does not undertake and expressly disclaims any obligation to update or alter its forward-looking statements whether as a result of new information, future events or otherwise, except as required by applicable law.

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

Now, I would like to turn the call over to Mr. James O’Leary, President and Chief Executive Officer of Kaydon Corporation. Mr. O’Leary, please begin.

James O’Leary

Thank you, Chris. Good morning and thank you all for joining us. I’m very pleased to be reporting under strong fourth quarter during which we achieved records in quarterly sales, fourth quarter orders and quarter end backlog. Also in the quarter, we completed the acquisition of Avon Bearings Corporation; we divested a small strategically unimportant component of our Friction Controls Product Segment. And we made considerable progress on our organic initiatives aimed at accelerating long-term secular growth and reducing structural cost. We’ll discuss how each of these steps fits into our strategy of selective market leadership a bit later.

I’m joined this morning by Ken Crawford, Senior Vice President and Chief Financial Officer; and Peter DuChants, Senior Vice President responsible for corporate development and strategy. In a slight departure from our past practice in a recognition really, of two things: 1) how dense and complex this quarter may be at first blush; but more importantly, 2) how much the company currently has going on in terms of major capital spending, recent acquisitions in divestitures, investment issues as it rates to a very significant cash balance. And a more uncertain business environment that we’ve faced in many years, we want to provide you with as much information, as many building blocks as possible without departing from our past practice of not providing formal guidance.

Now that said, it’s complex at first blush. I’ll kind of jump ahead a little bit and say if you understand the cash how it’s draw down and what we’re earning on it in this environment you’ll actually see that it’s a simpler set of comparisons and again, it is at first blush. And we’ll go up through it in a fair amount of detail. We’ve tried in this press release, and we’ll try in the prepared remarks to address as many of these matters as practical short of changing the policy. And as the year goes on we’ll try to address these in sufficient detail, so you can keep track of them relative to current expectations.

Now, let’s start off reviewing the current quarter. During the quarter, we had fourth quarter order entry of 118 million up 22% year-over-year. This leaves us with a record quarter end backlog of 238.9 million going into 2008. We’ll comment more on 2008 later in the call. But during the quarter, including the recently acquired Avon, Kaydon had record fourth quarter sales of 123.7 million up 23.5% year-over-year.

Gross profit for the fourth quarter was 48.2 million or 39% of sales as compared to 41.4 million or 41% of sales during last year’s fourth quarter. The temporary decline in gross margins was largely due to the wind energy expansion, the ongoing ceiling products relocation, a sales mix that’s more heavily weighted towards rapidly growing high but lower than the overall average margins within our split role of Bearing Group and the inclusion of Avon who’s profit contribution is minimized somewhat in the first few post closing quarters by acquisition accounting requirements, which again, we’ll discuss each component momentarily.

Selling, general, and administrative expenses, including a $5 million pretax gain on the sale of a component to Friction Control products were 16 million or 13% of sales during the fourth quarter of 2007. This compared to 17.4 million or 17.4% of sales in the fourth quarter of 2006. Excluding the gain, selling, general and administrative expenses would have been consistent with those attained as a percentage of sales in the prior year. Operating income during the fourth quarter was 32.2 million as compared to 24 million in the prior year’s fourth quarter. On a non-GAAP basis backing out the 5 million gains, our operating margin would have been about 22% this year, as compared to 24% last year. And again, this temporary decline was largely due to the project just noted.

Net income, including the after tax 3.1 million impact of the gain on sale equaled 22.7 million or 18.3% of sales as compared to 17.7 million or 17.6% of sales last year. Diluted EPS equaled $0.70 including the $0.09 gain as compared to $0.55 in the prior year’s fourth quarter. Now let’s review our operating performance and provide you with the framework for analyzing the year ahead.

Sales of Friction Control products including Avon increased 17.2 million to 76 million or 29.3% when compared to the fourth quarter of last year. This increase was driven by strong sales of split roller bearings in almost every market we sell into, but most notably in China and India. The segment was also positively affected by increased demand for specially bearing utilized in the wind-energy market, machinery and medical equipment markets, partially offset by lower sales to semiconductor and heavy equipment. Our heavy equipment effort should be bolstered in the near term by Avon which served this market effectively over its long history.

Operating income from Friction Control products, including the $5 million gain increased to 24.3 million. Operating income and margins were affected by product shifts including growth in the lower but still high margins split roller bearings business, the ramp up of our wind energy expansion project and the inclusion of Avon whose margins are impacted in the short term by acquisition accounting requirements. Acquisition accounting adjustments totaled about 1.1 million during the fourth quarter of 2007. These factors will continue effect the segment’s operating margin through the first half of 2008 which Ken will provide greater detail momentarily, but after that they’ll phase out. Operating margin equaled 31.9% as compared to 29.6% attained in the prior year. Including Avon, fourth quarter orders in this segment increased 14.3 million or 25.8% as compared to 69.8 million in the prior year. After the impact of initial accounting adjustments, Avon’s expected to generate gross and net margins comparable to Kaydon’s existing wind business.

Turning to Velocity Control, fourth quarter 2007 sales Velocity Control products increased 2.2 million to 15.6 million or 16.8% over the prior year fourth quarter with strong sales in both Europe and the United States. Operating income increased to 3.4 million or 39.5% higher than the fourth quarter of 2006 while operating margin rose to 21.9%. Orders increased by more than 15% over the prior year’s fourth quarter with double digit growth achieved by both our United States and European operations.

In ceiling products, sales increased to 11.2 million or 11.2% higher than those achieved in the fourth quarter of last year, with operating income of ceiling products declining slightly from 2 million to 1.9 million largely because of direct relocation expenses of 400,000 associated with the ceiling products relocation project. Ken will review this in more detail momentarily and how it will impact the first and second quarter of 2008. By third quarter, we should begin realizing the benefits of this project, which is expected to make us significantly more competitive in competing for new business. Orders during the fourth quarter of 2007 totaled 12.2 million, an increase of 26.8% or 2.6 million compared to the fourth quarter of last year. And finally within our Other product segment, sales in other businesses equaled 21 million during the fourth quarter of 2007, an increase from the fourth quarter of 2006 of 3 million principally due to higher demand for our air and liquid filtration products.

