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Mueller Water Products, Inc. (NYSE:MWA)

Q2 2008 Earnings Call

April 30, 2008 9:00 a.m. EST

Executives

Martie Zakas - SVP, IR

Greg Hyland – Chairman, President, and CEO

Mike Vollkommer – CFO

Analysts

Keith Huges – Suntrust Robinson Humphrey

Mike Schneider – Robert Baird

Kevin Maczka – BB&T Capital Markets

Brent Thielman – D.A. Davidson

Matthew Ermous

Operator

Welcome and thank you for standing by. At this time all parties have been placed on a listen only mode until the question and answer session. (Operator Instructions) I would now like to turn the call over to Martie Zakas. Thank you, you may begin.

Martie Zakas

Thank you Wendy. Good morning everyone, and thank you for joining us today as we discuss Mueller Water Product’s results for the 2008 second quarter. We issued our press release reporting earnings for the period ended March 31, 2008 yesterday afternoon and a copy of it is available on our website.

Slides related to this morning’s call are also available on the website to help illustrate the quarter’s results. In addition, we have filed a copy of this morning’s calls prepared remarks on Form 8-K.

Mueller Water Products had 115 million shares outstanding as of March 31, 2008 which is comprised of 85.8 million Series B shares and 29.2 Series A Shares. With us on the call this morning are Greg Hyland, our Chairman, President, and CEO; and Mike Vollkommer, our CFO.

In our press release and on this call we referenced certain non-GAAP financial measures which were derived from GAAP financial measures. These non-GAAP measures are provided, because management finds this financial data useful.

We believe this will assist the investment community in assessing the company’s underlying performance for the period being reported. Reconciliations between GAAP and non-GAAP financial measures are included in the supplemental information within our earnings release.

This morning we will refer to adjusted income from operations, adjusted net income, adjusted EPS and adjusted EBITDA, all of which exclude the previously announced Burlington restructuring charges in fiscal 2008. These numbers are provided in the press release.

On today’s call we will make forward-looking statements in accordance with the Safe Harbor Provision of the Securities Litigation Reform Act of 1995. Remarks containing words such as expect, believe, anticipate and project, constitute forward-looking statements. They are not guarantees and such statements involve risk and uncertainties that could cause actual results to differ materially from these statements. Please see our Form 10-K for the fiscal year ended September 30, 2007 for a discussion of these risks.

This morning’s call is being recorded and webcast live on the internet. The archived webcast along with the corresponding slides we are presenting this morning will be available in the investor relation section of our website www.MuellerWaterProducts.com for at least 90 days after the presentation. After the prepared remarks we will open the call to questions from our dial-in participants.

I’ll now turn the call over to Greg.

Greg Hyland

Thank you Martie, and good morning everyone. We appreciate you joining us this morning as we discuss our results for the second quarter of fiscal 2008. I’ll begin today with a brief overview of the quarter. Mike Vollkommer will then follow-up with a detailed financial report after which I’ll update you on our strategy, key drivers influencing our business, and our outlook for the second half of the fiscal year. We will then open the call up for your questions.

Our second quarter results reflect the current state of residential construction, rising raw material costs, and the general uncertainty of the economy. We saw much less of a seasonal up tick in shipments this quarter compared to what we traditionally see in the second quarter. Raw material costs were higher in the quarter on a year over year basis, and they continue to increase in April.

Rising raw material costs will remain a challenge since the higher prices we paid during the second quarter. And in April, we’ll flow through our results in the second half of the year. Net sales for the 2008 second quarter totaled $421.6 million. Adjusted income from operations was $29.5 million. And adjusted net income was $6.6 million or 6 cents per diluted share.

The adjusted operating income margin was 7%. And adjusted EBITDA margin was 12.4%. These results were adjusted for the $1.5 million of restructuring charges recorded in the second quarter associated with the February closure of US Pipe’s manufacturing facility in Burlington, New Jersey.

Net sales for the 2008 second quarter were down 8.3% compared to the 2007 second quarter. Sales in our Mueller Company Business Unit declined $27 million or 13.8%. US Pipe sales declined $15.5 million or 12%.

Our business continues to be impacted by unprecedented rising raw material costs. The year over year impact of which was $12.1 million during the quarter. Cost savings in the quarter of $10.8 million reflect our determination to reduce both fixed and variable costs. I’ll talk about these initiatives in our continued plans later in the call.

I’ll now turn the call over to Mike Vollmokker who will discuss our financial results for the second quarter in more detail.

Mike Vollmokker

Thanks Greg. I’ll start by reviewing the consolidated results and then discuss segment performance. Consolidated net sales of $421.6 million in the 2008 second quarter decreased $38.1 million year over year due to $51.8 million of lower shipment volumes principally caused by the continued difficulties associated with residential construction. Lower volumes were partially off-set by $6.4 million of higher pricing and a $7.2 million favorable impact from Canadian currency exchange rate.

