Kaydon Corporation F1Q08 (Qtr End 3/29/08) Earnings Call Transcript

Apr.28.08 | About: Kaydon Corporation (KDN)

Kaydon Corporation (NYSE:KDN)

F1Q08 Earnings Call

April 28, 2008 11:00 am ET

Executives

James O’Leary - President and Chief Executive Officer

Kenneth W. Crawford - Senior Vice President and Chief Financial Officer

Analysts

Holden Lewis – BB&T Capital Markets

Peter Lisnic - Robert W. Baird & Co., Inc.

Walter Liptak – Barrington Research

Nigel Coe – Deutsche Bank Securities

Ian Fletcher – SBR Capital Markets

Peter Thompson – Coho Partners

Richard Marshall – Longbow Research

Tim Curro - Value Holdings

Operator

Welcome to the Kaydon Corporation First Quarter 2008 Earnings Conference Call. Before the conference begins, the company would like to make the legal disclaimer that certain information in this formal discussion, and may be included in the question and answer session, is forward looking within the meanings 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 statement may be reasonable, actual results could differ materially since the statements are based on the company’s current expectations and are subject to the risks of uncertainties beyond the company. Listeners are cautioned to refer to the company’s 2007 Form 10-K for a list of factors that could cause these results to differ from any anticipated and any forward-looking statements.

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

During the conference call, Kaydon’s spokespersons will reference certain non-GAAP measurements to assist you in understanding such non-GAAP measures, as well as to comply with the SEC requirements, the company has included in their press release, reconciliations of the non-GAAP measures to their most directly compatible GAAP measures. Today’s conference is being recorded now. I would like to turn the call over to Mr. James O’Leary, Chairman and Chief Executive Officer of Kaydon Corporation. Mr. O’Leary, please go ahead.

James O’Leary

Thanks William. Good morning and thanks for joining us today, but for those of you who were on the call promptly at 11, we apologize for starting a little bit late. We had a flood of people coming on and wanted to give them a couple of minutes to join us, but we apologize for the slightly later start, but welcome to our call today. I’m joined this morning by Kenneth Crawford, Senior Vice President and Chief Financial Officer, and Peter DeChants, Senior Vice President responsible for Corporate Strategy and Development. I’m pleased to be reporting on our first quarter which met our expectations and was consistent with our overall plan for the year. More importantly, we’re pleased to achieve all-time Kaydon records for quarterly orders and quarter-end backlog. During the quarter we made considerable progress on our well-defined initiatives to accelerate long-term growth, both internationally and in securarly strong markets such as supplying the global alternative energy infrastructure build-out; namely, wind energy. We’ll discuss these liberally throughout today’s call as both are integral to our long-term profitable growth strategy. As I’ve noted in prior calls, we want to provide as many of the building blocks needed to help set your expectations without departing from our policy of not providing explicit guidelines in our press release, and in our prepared remarks; we’ll address as many of these as practical, and as the year goes on, we’ll continue to address these in sufficient detail so that you can keep track of them relative to current expectations. Now, let’s review the current quarter.

During the quarter, we had record order entry of $204.3 million, up of 44% year-over-year. This leaves us with quarter-end backlog of almost $320 million, an increase of nearly 72% as compared to the first quarter of 2007 and 33.9% higher than the previous record recently achieved in our fourth quarter of 2007. Total wind orders booked in the quarter exceeded $80 million due in large part to a significant single order of almost $64 million. Our book-to-bill ratio excluding that order still ticked above 1 for the company as a whole and for friction control products as a segment. During the quarter, Kaydon had record first quarter sales of $123.3 million, up over 15% over last year, driven by especially strong sales in our two larger segments, friction control and velocity controls. Gross profit for the quarter was $47.3 million or 38.4% of sales as compared to $44.8 million or 41.9% of sales during last year’s first quarter. The temporary decline in gross margins was partially due to the wind energy expansion, as we’ve discussed liberally in the past, and the inclusion of Avon, whose profit contribution is minimized in the first few post-closing quarters by acquisition accounting requirements; Ken will give you a lot more detail on that in a little while. We’re also impacted by the absence of a major military order which peaked at the end of 2006 and early 2007 and then dropped off. It’s now being replaced by another significant opportunity, but one which doesn’t fully ramp up until the end of the second quarter and into the third quarter; that’s the M wrap opportunity we’ve discussed in prior calls.

Selling and general administrative expenses were $21.2 million or 17.2% of sales during the first quarter of 2008 as compared to $18.5 million or 17.4% of sales in the first quarter of 2007. Operating income was $26.2 million as compared to $26.3 million in the prior quarter with an operating margin of 21.2% compared to 24.6% last year, again with a decline due to the projects we’re putting in and the military timing issue I’ve discussed a second ago. First quarter 2008 interest income was $1.9 million, and it declined significantly from the $4.6 million earned in the first quarter of 2007. This decline was due to lower interest rates achieved on investable balances and the recognition of a $500,000 charge, part of which had already been classified in other comprehensive income in the prior quarter. Average interest rates declined from 5.1% to 3.4% due to lower rates and the impact of steps taken by us to preserve capital and liquidity rather than pursue short-term yields at a higher than what we’re currently attaining. We looked for safety and liquidity rather than higher yields in the last two quarters. The lower average investable balances resulted from the Avon acquisition, 2007 pension contributions to fully fund our pension plans, and higher capital expenditures to support the capacity on our expansion projects and our stock re-purchase activities. Net income equaled $16.6 million or 13.5% of sales as compared to $18.2 million or 17.1% of sales last year with diluted EPS equaling 53 cents as compared to 57 cents in the prior quarter with the biggest driver of the differential obviously being the interest we just discussed.