Operating income increased to 2.8 million in the fourth quarter of 2007, an increase of 26.9% over the prior year. Operating margin equaled 13.3%, as compared to 12.3% in the prior year. The improvement in both operating income and operating margin was due primarily to the higher sales volume and improved product mix as virtually every business, but particularly our filtration businesses did well.

In total, as well as by segment, order entry was strong during the fourth quarter of 2007 as we achieved a fourth quarter record of 118 million, 22% higher than last year’s total. Total order entry for 2007 was 505.5 million an increase of 24.7% over the full year of 2006. The strong order activity combined with the backlog added from the acquisition of Avon results in a record backlog at year end of 238.9 million at the end of 2007, a 57.6 increase compared to backlog of 151.6 million at the end of last year. Our backlog consists of orders shippable over the six quarters with the overall timing of when we expect to ship being approximately 40% in the upcoming quarter, 35% over the next two and the final 25% over the final three over a six quarter period.

Now I’ll turn it over to Ken to discuss some of the key financial items. Ken.

Kenneth Crawford

Thanks, Jim, and good morning everyone. I’m going to spend a fair amount of time this morning on cash investments and their contributions to earnings because, as you will see its impact respectively on the timing and overall level of 2008s results will be significant.

Starting first with the fourth quarter of 2007 we earned 5% on average cash and short-term investments of $307.2 million which generated 3.9 million of interest income. During the fourth quarter of 2006 we earned 5.1% on average cash investments of 355.1 million, which generated $4.6 million of interest income. The lower average cash in short-term investment balances compared to the prior fourth quarter resulted from the Avon acquisition, our third quarter contribution to fund our pension plans and a full year of capital expenditures to support our capacity expansion projects.

We head into 2008 with total cash in short-term investments of $287 million, which is approximately $84 million less than at the beginning of 2007. Of at least equal significance looking forward into 2008 is the Fed’s recent interest rate reductions and the general flight to safety spread compression caused by the current credit squeeze. This will result in as much as a 200 basis point reduction in the interest rate earned as we presently see it relative to 2007. Together, the lower average interest rate and our lower average investable balances will reduce first quarter 2008 interest income by approximately $2 million or approximately $0.04 per share on a diluted basis compared with the first quarter of 2007.

Due to the recent highly publicized liquidity problems with previously marketable short term near cash securities, we have opted to be conservative at the present time as the company focuses near term on preserving capital for longer term investment opportunities rather than pursuing higher yields. That said, we believe our financial resources will provide us with the flexibility to take advantage of potentially unique opportunities that may arise during a period when liquidity can be a competitive advantage.

Interest expense during both the fourth quarters of 2006 and 2007 was $2.4 million with our only long-term debt outstanding being the $200 million convertible, which is addressable at the end of this upcoming May. The effective tax rate during the fourth quarter of 2007 was 32.6% compared to 32.7% in the prior fourth quarter. Fourth quarter 2007 net income was favorably impacted by $900,000 due to the net tax benefit associated with the company’s disposition of an idle facility and adjustments to our deferred tax accounts. The fourth quarter 2006 tax provision was reduced primarily by deductions recognized for financial reporting purposes after examinations by taxing authorities or after the expiration of applicable review periods. We expect the effect tax rate for 2008 to be approximately 36%.

Net income for the fourth quarter was $22.7 million or $0.70 per share on a diluted basis as compared to fourth quarter 2006 net income of 17.1 million or $0.55 per share on a diluted basis and as noted 2007 included the gain on a sale of a component of our Friction Control Products reporting segment totaling $0.09.

EBITDA is a non-GAAP liquidity measure we consider an important indicator of financial health. During the quarter EBITDA including the aforementioned gain on sale was 37.9 million as compared to EBITDA for the fourth quarter of 2006 of $28.4 million. EBITDA for the full year of 2007 totaled 132.5 million as compared to EBITDA for the full year 2006 of 116.1 million. Free cash flow is another non-GAAP liquidity measure we consider to be an important indicator of the company’s health as it reflects our ability to generate cash in excess of both growth and maintenance capital investments. Free cash flow during the fourth quarter of 2007 was $9.8 million compared to 23.6 million in the prior fourth quarter. This reduction was due to higher capital expenditures to generate long-term profitable growth and reduced cash from operating activities associated with working capital increases supporting our sales growth as significant year-over-year growth and fourth quarter sales caused lower cash generation from year end working capital reductions.

Free cash flow for the full year 2007 totaled 20.2 million as compared to free cash flow for 2006 of 63.6 million. The year-over-year reduction was due to the $27.8 million increase in capital expenditures and lower cash from operating activities. The lower cash from operating activities was due to a $19.2 million increase in pension contributions and increased working capital support our sales growth. The full funding of our qualified pension plans in 2007 is expected to eliminate contributions to these plans for the next five years. Capital expenditures will remain at high levels in 2008 as we expand to take advantage of the outstanding secular growth opportunity in wind-energy.

Again, EBITDA and free cash flow should be viewed as supplemental data rather than it substitutes or alternatives to the GAAP measures. We’ve included in our earnings release a reconciliation of these two metrics to the most comparable GAAP measures for your reference.

Turning to the balance sheet, cash and cash equivalents plus short-term investments totaled 287 million at the end of the year, as compared to 370.8 million at the end of 2006. Long-term debt remains unchanged to 200 million and equaled 29.3% of total capitalization. During the fourth quarter we acquired Avon Bearings Corporation in a cash transaction totaling $54.9 million. We paid dividends of 4.2 million or $0.15 per share. And we repurchased $7.5 million of common stock and invested $17.1 million in net capital expenditures. In terms of cash in flows during the fourth quarter, the company received proceeds of $6.5 million for the sale of a component of our Friction Control products reporting segment.