Gross profit was $98.8 million in the 2008 second quarter. It decreased $19 million compared to $117.8 million in the 2007 second quarter. Gross margin was 23.4% compared to 25.6% in the prior year period. The decline in gross profit was primarily impacted by $16.8 million from lower shipments and $12.1 million of higher raw material cost which exceeded sales price increases of $6.4 million.

Cost reductions of $10.8 million off-set the negative impact of $10.3 million of under absorbed overhead resulting from reduced production levels. Selling, general, and administrative expenses were $69.3 million in the 2008 second quarter compared with $64.1 million in the 2007 second quarter. The increase was primarily due to a $1.1 million provision for doubtful accounts, higher administrative costs largely associated with realignment of Vendrell’s Canadian Manufacturing and Distribution Operations, and the comparative impact of Canadian currency exchange rates.

The 2008 second quarter results also included cash restructuring charges of $1.5 million comprised of severance and other costs in connection with the previously announced closure of US Pipe’s manufacturing operations in Burlington, New Jersey. Last November the company announced its intention to cease manufacturing at this facility and convert it to a full-service distribution center for customers in the northeast. This initiative remains on schedule and within our projected costs.

Year to date the company has recorded $17.7 million of total restructuring charges of which $14.8 million are non cash asset impairment charges. And $2.9 million are cash charges related to employee severance and other closure costs. Final cash restructuring charges of about $1 million are expected to be incurred in the second half of fiscal 2008.

Income from operations, adjusted for the restructuring charges, was $29.5 million compared to $52.9 million in the 2007 second quarter. Second quarter 2008 adjusted operating income margin and adjusted EBITDA margin of 7% and 12.4% respectively compare with the 2007 second quarter margins of 11.5% and 17% respectively. The margin declines were principally from the impact of lower shipments and higher raw material costs.

Interest expense, net of increase income declined $3 million to $18.1 million in the 2008 second quarter compared to $21.1 million in the 2007 second quarter. Gross interest expense totaled 19.1 million in the 2008 quarter compared with 21.7 million in the prior year quarter, reflecting a benefit for the May 2007 refinancing, reduced debt levels, and lower interest rate.

Our effective tax rate was 42.4% in the 2008 second quarter compared with 43.7 percent in the 2007 second quarter. Diluted earnings per share was 6 cents on an adjusted basis excluding the restructuring charges and was 5 cents per share on a GAAP basis. The compares with diluted earnings per share of 16 cents in the 2007 second quarter.

I’ll now move on to the segment performance. Net sales for the Mueller Co. segment were $168.9 million in the 2008 second quarter compared to $195.9 million in the prior year quarter. Net sales declined primarily due to reduced volume of $31.7 million, partially off-set by higher pricing and favorable Canadian currency exchange rates.

Shipment volumes of iron gate valves and hydrants declined 17.6%. And brass service products declined 41.6% in the quarter, primarily due to the soft market associated with the continued downturn in residential construction. Income from operations is $27.4 million an EBITDA of $39.7 million in the 2008 second quarter, compares to income from operations of $42.8 million and EBITDA of $55.8 million in the 2007 second quarter.

Volume declines reduced profits by approximately $12.7 million. Higher sales pricing of $2.8 million did not off-set a $4.2 million increase in the cost of raw materials and purchased components. And the negative impact of reduced production, which resulted in under absorbed overhead of $6.8 million, was partially off-set by cost reductions of $4.5 million.

Net sales in the US Pipe segment of $114.2 million in the 2008 second quarter decreased from $129.7 million in the prior year quarter. Both periods reflect full quarter results for the January 2007 acquisition of Fast Fabricators. Lower shipment volumes as a result of overall weakness in residential demand and a less favorable product mix caused $16 million of the decline. Slightly higher pricing only partially mitigated this decline.

Loss from operations of $2.8 million in the 2008 second quarter includes the cash restructuring charges of $1.5 million. Excluding these charges, adjusted loss from operations was $1.3 million and adjusted EBITDA was $4.1 million. These results compared to income from operations of $6.8 million and EBITDA of $13 million in the 2007 second quarter.

2008’s second quarter operating income was negatively impacted by $7.5 million of higher raw material costs and $3.8 million due to lower shipments and a less favorable product mix. Cost savings of $6.3 million realized during the quarter helped reduce the impact of negative factors such as higher raw material costs and lower shipments.

Net sales in the Anvil segment were $138.5 million in the 2008 second quarter compared with $134.1 million in the prior year quarter. The net sales increase was driven by a $5.4 million favorable impact of Canadian currency exchange rates and higher sales pricing partially off-set by volume declines.

Income from operations of $12.9 million and EBITDA of $17.9 million in the 2008 second quarter compares with 13.6 million and 19.3 million respectively in the 2007 second quarter. The 2008 second quarter operating income was primarily impacted by administrative expenses associated with the Canadian realignment, lower volumes, and slightly higher raw material costs. Currency exchange rates had an immaterial impact on income from operations.

Before I turn the call back over to Greg I will review cash flow. Cash provided by operating activities in the 2008 second quarter amounted to $4.8 million compared to $32.8 million in the 2007 second quarter. And historically, the second quarter is our weakest operating cash flow quarter and at times has been negative due to the typical seasonality of the business.