Now, let’s review our operating performance by major segments. Sales of friction control products increased $13.4 million to $74.1 million, 22.4% higher compared to the last quarter of last year. This segment benefited from increased demands especially bearings utilized in the wind energy, heavy equipment, machinery, and medical equipment markets, partially offset by lower sales to the military and semi-conductor markets. We also benefited from strong sales of split-roller bearings notable to the Far East. Revenues and operating income from military sales in the first quarter were below prior year’s levels due in part to lower sales of the high-volume legacy program that peaked in 2006 and early 2007. Operating income from friction control products increased to $17.1 million from $16.3 million in the prior first quarter. Operating income and margins were affected by the ramp-up of our wind energy expansion project and the inclusion of Avon whose margins were negatively impacted in the short-term by acquisition accounting requirements. Acquisition accounting adjustments totaled $800,000 during the fourth quarter of 2008. These factors will affect the segment’s operating margins through the first half of 2008 which Ken will discuss momentarily, and rather than wait until the Q&A, I’ll tell you, thus far, we’re extremely happy with Avon, all on track, and we’d love to talk a little bit more about how it fits into our overall strategy for servicing a large turntable market during the Q&A.

Operating margin equaled 23.1% as compared to 26.9% attained in the prior year. After the initial impact of acquisition adjustments turn, Avon should generate gross and net contribution margins consistent with our existing wind energy business. First quarter orders in this segment increased $59.5 million or 66.1% to a record $150 million during the quarter. First quarter 2008 sales of velocity controlled products increased $3.1 million to $18.8 million, nearly 20% over the prior quarter, with strong sales from both our European and North American facilities. Operating income increased to $5.6 million or 36.3% higher than the first quarter of 2007 while operating margin rose to 29.7%. Both sales and operating income benefited from strong end-market demand and the favorable impact of currency translation. Orders increased almost 20% over the prior first quarter leaving backlog at all-time record levels with continued momentum in every end-market we serve.

Sealing product sales were $11.5 million as compared to $12 million in the first quarter of 2007. Operating income of the sealing products segment declined from $2.5 million to $1.5 million because of direct relocation expenses associated with our move from Baltimore to Mocksville, and workers’ compensation claims which together totaled about $700,000, and the balance being the impact of lower sales. Orders during the first quarter of 2008 totaled $15.6 million which was 5% higher than the prior year as the commercial aerospace market in particular has been strong for our sealing products business.

Sales in our other businesses totaled $18.9 million during the first quarter of 2008, an increase from the first quarter of 2007 of about 2%, principally due to higher demand for our liquid filtration products. Operating income decreased about 22% to $2 million of a lower base due to the lower profit contribution from certain of our non-core non-filtration businesses particularly those that are serving the residential plumbing market. In total as well as by segment, order entry was extremely strong during the first quarter of 2008 as we achieved a quarterly record of $204.3 million, a 44.2% increase of our last year’s total. During the quarter we took a major wind energy order which will utilize the capacity coming online later this year. Non-wind orders were also strong increasing both year-over-year and sequentially. The strong order activity resulted in a record backlog of almost $320 million, an increase of 71.7% as compared to the prior year first quarter and 33.9% over our previous quarter end record of $238.9 million reported at the end of 2007. Remember, our backlog consists of orders shippable over the next six quarters. As we’ve discussed in previous quarters, our large wind energy orders will ship a bit later than our non-wind orders largely due to when capacity expansion projects come online into the back half of this year. As a result, these large orders have continued to shift the timing of when our backlog is expected to ship, and presently, we expect to ship approximately 35% of our backlog during the next quarter, approximately 35% over the next two quarters, and the final 30% over the three subsequent quarters stretching out over the 18-month period during which we book backlog.

Now, I’ll turn it over to Ken to cover some key financial items.

Kenneth W. Crawford

Thanks Jim and good morning everyone. I am going to spend a fair amount of time this morning on the cash investment contribution to earnings as it had a significant impact in the first quarter and its impact respectively on the timing and overall level of 2008’s results will be significant. During the first quarter of 2008, we earned 3.4% on average investable balances of $288.8 million. In addition, we recorded a $500,000 charge to recognize the loss in value of an investment as a reduction in interest income, a portion of which was classified in accumulated other comprehensive income in the fourth quarter of 2007. Interest income totaled $1.9 million in the first quarter including the charge. During the first quarter of 2007, we earned 5.1% on average investable balances of $366.3 million which generated $4.6 million in interest income. As Jim noted earlier, the lower average investable balances compared to the prior first quarter resulted from the Avon acquisition, our third quarter 2007 contribution to fund our pension plans, and the effects of capital expenditures to support our capacity expansion projects. The lower interest rates were caused by the recent general flight to safety in addition to proactive steps by the company to protect principal and liquidity.