Regarding 2008, we currently expect continued strong financial performance during the year. However, during the early part of the year, in particular the first quarter and to a lesser extent in the second quarter, direct start up project expenses, short-term outsourcing costs and lost overhead absorption associated with our current growth and cost reduction initiatives will make comparisons to 2007’s quarterly results difficult. These expenses could total as much as $2 million during the first quarter of 2008. We expect to realize meaningful benefits from these programs later in the year. Also, approximately $800,000 of additional depreciation and amortization expense associated with acquisition accounting will reduce Avon’s contribution to first quarter earnings.

Now I’d like to turn the call back over to Jim.

James O’Leary

Thanks, Ken. 2007 was an important investment year for Kaydon as we laid the groundwork for future growth. We’ve accelerated investments in a major growth market targeting wind-energy. We’ve also pushed harder into developing international markets to capture our fair share of available business for each of our leadership companies.

Our capacity expansion will provide Kaydon with substantially increased manufacturing capacity to satisfy the rapidly growing wind-turbine demand for advanced custom bearing assemblies of up to 11 feet in diameter for new larger wind turbines up to 3 megawatts in capacity. This is supplemented by the Avon acquisition which gives us the capability to make the largest bearings in North America. Together, these investments will give us both a North American and a global leadership position in the strong secularly fast growing global market.

During 2007, we invested 54.1 million in capital expenditures and we expect capital expenditures to be approximately 70 to 75 million in 2008. Also underway is a relocation of a portion of our ceiling product segment from Baltimore, Maryland to a lower cost facility in Mocksville, North Carolina. This will result in a significantly more efficient manufacturing process and higher profitability, which will make us much more competitive for new business opportunities that were previously out of reach from a cost competitiveness perspective.

With respect to acquisitions and divestitures, we’re very pleased with the acquisition of Avon Bearings thus far and it’s integration into Kaydon. We expect the acquisition to be slightly accretive to Kaydon’s earnings within the first full year of ownership and it’s all ready been cash accretive. Avon is expected to add approximately 30 million to Kaydon’s fiscal 2008 sales. And again, the acquisition solidifies our position as a market leader in the global wind-energy market. Our decision to sell a portion of our Friction Control product segment was based really on its inability to obtain a market leadership position during its ownership at Kaydon. As a result, we opportunistically divested it when the right offer came along.

Regarding 2008, the company’s recent and ongoing investments expand capacity for large diameter bearings, relocate a portion of our ceiling products business and increased our international sales efforts should result in continued strong performance during 2008. However, as Ken noted during the early part of the year, in particular the first quarter, direct and indirect costs associated with these initiatives, short-term outsourcing costs, and lost overhead absorption as we ramp up will make comparisons with our first half particularly the first quarter of 2007 difficult.

We currently expect to begin realizing benefits of these programs during the end of the second quarter and then into the full year. At the present, we expect earnings per share growth for the full year to exceed our long-term average target of 10% to 12% as the benefits of our capacity expansion and relocation contributes significantly to the last half of 2008 and fully online into 2009.

In summary, we’re pleased with our fourth quarter results. Our record quarter end backlog positions as well for 2008 and beyond as we expand our internal capabilities to serve segments enjoying strong secular growth. This completes the year which saw a positive operating performance across each of our segments. And during the year, we made considerable progress on each of the long-term initiatives we focused on. In particular, we accelerated our expansion in serving the wind energy market as well as focused on growing our share in a number of high growth developing countries, notably India and China.

During the past few months we’ve increased our capital program to serve the large diameter bearing market twice. We’ve completed the first major bolt on acquisition in the company’s history and the first acquisition in several years. We’ve opened, this past month in fact, a sales office in China for our liquid filtration business. And we’ve pushed forward a number of other international initiatives including giving our Velocity Controls business the green light to set up a subsidiary in India. In short, it’s been a busy couple of months.

We expect meaningful gains in the latter half of 2008 as additional capacity comes online and more important beyond 2008. We believe we’re taking all of the appropriate measures to maximize shareholder value well into the future. With our strong balance sheet and tremendous financial flexibility, you can expect to continue driving internal growth while selectively evaluating external opportunities.

Finally, I’d like to thank each of our Kaydon Employees for their efforts this past year, they are our most valuable assets. And I’d like to thank them for the great work done in delivering outstanding results during 2007. And I’d like to thank them prospectively for their efforts in delivering strong performance into 2008 and beyond.

Chris that concludes the formal presentation. We’d be glad to take any calls.

Question-and-Answer Session

Operator

Thank you, Mr. O'Leary. We will now begin our question-and-answer session. (Operator Instructions). Our first question comes from Peter Lisnic of Robert W. Baird.

John Householter – Robert W. Baird

Good morning. It’s actually John Householter on for Pete.

James O'Leary

Hi, John.

John Householter – Robert W. Baird

Just a couple of questions for you. First off, could you quantify just in terms of both revenue for the quarter and then what it did to orders and backlog what exactly Avon contributed?

James O'Leary

Sure. John, you get to ask that question one time because going forward, the integration process with Avon is really pulling that into our existing bearings operations. And we’ll be toggling capacity between our existing facilities including the one that will be opened later in the year in Mexico. And, you know as an acquired entity Avon really begins to lose its separateness, you know in to the second quarter, really beginning in the first. Now, that said, it was around pretty autonomously during the first quarter that’s why we gave you the acquisition adjustments. The sales were about 4.5 million. The orders were about 7 million. And the backlog acquired plus built during that fourth quarter of 2007 was about 36.5 million. That’s 4, about 4.5 in sales, about 7 in orders, and about 36.5 of backlog added to Kaydon to the end of 2007.