Sequentially, in the fourth quarter of 2007 we earned 5% interest on average investable balances of $307.2 million which generated $3.9 million of interest income in the fourth quarter of last year. Together, the lower average interest rate and the lower average investable balances, and the $500,000 charge on the loss in value of an investment reduced first quarter 2008 interest income by $2.7 million equivalent to 5 cents per share on a diluted basis compared with the first quarter of 2007. At the end of the first quarter this year, our investable balances totaled $290.8 million which is $11.2 million lower than the beginning of 2008. Of at least equal significance looking forward into the balance of 2008, are the Fed’s recent interest rate reductions and the general spread compression caused by the current credit squeeze. This will result in as much as a 260 basis point reduction in the second quarter interest rate earned as we presently see it relative to the same quarter in 2007 during which we earned 5.1%. The lower interest rates and the expected reduction during the quarter in average investable balances will reduce interest income by approximately $3 million compared to the second quarter of 2007. 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 first quarters of 2008 and 2007 was $2.4 million with our only long-term debt outstanding being the $200 million convertible which will be addressable at the end of May. The effective tax rate during the first quarter of 2008 decreased to 35.4% compared with 36.1% in the prior first quarter, primarily because of an increase in foreign soft earnings. We expect the effect of tax rate for 2008 to be approximately 35.4%. Net income for the first quarter was $16.6 million or 53 cents per share on a diluted basis as compared to the first quarter 2007 net income of $18.2 million or 50 cents per share on a diluted basis. Free cash flow during the first quarter of 2008 was a negative $2.1 million compared to a positive $10.7 million in the prior year first quarter. This swing was due to increased capital expenditures to generate long-term profitable growth and working capital increases supporting our sales growth as significant year-over-year growth in sales caused higher cash usage to support higher working capital growth.

During the first quarter 2008, we invested $14.8 million in capital expenditures, double the $7.4 million invested in the first quarter last year. Capital expenditures will remain at high levels in 2008 as we expand to take advantage of the outstanding secular growth opportunities in wind energy. We currently expect capital expenditures to be approximately $70 million to $75 million in 2008. Free cash flow for the last 12 months ended March 29, 2008, totaled $7.4 million as compared to free cash flow for the last 12 months ended March 31, 2007, of $63.4 million. The comparative reduction was due to the $31.9 million increase in capital expenditures and lower cash from operating activities. The lower cash from operating activities was due primarily to the increase in pension contributions and increased working capital, again to support our sales growth. Free cash flow should be viewed as supplemental data rather than as a substitute or alternative to the GAAP measure. We’ve included in our earnings release a reconciliation of this metric to the most comparable GAAP measure for your reference.

Cash and cash equivalents for short-term investments totaled $276.2 million at the end of the first quarter this year as compared to $287 million at the end of 2007, and long-term debt remains unchanged at $200 million equal to 28.9% of total capitalization. During the first quarter, we paid dividends of $4.2 million or 15 cents per share, repurchased $7.6 million worth of common shares, and invested $14.8 million in net capital expenditures. During the quarter, we incurred approximately $800,000 of additional depreciation and amortization associated with acquisition accounting at Avon. In addition, we incurred direct startup costs associated with our wind energy expansion totaling approximately $500,000, and relocation and workers’ compensation costs at our sealing products business totaling approximately $700,000. We also incurred significant expenses associated with our efforts to grow our market share in international markets.

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

James O'Leary

Thanks Ken. As I noted at the top of the call, we’re pleased with the results achieved in the first quarter of 2008 which came in pretty much as expected if you listened to our prior quarter call, but more importantly, we made significant progress on our long-term growth initiatives. Our accelerated and increased expansion in the large-diameter bearing market and our re-prioritized efforts to grow our market share in high-growth developing countries such as China and India should yield considerable benefits as we move into the second half of 2008 and into 2009. The record bookings achieved in the first quarter leaves us with the highest backlog in Kaydon’s history. Our continued penetration in the fast growing wind energy market bolstered by last year’s acquisition of Avon bearings positions as well for the balance of 2008 and beyond. While margins in the first quarter were lower due in part to the direct and indirect costs associated with this expansion and sealing products relocation, we’ve positioned the company to take maximum advantage of the secularly strong wind energy market and the opportunities available to us to expand our international market share. These will benefit us increasingly as the year progresses and we expect meaningful gains in the latter half of 2008 as the capacity comes online in our key growth markets. The company’s recent and ongoing investments to expand capacity for large-diameter wind energy bearing and to increase our international sales effort 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 make comparisons with the first two quarters of 2007 difficult and will affect the first-half comparisons really exactly as we discussed in the prior quarter and we will not do it today. The cost associated with our initiatives, and the interest issue impact comparability to the first two quarters of last year. However, we expect to begin realizing the benefits of these programs during the end of the second quarter and for the full year of 2008. At the present, we continue to expect earnings per share growth for the full year to exceed our annual average target of 10% to 12% as the benefit to these initiatives contribute significantly to the last half of 2008 and into 2009.

In summary, we’re pleased with our first quarter results, our record quarter back-end backlog positions us well for the balance of 2008 and beyond as we expand our internal capabilities to serve segments enjoying strong secular growth. We expect meaningful gains during the latter half of 2008 as capacity comes online in our key growth markets, and more importantly, beyond 2008. We believe we’re taking all the appropriate measures to maximize shareholder value well into the future. With our strong balance sheet and financial flexibility, we’ll continue to drive internal growth while selectively evaluating external opportunities. Finally, I’d like to thank each of our Kaydon employees for their efforts this quarter. They are our most valuable assets, and I’d like to than them each for their contribution to this quarter. And with that William, we’ll turn it back over to you to moderate Q&A.

Question-and-Answer Session

Operator

The question-and-answer session will be conducted electronically. If you’d like to ask a question, please do so by pressing the * key followed by the digit 1 on your touchtone telephone. If you’re using a speaker phone, please make sure your mute function is turned off till allow your signal to reach our equipment. We’ll proceed in the order that you signal us and we’ll take as many questions as time permits. Once again, please press *1 on your touchtone telephone to ask a question. We’ll move to our first question from Holden Lewis - BB&T Capital Markets.

Holden Lewis - BB&T Capital Markets

Thank you. Good morning.

James O'Leary

Hey Holden, how are you?

Holden Lewis - BB&T Capital Markets

I’m fine, thanks. I wanted to ask you about the margins, I guess, in a broad sense – I think, you go back to 2006 and you were sort of running your gross margins, 41% to 42%, lately off it has been depressed – there just seems like there is a lot of moving pieces here – the Avon accounting, the depression from the constructions, the mix of Cooper bearings, the margin from wind – that comes on, I guess that’s somewhat lower than your past corporate average, but of course the impact of sealing – when all of this smoke kind of clears from all of these things, sort of at the end of 2008, I mean where would you expect in general terms for the gross margin to settle in at once all those moving pieces are resolved? Do you have any sort of guidance for that?

James O'Leary

In total, in aggregate, I’d say low 20s to mid 20s, and I’m glad you used the fourth quarter of 2006 because that is probably the high water mark as we’ve discussed both on prior calls and in one-on-ones and in group presentations – that’s the high water mark in the quarter that probably is not repeatable, certainly not in this cycle – the mix of business was very orientated towards – as we talked about these military orders – very orientated towards legacy military programs, extremely high margin that ran through some of our more profitable facilities; we had not yet begun any of the capacity expansion that we’re talking about now, so if you looked at our capital spending over the preceding 5, 10, or 20 years, expect for a few major projects we’re spending 2% to 4% of sales – was barely maintenance – the real expansion efforts now which we’re seeing in wind energy didn’t start until the first quarter of 2007; so you have the two things, mix that is heavily weighted towards legacy programs, particularly in military, is before the explosion in growth at Cooper split roller bearings which you know now in terms of operating margin are getting close to 20%, but that’s still lower than the overall average of the company, so you’ve got extremely high margins but lower than the highest margins in the industry – I think that’s still something we take all day long if it continues to grow at the rate it has been, and capacity utilization met – if you’re growing beyond the 400 million sales base that we’d averaged over the preceding 10 years, it will be pretty tough to repeat that type of performance, so when all this settles in a steady state with the capacity we’ve got coming online and the existing mix, particularly you’ve mentioned Cooper, but that’s a good one to point to, it’s probably in the low to mid 20s operating margin.

Holden Lewis - BB&T Capital Markets

Okay, and that compares to – I think it’s fixed – your operating margins – of about 24.4 – so, I mean, it’s not like you feel like your margins are going to step down much when everything clears out from where you’ve been in the past.

James O'Leary

We’re talking 24 to 29-ish…

Kenneth W. Crawford

Yeah. I think that the mid 20s is certainly attainable, that’s our plan at this point, and we also intend to have a gross margin that is in the low 40s again by the time all this dust settles – so you’re taking about a gross margin that may not get to 42, but it certainly will be something that starts with a 4 and operating margins in the 24-25% range is certainly our plan.

Holden Lewis - BB&T Capital Markets

Okay, and then the expenses for the wind expansion, obviously you continue to incur those. Have you accelerated those, so may be the cost we incur in 2009 may be less than what we’re doing in 2008, or are you just sort of assuming given the growth there that you’re going to sort of see a steady state of expenses even going out into 2009?

James O’Leary

I think it’s steady state. Because of the capacity constraints and largely when you can order equipment, there’s not a lot we can do to accelerate the things such as hiring, trading, and the like around them, so as long as you’re adding capacity, you’ll have some of those issues, but as we have in the past, we’ll be very explicit about when that capacity gets added, when it comes online, and the cost associated with it, but there is nothing being frontloaded for that from 2009 because you really can’t – we’re constrained by when the equipment arrives and when the infrastructure is ready.

Holden Lewis - BB&T Capital Markets

Okay, alright. Great, thanks guys.

James O’Leary

You’re welcome Holden, thank you.

Operator

We’ll move to our next question from Peter Lisnic - Robert W. Baird & Co., Inc.

Peter Lisnic - Robert W. Baird & Co., Inc.

Good morning gentlemen.

James O’Leary

Hi Pete. Good morning.

Peter Lisnic - Robert W. Baird & Co., Inc.

Do you mind giving out the exact wind order number and then what the Avon impact was on orders as well?

James O’Leary

Thought we did give out the exact number; 80 million in total and about 65 was the large single order.

Peter Lisnic - Robert W. Baird & Co., Inc.

Yeah, you said over 80, I didn’t know if that was an exact. That’s okay.

James O’Leary

Close enough. Ken, you got the Avon stuff?

Kenneth W. Crawford

Avon’s wind orders were relatively minor in the first quarter around $2 million.

Peter Lisnic - Robert W. Baird & Co., Inc.