John Householter – Robert W. Baird

Okay. Thank you for that. And I understand it’s being integrated. And I assume, kind of natural follow up to that, the CapEx outlook you have is some of that is going into Avon itself, right, revenue of 75 million?

James O'Leary

A little bit. But a lot of it is still the continuation of our existing Mexico expansion and some internal capital at Sumter. We’ve made some changes to accommodate more capacity going forward for wind-energy and heavy equipment. It will include some capacity expansion or I’d say modest expansion and improvement of the existing capabilities at Avon. But, again, it will fit seamlessly into our existing operations.

John Householter – Robert W. Baird

Okay. Thank you for that. And then turning to cash…

James O'Leary

John, we’re going to limit you. This is your last question because we’re trying to limit people to one or two tops.

John Householter – Robert W. Baird

Okay. It looks like you’re classifying some of your securities as available for sale. Are there, have you guys taken losses and just taken the hit through equity? Or, I mean what’s the exact status there? Have you taken kind of adjustments through shareholders equity that aren’t through the income statement?

James O'Leary

I’ll let Ken cover that. But, no we haven’t taken losses. Ken, talk about the classification?

Ken Crawford

Yeah. We’ve taken about $200,000 and it is classified in other comprehensive income. And at the end of the year with that, we did that because we consider those to be other than permanent losses. The good news is that we’re getting and have gotten some distributions as our investments are being liquidated. So, the amounts are minor and have not affected P&L yet.

John Householter – Robert W. Baird

Okay. Thank you.

Operator

Our next question comes from Walt Liptak of Barrington.

Walter Liptak – Barrington Research

Hi, thanks. Good morning, guys and congratulations on the strategic work for looking into 2008.

James O'Leary

Thanks, Walt.

Walter Liptak – Barrington Research

My first question is, you know on the guidance of 10% to 12% EPS growth, is that, as we look at that, should we work off the base of the reported number, the 241? Or should we look off the adjusted, you know excluding the gain?

James O'Leary

I’d look off the adjusted excluding the gain but this also doesn’t contemplate things, it would, you know if you said, Are there going to be divestitures? Could there be other acquisitions? Will there be other or accelerated share repurchase activity? I’d say for a clean comparison I’d look at excluding the gain, but that doesn’t contemplate other things we might do. I think the biggest, I’m going to digress a bit, the biggest thing impacting comparison year-over-year, particularly the distribution of earnings are the cash balances. If you look at the last two years and really the third, three years, if you go back to 2005, the interest income earned on the cash balance was bigger than every segment with the exception of our bearing segment, the Friction Control segment. And the 18 million earned last year, you know when you assume it’s going to be earned straight line over the course of a year, you know which certainly was the case in 2006 and to some extent in 2005, you know that kind of created the stabilizing effect that when you drew down on the cash this year for Avon to fund the pension and most importantly for the capital which doesn’t start throwing off income until the Mexican facility is open in the second quarter of next year, you have a distribution shift of earnings where, you know we were pretty much a quarter, a quarter, a quarter, a little bit weighted towards the back half for the year. I think going forward for particularly this year, as the cash is drawn down and you’re comparing first quarter of this year to a first quarter of last year that had a full balance at probably the highest rates we’ve earned over the course of the five year since we’ve done the convertible, you end up with the first quarter and second quarter, it together, will probably be about 40% of earnings and a back half of the year, which will be about 60% where you get stronger as the year goes on, not because of any change in seasonality or sequacity but really just because of available capacity and the cessation of some of the costs and the absorption issues that you have until you’re up and running.

Walter Liptak – Barrington Research

Okay. Okay, thanks for that. Let me try and just drill into that a little bit more. Ken, when you’re talking about the, you know the cash balances, the flight to quality issues, the 2 million or $0.04 that was over a year time period. Is that correct or is that in the first quarter?

Ken Crawford

That’s only in the first quarter, Walt.

Walter Liptak – Barrington Research

Okay. And then in the first quarter as well, you’re going to have another 2 million related to the relo expenses, the planned expansion, et cetera.

Ken Crawford

That’s correct.

Walter Liptak – Barrington Research

Okay. Okay, that helps. I’ve got a few more questions but I’ll get back in queue.

Ken Crawford

Sure.

James O'Leary

Thank you.

Operator

We’ll take our next question from Holden Lewis of BB&T Capital Markets.

Holden Lewis – BB&T Capital Markets

Good morning. Thank you.

James O'Leary

Hey, Holden.

Holden Lewis – BB&T Capital Markets

As that, you know sort of pacing out the Avon business, given that we have one quarter in which to do that, you know it kind of looks like, you know your book to build the orders, the order rate was less than the sales? The book to build was sort of below one for the first time this year. The backlog was actually somewhat lower, sequentially anyway. Can you, you kind of reference, I think some weakness in defense, can you talk about, you know is defense the entire explanation for that? If you take out defense what do the rest of the markets look like? What is the order rate to book to build, can you just get some greater color on that?

James O'Leary

Well, yeah. I would say defense is down a little bit, particularly in the second half for the year, it’s down a little bit and it’s shifting from programs that are in the process of winding down and shifting into some new programs that are just coming online. I don’t know if this will answer your question or not, but, you know we have talked about the fact that our backlog is shifting from, shipping out approximately 50% in the next subsequent quarter and we think now that because of the wind component in there it’s shipping out more like 40% in the next quarter and wind is becoming a bigger component of our backlog, so it’s causing that shift. And so the answer to your question is defense is down a little bit but there’s shifting around into different programs and wind is becoming a more important part, so it’s, the backlog is shipping later.

Holden Lewis – BB&T Capital Markets

Right, okay. Fair enough. But, I mean, the backlog do have decreased sequentially. I mean in effect, it looks like absent Avon, you know the orders didn’t replenish as quickly as the sales went out the door. So, obviously, backlog came down. And it sounds like defense is down a bit but, I mean, if you sort of look at the business, I guess, the core industrial business, excluding defense, excluding wind, wind very strong, defense is weak, what’s the rest of it looking like?