Okay, alright. Thank you for that. And then just a followup on Holden’s question on the cost that you’ve incurred to ramp wind, I thought in the fourth quarter, we were looking at like a $2 million number that you were talking about for this quarter, and then I thought I heard $500,000 as kind of the incremental expense in the first quarter here, so….

Kenneth W. Crawford

Yeah, the $2 million was the combination of the wind ramp up, the Baltimore to Mocksville relocation, and also the cost associated with penetrating some of these distant markets that we’ve talked about – China, India, and others, and as we indicated I think in both the press release and the prepared remarks, wind energy was $0.5 million, the relocation expenses combined unfortunately with a fairly significant workers’ comp charge was another $700,000, and then we had significant costs associated with penetrating those distant markets that we didn’t quantify.

Peter Lisnic - Robert W. Baird & Co., Inc.

Okay.

Kenneth W. Crawford

So the $2 million – we got close to in the quarter.

Peter Lisnic - Robert W. Baird & Co., Inc.

Okay, alright. And then Jim, longer term I guess, if you’re looking at, you’re basically firing at all cylinders – any changes in the long-term strategy in terms of growth opportunities for wind in China and India acquisitions, any change in thinking along those fronts.

James O’Leary

No. I think at the top of the call I said the quarter came in about where we expected; we’re happy. I think more importantly, the quarter came in as we needed it to for the rest of this year, and more importantly into 2009 and beyond. The growth opportunities we’ve identified and we added investment to almost quarterly during last year to make about two additional expansions, last quarter the acquisition of Avon, and there are other little expansions to improve throughput that we’ve done along the way that you’ll see in our CapEx numbers by the time the year is out – we’re expanding to bolster up what we’re doing in the energy infrastructure market, an incredibly hot market that continues to get stronger. The backup, I wouldn’t say alternative use of equipment, but where else can this equipment be used – this heavy equipment – and if you go through the [__________], the guys servicing heavy industrial usage globally, all those guys are reporting record backlogs; that is the other use for this equipment and for the capacity expanded – so in terms of secularly strong growth markets, we’re very confident we made all the right steps over the last year and we’re continuing to focus on it, and I think you’ll probably see more capacity expansions over the next few quarters; whether or not it comes in the form of large offshore manufacturing or adding to what we’ve got already, it’ll depend on the opportunity and which customers and which markets we’re prioritizing at that point, and that’s constantly influx – I would say we have several anchor clients, one in particular, and we’re looking at where we can grow with the guys going to be growing for the next 5, 10 plus years. In terms of internationally, if you look at the velocity control segment in particular, we had a great relative to the past couple of years’ quarter North American business, but internationally, this continues to exceed our expectations from our facility in Germany, we’re seeing great improvements all throughout the markets they serve, which would include eastern Europe, they’ve taken over custody of growing our Indian operation which we announced and are in the process of setting up over the next few quarters, our filtration businesses, we’ve added an office in China, we’re looking to add an office in India, we’ve added international sales people throughout positions in our liquid filtration business; so I think all the actions that we’re taking are around two principal growth objectives which will contribute meaningfully to a company of Kaydon’s size which is large turntable business focused on energy infrastructure, the global heavy equipment market, and international, where we’ve talked a number of times about the fact that we’re probably a bit under-represented compared to the peer group. We’re seeing right now considerable progress and we see huge opportunity going forward.

Peter Lisnic - Robert W. Baird & Co., Inc.

Okay, that’s comprehensive, thanks and well done.

James O’Leary

You’re welcome, thank you.

Operator

We’ll move to our next question from Walter Liptak - Barrington Research.

Walter Liptak - Barrington Research

Hi, thanks, good morningthis is Walt with Barrington.

James O’Leary

Hi Walt.

Walter Liptak - Barrington Research

Hi. I just want to back up and just go over the order entry again and make sure I’m doing the math right – your orders were up $86 million year-over-year – that’s your incoming order growth right—the 204, and last year, you were at 109…

James O’Leary

No, last year we were at 142.

Walter Liptak - Barrington Research

Okay, last year 142, okay. I may have to go over….

James O’Leary

The 109 was non-wind – Walt – we had $32 million in wind last year.

Walter Liptak - Barrington Research

Okay, right. The 109 is non-wind, okay so if you back out the non-wind, it looks like your non-wind orders are up 27% from last year, is that right?

James O’Leary

Our non-wind orders are up from 109 to 123 – I don’t think that’s 27%.

Walter Liptak - Barrington Research

Okay, still a pretty decent growth.

James O’Leary

Right.

Walter Liptak - Barrington Research

Okay great. And then, you kind of addressed this with the first question – the margins in the large wind power orders – can you just quantify it or just talk a little bit more about how you feel about the pricing on that?

James O’Leary

We’re extremely happy with the pricing on it. The margins will come in consistent with in the low 20s and mid 20ish overall corporate average that we’ve talked about, it’ll be on the lower end because of the nature of the product, and the growth opportunity in it. As far as the pricing, we’re very happy with it. I think as we talked about in previous quarters, to start off this investment we focused on margins and return on capital, and we executed some contracts that protects both over the long-term nature of the investment. Around that, we’ve added some customers, we’re pricing more towards market, but we’re not going out and speculatively trying to grab the highest price for short orders – we’re trying to develop relationships with people that will go out for, in some cases 5 plus years, so we balance return on investment, margin protection with we think attractive pricing with everyone we do business with, without being perceived as gouging a short-term opportunity, so without going into specific pricing – where it’s lost, where it’s made, and who the customers are, all I can tell you is we’re pretty happy with it.