James O'Leary

I think over all its very strong, but the two things that Ken talked about and you alluded to, the biggest issue as it relates to bearings in particular, is something we talked about on the last call. I hope next quarter will be the next quarter we talk about it, but it’s a major program we had. It started in 2006, carried forward into 2007 and then tailed off and that was a military order for a legacy program, which started to tail off. We have replacement business for that but it doesn’t get up and running until the second quarter and that’s really the M wrap opportunity that we’ve talked about pretty liberally on our last call and, you know certainly out on the road. The second thing, which is of significance and it will impact comparisons and, I think, until you have a normal order flow meaning you’re closer to shipping after you take the order, not with this large lag created by when our capacity comes on line, is the lumpiness of the wind orders. (Inaudible) we probably had a good quarter or two at the end of last year, which, you know certainly we could take more orders for 2010 and ’11 from our customers for wind, but I don’t know if that necessarily would make sense, particularly since we don’t enter them in until they are 18 months away from shipment. So, then there are comparability issues. I think the biggest issue on not just orders but the actual realized results which have been the last two quarters and we will be into the first quarters of next year is the major order we talked about in defense, which ran down during the back of 2000, second quarter of 2007 and will be replaced, but won’t be replaced until the second quarter as we ramp the program up for M wrap.

Holden Lewis – BB&T Capital Markets

Okay. And then just lastly, you know, you’re, prior to this year, your friction and motion control margins, operating margins were somewhere in the vicinity of 29%. You know, this year they came in around 26%, you know as you go into the second half of ’08, are you looking more at that 29%? Does the fact that Coopers been so strong kind of impair that down so much? I mean how much of the 26 to 29 do we think we begin to recover as you bring this capacity on stream?

James O'Leary

Holden that was a question someone asked last time. I think it’s a critical question because the 29.3 based on the fourth quarter of 2006 where you had incredible absorption, good quarter, no expansion underway. And, you know you were probably selling as much of our highest margin really as you could, that is not a repeatable quarter. I think that was probably the high mark for a while. We’re in the process now of adding major capacity, which has margins consistent with our average, which we’ve said before has been in the low to mid 20s. I don’t know if the 29.3 is attainable if we want to grow this company. If we want to leave it as a $400 million sales company it’s absolutely attainable. I don’t know if that serves us best turning down business, it’s in the low 20s or in the case of Cooper high teens. I mean those are great margins. It’s growing like wildfire. The company has nearly doubled in the last few years, but the reality is the products we sell within the split roller bearing business which many people, many of our, if not most of our peers would kill for, are lower than Reali Slim that use to attain, you know substantially higher than that. So, to grow the company behind a $400 million sales base, I think we have to accept it. The 29.3 is kind of a high watermark when we were all out capacity in a single quarter. And it’s also before something, things think been talked about pretty significantly, which we will recover with a bit of a lag, but, you know, iron ore is going up. It’s being passed along to steel manufacturers. It will be passed along to us. We are doing, I think, heroically to offset it and pass some of it along. We have contractual provisions for some but; you know that’s really overtaken not just ourselves, many of our peers and many other industries that are heavily raw material intensive, only over the last few quarters. So, I think, 2006 is not an attainable goal but it’s also not a goal that could be attained unless you’re prepared to sit there at 400 million forever.

Holden Lewis – BB&T Capital Markets

Yes. I guess your response; you know that was the, a different way to ask it is if you’re talking about, you know, Cooper growing in, with a 19% type margin high you know, sort of high teens. If you’re talking about being willing to take low 20s type business to support the growth, I guess it beg the question is the 26.4 margin that you’re seeing this year going to be kind of the high watermark?

James O'Leary

No. Because remember the 26, that number includes a lot of restructuring costs, a lot of unobserved overhead. And as Ken went through, it does include some costs for, in the case of severance, relocation within ceiling products. It includes a host of non-reoccurring items, which once you run through them by the end of this year get you up to a higher margin but, again, not to 29.2%.

Holden Lewis – BB&T Capital Markets

Got it. Okay. Thank you.

Operator

Ian Fleischer your line is open.

Ian Fleischer – FBR Groups

Yeah. Hi, good morning.

James O'Leary

Good morning, Ian.

Ian Fleischer – FBR Groups

Just on the wind, you know, you look at that market and obviously, there’s a huge bottleneck for the bearings that support that market. And understanding that you have you know, some contracts, I guess in place at this point but at what point, do you get better margins in that business? Meaning at what point does the overriding huge demand and supply imbalance favor you?

James O'Leary

I think we get better margins relative to just the numbers that are on paper today because of the absorption issue and the start up costs. You stop getting them and attaining them by the third and fourth quarter of this year. When you start realizing because of pricing and the supply demand imbalance it’s really customer-to-customer basis and it will be dictated by the market. For new customers, for smaller orders, for business that we’ve got capacity for but isn’t subject to long-term contract you’ll obviously price to the market with some recognition to where you’re producing it. As contracts run out, obviously we’ve traded some price for certainty with respect to our longer term contracts, as they run out, again, you will look to the market, may be able to price up but I think, it will be dictated by what competitors are doing and we believe largely dictated by how strong the market securely continues to be. And we believe it will be strong for, at least the next few years. And as even before, what we’re told is 2009 out and I think, it’s probably mid 2009, is largely booked up, irrespective of PTC, irrespective of any legislative changes. Renewable portfolio standards are being enacted, I think, now in 29 to 30 states. Companies are asking for carbon emissions audits in the likes of their suppliers. So, even though we expect the market, you know we know the market will be strong through 2009 forward, there’s so much going on that tells us it will be secularly strong beyond that, that we like to think there will be pricing power and there will be things that are favorable to us on a margin basis beyond that but, you know that’s somewhat of a crystal ball question.

Ian Fleischer – FBR Groups

Right. And that’s helpful. And just my final question it looks like you, it looks like the wind capacity expansion is going better than maybe I expected. It looks like you’re going to better than maybe I expected. It looks like you’re going to be, mostly, fully online by the end of this year, you know, where my assumption was more into 2009. Am I right in that assumption that that’s going better? And secondly, with Avon, how much in sales can that capacity support?

James O'Leary

I think it’s growing consistent with what we’ve talked about before. If it sounds or feels a little bit better it’s probably because of the addition of Avon. And as I mentioned before, some additional capital is been added to other facilities besides Mexico to accommodate wind orders. And by the end of this year, we’ll be clicking along at what should be although will not be realized this year a sales basis that supports about a 115 to 120 for ’09.

Ian Fleischer – FBR Groups

Thank you.

James O'Leary

You’re welcome.

Operator

Our next question comes from Nigel Coe of Deutsche Bank.

Nigel Coe - Deutsche Bank

Thanks, good morning.

James O'Leary

Hi, Nigel.

Nigel Coe - Deutsche Bank

Jim, can you maybe talk about, you know with the cash interest deals coming down to 3%, probably going a little bit lower than that, you know this year. I mean I guess the economics of, you know calling back in (inaudible) bonds becomes a little bit easier, can you maybe talk about that? And perhaps, you know, roll into that discussion; you know what you’re seeing on the M&A backlog right now?

James O'Leary

Sure. You know, what’s going on in the last quarter as it relates on the investment industry investing, you know particularly for public companies there have been a few pretty high profile disclosures recently. I think, a major drug company wrote off 300 million, a similar issue much larger scale then a bunch of technology companies noted, it was in the journal yesterday, where they went through the laundry list of, you know very significant companies, very high class treasury departments. You know, they’re having challenges to the similar to the one that we talked about. What we’ve opted to do here is we’ve probably gotten a little bit more conservative than is absolutely necessary. I’d say it’s probably belt and suspenders. It takes about 200 basis points off of what we’ve earned previously. However, you know when you look I do believe the acquisition market is changing and I’ll talk about that momentarily. We have stepped up share repurchase a bit demonstrated this year but, you know we’ve got out toe, maybe a couple of toes in the water and thinking about what to do in May of this year when the convertible comes due. You know, after sitting with $400 million it’s a little over 300 today as we speak of cash, you know and now the opportunity maybe to see a shift in the M&A market and certainly to address the convertible and maybe some of the dilution that that brought on us, now just doesn’t feel like the time to stretch for, you know even a 100 basis points on cash balances, which I don’t think do must should build the long-term value of the company. We’ve put a lot of that into capacity expansions and to Ian’s question a minute ago and what is a securely strong market to grow our capacity. We’ve done a lot of on terms of international expansion. I’ve enumerated a few of those aren’t big capital items, but, you know, they do cost money in that shipping away at the cash balance and, I think, adding a long-term value to the company. You know, at some point we either get the right acquisition. We’ve got one this year. It’s the first in several years and the first major bolt on, really ever. And the market is changing. You know, to your question, the pipeline for big potential second legs, I’d still say is a bit weak. And I’d say it’s weak because if you don’t have to sell a company today why would you? The leverage loan market is still, I would say, seized up a bit. If you’re a bag and you’ve got a lot of leveraged paper all ready whether it’s sponsor paper or strategic, you know you’ve got enough, I don’t hear of a lot of deals getting done. With that said, I think, sellers are not coming to market with major properties today because you have a whole class of potential buyers in terms of financial sponsors who probably wouldn’t participate as robustly otherwise. Now the flip side of that there’s no fore selling. The covenant packages out there are sufficiently favorable to borrowers where, you know we’ve only been in this for three-ish quarters, two to three quarters. If you don’t have to sell, you’re not. So, the big chunky acquisition which would be a couple of hundred million, I still think the guys who might sell properties like that are on the sidelines waiting to see if the market recovers sufficiently that you can bring financial sponsors back into the fray. There’s a lot of strategic stuff. I hear a lot of deals being done among strategies. We are looking, I’ll tell you our pipeline is probably more robust with respect to potential bolt on’s than it’s been in a while. But I’d categorize those as singles and doubles. I would say Avon was a double, maybe a stretch triple. It was a large acquisition. It will be very accretive in ’09. Hit all of the parameters for ’08. But, obviously, it’s a tuck in. It’s a major tuck in. The things we’re looking at now, I’d say, if Avon was a double stretch triple probably singles and doubles, a couple of things internationally fall in the $10 million to $30 million range and things it would bolt on, add value, not meaningfully chip away at the cash balance, but I do think noticeably from an accretion perspective. And then, when May rolls around we consider, you know, what we’re doing on the convert. We’ve stepped up the repurchase program already. And, you know, it’s a really day-to-day what the prices and what we think our, how we think our forecasts look.

Nigel Coe - Deutsche Bank

Okay. That’s really helpful. And the second question, you know wind bearing markets; I think that’s commonly viewed as an OE market. But, you know we’re hearing increasingly that, you know there’s, you know of course significant replacement potential with these bearings. I mean have you seen any of that now mainly on installation?

James O'Leary

Way too soon, I think. But I will tell you part of the rational and part of the logical core in Avon is it has, over the course of 20-plus years carved out a unique identity for itself and replacement and refurbishment. We believe, as the wind market matures, and I think, we’re talking 2010 out that will uniquely position us or probably keep the Avon name for replacement refurbishment but meld the facility into our existing footprint. But yes, 2010 out we do think there will be a repair refurbishment market. Avon right now gets some pretty amazing business, but you can’t say that wind falls because they repeat but they’re hard to forecast, to do major bearings for gun turrets for battleships. You know, we get orders from all over the world for enormous bearings for replacement refurbishment that are very profitable. They kind of come when they come, so they’re tough to forecast but my guess is as the wind market matures and as long as it’s the heavy equipment market, you know, turrets posted extremely good numbers. It sounds like globally the heavy equipment market is still doing very well. Avon has carved out a very nice identity for itself there. We think the Avon acquisition, not just in repair refurbishment but in heavy equipment continues to position ourselves in markets that will be securely strong at least for the foreseeable future.