Walter Liptak - Barrington Research

Okay, can you tell us how many customers you’ve got in wind now?

James O’Leary

Over five.

Walter Liptak - Barrington Research

Okay, and then if I could go back over to the cost, the marketing initiative, can you quantify the incremental cost in this quarter and for next quarter?

James O’Leary

For international?

Walter Liptak - Barrington Research

Yeah, for international.

James O’Leary

The reason we didn’t do that, I think the $2 million that we left you guys with is probably about right. I think it’s $1.3 in total between the sealing products which is easy to identify, and the wind expansion which is relatively easy to identify. We are kind of at the point where a lot of the balance of the $700,000 is starting to blend in to ongoing operations, so I don’t feel like we’re doing you a service by saying those are nonrecovering going forward. They’re melding into existing operations; they are beginning to produce income, so tell you that for the next three quarter, it will be $2 million, although it’s starting to generate sales and profit, doesn’t feel like the right thing to do. The initial costs we handicapped at about $700,000—the balance of that $2 million, but going forward they are part of our ongoing operations. Carving them out separately not only is difficult, I don’t think that’s the right way to present it to you.

Walter Liptak - Barrington Research

Okay, great!

James O’Leary

Does that make sense?

Walter Liptak - Barrington Research

Yeah.

James O’Leary

Okay.

Kenneth W. Crawford

Yeah, Walter, it’s really more of a first quarter ’08 compared to first quarter ’07 comparison in that differential because those costs, as Jim said, are built into our infrastructure currently.

Walter Liptak - Barrington Research

Okay, got it. Alright, thanks guys. Have a great day.

James O’Leary

You’re welcome. Thank you Walt.

Operator

We’ll move to our next question from Nigel Coe of Deutsche Bank.

Nigel Coe – Deutsche Bank Securities

Thanks good morning! Just want to pick up on a couple of points just discussed.

Kenneth W. Crawford

Have you changed the pronunciation of your name?

Nigel Coe – Deutsche Bank Securities

Yeah, I’m actually trying to keep a low profile here.

Kenneth W. Crawford

Hi Nigel, how are you?

Nigel Coe – Deutsche Bank Securities

Good, thanks. You made the point that you feel pretty good about the margin protection you got, which is pretty important given your backlog. It sounds like you are pretty comfortable with the price tags you got there, but steel prices are on a tear. Would it be fair to say that maybe there’s some lag between seeing the inflation actually puffing out through?

Kenneth W. Crawford

It wouldn’t be fair. You would be explicitly correct, and we talked before that a lot of the margin arrangements we have with customers who understand the need to help protect our return on investment for the long term operates at a quarter lag or quarter to 6 months lag. We present them with invoices and loaded costs and you catch up, so in a constantly increasing environment, you are shooting about a quarter or two behind the curve, you catch up when it flattens out, and you pick up when it goes down, but you are not happy when you are picking up because it’s going down.

Nigel Coe – Deutsche Bank Securities

Okay, and then secondly on the international costs, you just talked a little bit about that, but would you be able to share maybe the revenue contribution from these initiatives? What would you think would be a good number in your mind for 2009 as a payback?

Kenneth W. Crawford

As a payback?

Nigel Coe – Deutsche Bank Securities

Yes.

Kenneth W. Crawford

The payback when you look individually—it’s a good time to ask because we just went through some of our business plan reviews for the quarter—we are typically looking at 3- to 4-year paybacks on adding some of the infrastructure. I think it’s a bit misleading because you usually have a year or two where you’re paying salespeople and the like and not really getting meaningful pickups. I would say Cooper was well ahead of that because they just hit the sweet spot of the curve with Far East, particularly China and India. I think Filtration will do better. In fact, we have pretty high hopes that they are going to do better, but I’d say probably 3 years is not a wrong way to look at the payback. The tough thing about looking at a payback on period cost is it’s different than capital. It’s much harder to run a DCF on that type of thing, but when we look at these as standalone entities, and we have nothing else around them, no other contribution, no other incremental benefit, I’d say probably about 3 to 4 years is when we’re expecting them to contribute. It’s been better than that so far.

Nigel Coe – Deutsche Bank Securities

Okay, great! Finally, you talked about the ramp up on the wind toward the latter end of this year. Would it be fair to say that’s more of a 4Q than a 3Q issue?

Kenneth W. Crawford

When the contribution begins?

Nigel Coe – Deutsche Bank Securities

From when, yeah, when we start seeing that ramping up.

Kenneth W. Crawford

It starts getting pretty meaningful in the third quarter. It’s very meaningful in the fourth, and then you would have a run rate in excess of $100 million, although the contribution for the year will be less than that, so I’d say it should start in the third quarter, accelerate in the fourth, and you’ll see a pretty big pick up in the second as well, but not as meaningful as the third and fourth.

Nigel Coe – Deutsche Bank Securities

Okay, and then just to run that out, so 1Q, you think you’ll be at the $100 million plus run rate, 4Q you can better that?

Kenneth W. Crawford

In excess of that by first quarter of 2009.