Nigel Coe - Deutsche Bank

Okay. Great. Thanks.

James O'Leary

You’re welcome.

Operator

Our next question comes from Mike Hamilton of RBC.

Michael Hamilton - RBC

Good morning.

James O'Leary

Mike.

Michael Hamilton - RBC

First recent quarters you’ve provided wind bookings. I wonder if you could give that for the fourth quarter.

James O'Leary

Ken, do you have that?

Ken Crawford

Yeah. I do. In the backlog is about $80 million of wind.

Michael Hamilton - RBC

Okay. What was bookings in the quarter? Do you have that?

James O'Leary

Do we have that?

Ken Crawford

Yeah. About $8 million.

Michael Hamilton - RBC

Okay. Thanks. I was wondering if you could take a couple of minutes talking about what you’re doing in terms of management team as you’re building out Far East. Are you where you want to be? What do you see as strengths there?

James O'Leary

Yeah. We’re not where we want to be because we really just started. We spent a considerable amount of time this past quarter recruiting a fellow to run our filtration office in China, which opened this past month. And, you know, we took our time. We spent a fair amount the last quarter hiring exactly the right guy and our Kaydon filtration business has an office up and running with the right guy. We believe that approach to having indigenous guys working for us, not going through distribution, will be successful for the types of products we have. Because if you look at Cooper exactly the same model, pretty much doubled its business and really has driven growth through Far Eastern markets, particularly India and China with having indigenous people working directly for us in wholly owned offices in those markets. So, we like to think through, you know absolutely through Kaydon filtration will be able to replicate the success that we’ve seen at Cooper. We’re doing a very similar thing in India with our Velocity Control business. We gave the go ahead to, it will be under the auspices of our European operation but who has some experience in India. But, you know similar to the success we’ve had in Germany, Europe and from Europe into Eastern European markets, we’d expect it to be able to replicate that India. It won’t happen over night but will happen, we believe in the next few years and few are not five. It’s probably closer to one or two. In that same model we’re really applying across each one of our businesses. We do have good distribution but we don’t know if we’re getting, all we should within the principle Kaydon bearings business. We’ve got great distribution but there’s still some opportunity within (inaudible), you know particular in India, China and Russia, but that’s a very international business to begin with. We do think it can be more. So, I mean, that’s kind of the business by business landscape. I think the shorter answer to your question is, we’re doing it judiciously. We’ve accelerated it considerably in the last two quarters and we think we’re finding the right guys. But, you know we want to make sure we get the right guys in every business because they’re going to be standalone direct employees and responsible for growing what we think is a significant opportunity for Kaydon across the board.

Michael Hamilton - RBC

Thanks. And final question, could you comment a little bit on outlook for raw material over the next couple of quarters?

James O'Leary

Yeah. It is up. Now it is not going to be up, I think if you saw the agreement between the Japanese and Korean iron ore producers to the steel industry, I think, they agreed on a 65% increase in iron ore. Steel manufacturers have been passing some of that alone, which of course, makes it into our product. You know, we expect there to be some margin contraction because of that. We have built that into our forecast already, Mike. But I don’t know if I’m any smarter than, you know if you go through the list of guys that have talked about it, including guys, I guess, KF and Timken and, you know other guys that are heavily sensitive to raw material, particularly steel, you know we’re expecting some contraction. We’re working on passing it through. We’ve got best practice efforts and purchasing efforts to minimize that. But right now, today, I don’t now if I’m any smarter than, you know some contraction, is it 100 basis points? It could be around there. We’ve baked that into our forecast already but we’re no smarter than the market. We will see where that goes over the next few quarters. I don’t think it’s 65% but it’s certainly more than we’ve seen in recent years.

Michael Hamilton - RBC

Yeah, thanks for the help, Jim.

James O'Leary

You’re welcome, Mike. Thank you.

Operator

And our next question comes from Steve Barger of Keybanc Capital.

Steve Barger - Keybanc Capital

Good morning.

James O'Leary

Hi, Steve.

Steve Barger - Keybanc Capital

Hey, I’ve been jumping back and forth between another call, so tell me if this has been covered.

James O'Leary

Jumping back, you think another call is as important as ours?

Steve Barger - Keybanc Capital

Not nearly that’s why I’m back on this one.

James O'Leary

All right, there you go.

Steve Barger - Keybanc Capital

But the market share build out for India and China, I know you’re really early in the process of that, but can you talk about the size of the market opportunity that you see maybe as we go into 2009 and how you think about margin differentials in those new markets versus what you get in the US?

James O'Leary

That has not been asked anyway. When we’re talking about India and China and where we are now, you know Cooper the margins are consistent. We expect the Velocity Controls business margins to be consistent. We’re early enough now to be able to build out business plans on them. I think the question you’re asking because I know we’ve talked about it is, if we were to do a big green field for the principle bearings business particularly in large diameter bearings, we’re not that far along yet. We can tell you the market is, at least, as big, or potentially bigger as certainly the US and, you know, the opportunity right now, in Europe for us is somewhat limited because they’re incumbent since it’s a more mature market.

Steve Barger - Keybanc Capital

Right.

James O'Leary

As far as pricing in margins, I think the only thing I can tell you is we wouldn’t do it if it’s substantially diluted what we think the kind of low 20s, mid 20 watershed is, you know not looking at between 29.2 from the fourth quarter but what we think the normalized level is, we wouldn’t do it if it wasn’t that good but there’s nothing that tells us it won’t be.