Nigel Coe – Deutsche Bank Securities

Thanks Jim

Kenneth W. Crawford

You’re welcome, Nigel. Thank you.

Operator

We’ll take our next question from Ian Fletcher, SBR Capital Markets.

Ian Fletcher – SBR Capital Markets

Hi, Good Morning!

James O’Leary

Hi Ian, how are you?

Ian Fletcher – SBR Capital Markets

On Seals, could you just touch on the decline in volume? Is any of that related to the movement of the facility or is it some other factors?

James O’Leary

I think it’s largely timing. I think the hydrocarbon processing markets slowed down a bit. The orders picked up considerably, and it largely had to do with legacy aerospace programs. We are seeing continued strength on commercial aerospace, but I’d say it’s largely little bit of a slowdown on hydrocarbon processing and a little bit on timing. We didn’t talk exclusively about it, but the nature of how people were placing orders in terms of bigger orders versus more even flow smaller batch continued to be the case. It just wasn’t significant enough to mention this time. I’d say a little bit of softness, maybe people holding their fire to see how the economy goes in hydrocarbon processing, offset particularly in the order rate because the orders were still pretty strong and picked up in commercial aerospace.

Ian Fletcher – SBR Capital Markets

Right! On Velocity Controls, can you talk about maybe how the weak dollar is benefiting you with respect to exports and to your distribution facility in Europe?

James O’Leary

Sure. I am now going to use that question to kind of go off on a modest tangent about dollar and our international sales. As we’ve talked about, our international sales are about 30% of the total company, but I’d say the benefit we’re getting from robust international economies, global infrastructure build-out, and currency, i.e., it makes dollar-denominated products more attractive. It’s considerably greater than the 30%. A lot our wind energy orders are shipping FOB to a domestic point, but we know they’re going somewhere else. It’s just harder to track, because in some respects, our customers don’t know. That same dynamic plays out with a lot of the things we make, and I’m going to back Velocity Controls. If you remember, our products are small pieces of big systems. In a lot of cases, they are components of aerospace products, energy infrastructure products, other things which are much bigger systems, many of which are ending up overseas, so our FOB destination may not necessarily give you the whole story, and in the case of Velocity Controls, we are helped by the strength internationally in a number of areas. Very easy one is we have a German facility; it services Western Europe, Eastern Europe, now India, and a number of other markets going great; record quarter after record quarter. We pick up considerably when you translate euros to dollars, so you’ve got two very easily quantifiable benefits. The other benefit in our North American facility is one of their principal customers—yes, it does get eliminated inter-company, but one of their principal customers is through Germany and out through the rest of Western Europe and Eastern Europe, and we also have a pretty reasonable export market, but in some cases, because our product goes to capital manufacturers who are shipping elsewhere, that’s harder to quantify, so I’d say we are getting a number of benefits from strength overseas, weakness of dollar, and currency in Velocity Controls. Two are very easily quantifiable, one is not, and then if you extend that to the other parts of our business particularly wind energy, we’re absolutely benefiting from strength overseas. We are absolutely benefiting from global infrastructure build-out. It’s just harder for us to quantify in that 30% because of who and how we ship to.

Ian Fletcher – SBR Capital Markets

That’s very helpful. Thanks very much.

James O’Leary

You’re welcome. Is that it, Ian?

Operator

We’ll take our next question from Peter Thompson, Coho Partners.

Peter Thompson – Coho Partners

Good morning, Jim and Ken.

James O’Leary

Good morning.

Peter Thompson – Coho Partners

Can I just ask you guys—if you disclosed it, I didn’t catch it—the wind number in the backlog?

James O’Leary

It’s about $150 million in our $320 million backlog.

Peter Thompson – Coho Partners

Great! Could you comment at all on your thoughts on the $200 million convert that’s coming due next month?

James O’Leary

Yeah. For a background, we have a convertible that was issued about 5 years ago, deeply in the money, coming due, and we will evaluate it. I can’t tell you unequivocally what we’ll do. I will tell you the right thing is probably to step up repurchases both before and after as we have talked about on prior calls and as we’ve talked about on presentations. Whether or not it makes sense to take it out really depends on prices stuck. There’s a very healthy contribution of tax benefit from having this instrument outstanding. Alternative uses of cash—I mean in the last year, we put to work $100 million that previously was sitting on the balance sheet earning 5%, now 3.4%. We are starting to see the acquisition market get a little bit better. We will have, I would say, significant capex in the markets we’ve talked about going forward as well, so it’s not obvious that retiring it is the right thing to do. It is obviously probably putting more to work in the form of share repurchases is, and how we balance the two we’ll talk about it a little bit more on our next quarter.

Peter Thompson – Coho Partners

Does it have to be an all or none type of deal?

James O’Leary

No, but the mechanics of how you do it, the signaling given that you’d have to give note-holders 5 days or a number of days or perhaps a month to tender. There can be a pretty significant run up in the price and a pretty big economic cost to you and our shareholders, so again if your alternative is stepped up repurchase versus calling it, it’s not obvious that calling is the right thing to do.

Peter Thompson – Coho Partners

And can I ask just one last one about just wind? Is it all in the friction area or is there some of it velocity, and I’m just trying to…

James O’Leary

What we’ve talked about is pretty much all in friction; however, we just went through our filtration products business review, and some of the filtration/oil separation products that we sell are going to turbines or people that we hadn’t previously thought of, so there are some knock-on benefits, but I’d say grossly predominantly the lion’s share is friction control.

Peter Thompson – Coho Partners

Perfect. Thanks so much and a great quarter, you guys!

James O’Leary

You’re welcome. Thank you very much.

James O’Leary

William, we’ve got time for one more if we’ve got one.

Operator

Absolutely! We’ll take our next question from Richard Marshall of Longbow Research

Richard Marshall – Longbow Research

Hi, Good Morning!

James O’Leary

Hello, Richard, how are you?

Richard Marshall – Longbow Research

I’m okay. Just a quick one on the wind power—what impact has the uncertainly of the PTC credits had on wind orders to this point? Has it seen either any acceleration in orders or any cancellations possibly there?

James O’Leary

None. I’d say it’s had no impact whatsoever. Our customer is the turbine manufacturer, his customer is typically a utility putting up to own or operate the wind farm, and these guys are booked out through ’09 and now in some cased into ’10 irrespective of PTC, and I believe that contracts are written in a fashion that addresses the cancellability on those types of issues, so PTC has had no impact now going out for at least two to three years. We see no cancellations. We’ve seen an acceleration in demand. I’d say the current state of that issue—it’s been passed through Senate, has to get through Congress. I think for a politician to say they think it’s a bad idea is arguing for spousal abuse or kicking your dog. I just don’t see that as being an issue. There are competing issues as far as other uses of energy. Coal obviously is a big political issue given that it is an alternative to wind. We’ve got to be recognizing that, but today, different than the last bust, there’s renewable portfolio standards in most of the states—over 50% of the states, a number of companies have imposed upon their suppliers carbon emission audits and carbon emission expectations. Last week, one of the bodies who track this said that carbons emissions in 2007 and in the early part of 2008 were dramatically worse than they expected, so there’s nothing about the macro backdrop that tells us there are going to be issues with supporting wind energy, particularly off a ridiculously small base in an extremely large country like the United States. That would play out even more so when you look at China and India. I think we’ll see a lot of that at the Olympics this year.

Richard Marshall – Longbow Research

Okay. Looking at the big wind order that you had—the $64 million order, is that with a new customer or is that with your existing customer base?

James O’Leary

That would be within our existing customer base.

Richard Marshall – Longbow Research

Can you just quickly give us an update on the capacity expansion in Mexico and how that’s going?

James O’Leary

It’s pretty much going exactly as we’ve talked about. By the end of the year, we’ll be at a run rate of 125, so it will be in excess of $100 million. As we go into the first quarter of next year including Avon, our overall capacity will be closer to 150 million. It’s going exactly as we’ve talked about, and we’re looking at additional opportunities to enhance and expand that, but it will be based on demand as we go, and demand continues to get stronger.

Richard Marshall – Longbow Research

So, there’s no change to the forecast for wind sales of $80 million this year and $130 million next year. Is that correct?

James O’Leary

That’s what we said before. That sounds right.

Richard Marshall – Longbow Research

Okay. I just heard you throw out $150 million. I wasn’t sure…

James O’Leary

That’s capacity.

Richard Marshall – Longbow Research

Okay, alright. And just one quick thing on the Velocity Controls. You mentioned foreign currency, but you didn’t really quantify it. Can we get a quantifiable number on that one?

James O’Leary

Sure. On that segment itself, on the topline, it would have been about a million, and on the operating margin, it would have been about half of that, and on a consolidated basis, you basically double those two numbers--$2 million and $1 million.

Richard Marshall – Longbow Research

Just so that we understand better, the Velocity controls, can you tell us a little bit about the end markets that are driving that if there are specific ones that are really humming, especially overseas?

James O’Leary

It is industrial capital spending, it’s for presses, these are industrial shock absorbers. Velocity control products including hydraulic dampeners, gas springs, and the end markets including virtually every aspect of capital spending continues to be strong, and we are holding our breath waiting for it to slow down as well, but this was the best quarter our North American operations have had in a while, and we think it really is execution. We think we’re outperforming a number of people in the market place. Whether or not we are taking share, I can’t give you an exact number on that because there’s a limited number of competitors, but we think we are out-executing people in North America, and in our European operations, all the industrial numbers, particularly those that are CapEx driven still seem pretty strong, so all still good.

Richard Marshall – Longbow Research

Great! Alright, that’s all I’ve got. Thanks.

James O’Leary

You’re welcome. Thank you.

William, if we have anybody else holding, we’ll take one more; otherwise, I think it’s maybe time to kill it. You’ve got anybody else?

Operator

We’ll move to our final question from Tim Curro of Value Holdings.

Tim Curro - Value Holdings

This was pretty much answered, but regarding the share repurchases, you’ve averaged about 7 million a quarter for the last few quarters. Should we expect that expenditure to increase given your earlier comments regarding the convert?

James O’Leary

I think we said it’s been 7, but we talked about this as a predominant use of free cash flow given the size of the cash on the balance sheet. I think 7 is the minimum and you may see a bit heavier, but that’s a board decision, and we talk about it at least quarterly.

Tim Curro - Value Holdings

Alright, thank you very much.

James O’Leary

You’re welcome. Thank you.

William, I think we’re going to call it a day.

Operator

And that concludes our conference for today. We thank you for your attendance, and have a nice day!

James O’Leary

Guys, thank you very much and thank you for attending!

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