Steve Barger - Keybanc Capital

Right. I mean global capacity isn’t up to the demand in the structural wind tower bearing business, right. So, presumably, you shouldn’t have to take a significant haircut on margin.

James O'Leary

I don’t think you would because if you had sufficient demand to justify the capital you’d have to be looking at a Indian market and a Chinese market that are going to continue to drove resources to renewable energy.

Steve Barger - Keybanc Capital

Right.

James O'Leary

At an accelerating rate when you look at the fact that, you know these are new industrialized economies growing like wildfire. I mean they talk about a slow down as being high single digits to 10% growth. You know, if they’re going to invest in renewable sources and address some of the environmental and the economic knock on effects of the environmental issues you have to believe that it’s going to be an incredible strong market for the foreseeable future. And we’ll justify products like ours there.

Steve Barger - Keybanc Capital

Okay. Next, I know you talked about steel prices a little bit in the prior question but are there any supply chain issues which are affecting you right now? And can you, or have you given us an update in terms of end market demand in power gen or petroleum and heavy industrial, general engineering, just kind of your good industrial end markets?

James O'Leary

Sure. On the first question, there are still some component issues. It’s largely in forgings and outsourced steel. And again, it’s the downside of good times. Things are so good that you have people competing for products that we outsource in some cases. And they’re getting better, but I wouldn’t say it’s completely better. They still are a source of constant breath holding at the end of each month and the end of a quarter. As it relates to end market, wind is obviously great. Ken just gave you 8 million added to the book. Assume that impacted the comparisons to the fourth quarter of last year where I think we took in more than eight. You know, that market is healthy. It’s extraordinarily strong. If we add the capacity online we could take whatever orders, probably, we choose. And because they come on kind of in lumpy fashion and within the construct of long-term contracts, I think you begin to lose the relevance of a quarter on comparisons with that product in particular. But wind energy market is incredibly strong, heavy equipment is incredibly strong. We will expect that to be much better with the addition of Avon. And, I think, part of our being down year-over-year probably have to do allocating capacity to wind. Where we are right now, heavy equipment used to be included with wind, as we looked at it. This year we broke up wind and heavy equipment ex wind separately but heavy equipment a reference to the tariff numbers, you know all of the major heavy equipment guys globally are still talking about strong years into ’09, at least. And if nothing, you know when you look at the agricultural market, which drives some of them, heavy crane market, certainly tariffs again (inaudible). You know, it still sounds like its pretty good. Medical technology, very strong. I think we had a self inflicted issue that we talked about in the previous quarter. You know that’s gotten better, we’ve got the qualifications. We’re expecting good business there this year. The only one that is noticeably soft, and you know I’d say that’s semiconductor, which we’re down, I think the market is down as well. You know, across the rest of the business lines, I’d say strong, not strengthening. I do think, you know I would say the cautionary note which I hate to the end call but the cautionary note is, you know, at once, book and ship business it happens within a quarter, it’s something that, you know we don’t have enough information today to say, you know let’s slow down a bit. But that’s where if people talk themselves into a recession you’d start to see it. Our backlog is obviously strong. Our orders, our contracts within wind energy are strong but if people start to delay your orders particularly on the book and ship business, you’d start to see that and we’d probably in a position to talk about it at the end of this quarter and into the second. But, you know, on any given day whether people are talking themselves into a slowdown or not, you know things would to fluctuate wildly.

Steve Barger - Keybanc Capital

Right.

James O'Leary

So, we’ve had a couple of good days. You know, people are talking, you know, a couple of good days in the market. I think once the credit issues and some of the credit contraction things which interestingly are impacting us in the unexpected fashion just in how we deploy the cash; that’s a transitory issue. Our preference is to deploy the cash into organic growth, acquisition growth and as a fail safe return to shareholders. So, the fact that we’re running a little bit less on the cash doesn’t trouble us because we should have better places to put the money.

Steve Barger - Keybanc Capital

Understood. Thanks very much.

James O'Leary

You’re welcome, Steve. Thank you.

Operator

And our last question today is a follow up from Walt Liptak of Barrington.

Walter Liptak – Barrington Research

All right, thanks. Okay. I guess a last one. I’ll make it an easy one.

James O'Leary

Well, Walt when you’re gentlemanly enough to get on the line again rather than just force your question in, we always take it.

Walter Liptak – Barrington Research

All right. The M wrap opportunity for this year is that in backlog all ready?

James O'Leary

Yes, some of it is. That ramps up during the year. I think it starts off in the second quarter. You know, there’s been a lot written about M wrap, you know is it as good as it was three months ago in the wild speculation, probably not. Is it better than it was six months ago, probably. Right now, we’ve got a good year’s worth of orders. We’re not sure where our 2009 ends up. It’s probably not as hot as probably six months ago when the real robust frothy forecast we put out there. But some of it is in backlog. We start going on that in the middle of this year. And we haven’t, I don’t know if we’re smart enough to know yet where, exactly, the government spending will go in ’09 and forward.

Walter Liptak – Barrington Research

Okay. I wonder so how much is in backlog in dollars?

James O'Leary

We don’t want to comment on that, Walt.

Walter Liptak – Barrington Research

Okay. And have you started producing these to inventory because you know you’re going to ship them or you don’t start producing them until the second quarter?

James O'Leary

We believe it starts in the second quarter.

Walter Liptak – Barrington Research

Okay.

James O'Leary

But don’t quote me on that, but I don’t know how you could.

Walter Liptak – Barrington Research

Okay. All right. Thanks, guys.

James O'Leary

Okay. Thanks, Walt.

Operator

And there are no more questions at this time.

James O'Leary

Okay. I’d like to thank you all for taking the time to joins us today. As always, we’re available if you have follow up questions. But, again, thanks to all of the Kaydon employees for this year and thank you all for your patience and support. Have a nice afternoon.

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Source: Kaydon Corp Q4 2007 Earnings Call Transcript
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