However, this was not the case in 2007 when the second quarter was stronger than the first quarter, primarily due to timing of receivable collections between the two quarters. On a fiscal year to date basis, free cash flow, which is cash from operating activities less capital expenditures, amounted to $23.4 million in the 2008 first half compared with $14.2 million in 2007. This is a $9.2 million improvement. For the second half of fiscal 2008 we expect to see positive free cash flow that follows business seasonality.

Net debt as of March 31, 2008 was $978.2 million, a decrease of $81 million from March 31, 2007 and a decrease of $23.4 million from our prior fiscal year end. With that I’ll turn the call back over to Greg.

Greg Hyland

Thanks Mike. During last quarter’s conference we said we believed revenues for the second half of fiscal 2008 would be comparable to the second half of fiscal 2007. As a result of the second quarter market developments as well as a number of key drivers we now believe flat revenues in the second half of the year could be challenging. These drivers which include residential construction, our distributor’s buying patterns, municipal spending, and price increases could also cause revenue to vary significantly.

The ongoing downturn in new residential construction impacts a portion of our business. While we expect the downturn to continue for the foreseeable future, the extent and length of the downturn is still uncertain as is the timing of the eventual recovery of the market. For instance, during the last three months the consensus Blue Chip Economic Indicators forecast for housing starts for 2008 drop from 1.1 million to 980,000.

As we mentioned earlier, the increase in revenues we saw in the second quarter over our first quarter of fiscal year 2008 was minimal. And the seasonal increase was much less than in previous years. January typically is the largest booking month for Mueller brand and products which include iron gate valves, hydrants, and brass products. Mueller company has a pattern of increasing prices effective February 1st, which it did again this past February.

Distributors usually place stocking orders in advance of the increase. And while January was our largest booking month of this fiscal year, bookings in January decreased $27 million from January of 2007. A number of factors possibly contributed to this decline. The downturn in residential construction undoubtedly contributed to weaker demand.

But we believe our distributors may also have adjusted their buying patterns this year by waiting for the beginning of the construction season before bringing in inventory to more tightly manage their working capital. We expect that their purchases in the second half of the year could be more closely aligned with their expected demand.

It is hard to assess if the general uncertainty of the economy will affect municipal spending over the next six months to repair and replace aging water infrastructure. However, we are confident that the need exists and the long-term prospects remain encouraging. Our ductile iron pipe floatation is the public works throughout 20%, in terms of tons, in the second quarter on a year over year basis. One quarter certainly does not constitute a trend, but it is a change that could highlight the uncertainty in the market.

We are implementing price increases in each of our three businesses. We do expect to obtain at least a portion of these price increases. But the extent of the realization of these increases could materially affect net sales.

Now I will address the variables that will impact profitability in the second half of the year. In addition to the affects of price increases, residential construction, our distributor’s buying patter, and municipal spending our profitability will also be impacted by the cost of raw materials and benefit from cost savings.

We will continue to be challenged by rising raw material costs in all three of our business units. For example, in January we paid $333 per ton for scrap at US Pipe. In April we paid $492 per ton. That’s a 48% increase in just three months, and an 82% increase over what we paid in April of 2007. At Mueller Company we paid $395 per ton for scrap in January. By April that had increased 52% to $599 per ton. And brass increased from $2.64 per pound in January to $3.12 per pound in April.

The higher prices we paid during the second quarter and in April will flow through our cost of goods sold in the second half of the year. As I discussed in our last conference call, we implemented a 15% price increase on ductile iron pipe effective January 25th. And a 5% price increase on our iron gate valves and hydrants effective February 1st. We recently announced another round of price increases including an additional 10% for our ductile iron pipe products effective April 25th.

We also announced that the price of our iron gate valves and hydrants will be increased an additional 15% effective June 2nd. And on March 26th we announced a 12% price increase on brass products to be effective this week. This is the first price increase on our brass products since June or 2006.

These additional price increases are necessary in responding to rising raw material costs. Our competitors announced similar price increases. But we recognize that reduced market demand could make it more challenging to realize the full effect of these price increases, particularly with some products. For instance, we have yet to achieve the full amount of the increases we announced that were effective in January for our ductile iron pipe and in February for our valves and hydrants.

Even with these market challenges we continue to believe that our announced price increases are reasonable and supportable in the market. We continue our focus on enhancing productivity by reducing our manufacturing cost structure and executing on our restructuring actions.

During the second quarter we achieved $10.8 million of cost savings which included those associated with the closure of the Burlington manufacturing operations. We continue to improve productivity and reduce headcount in a number of our production facilities. During the quarter we reduced headcount at our Decatur operations by 7% or 41 positions.

Also, lean manufacturing initiatives enable us to improve our processes at both our Union City, California and North Birmingham, Alabama ductile iron pipe manufacturing facilities. As a result over the last four weeks we reduced production headcount in these US Pipe operations by 19% or 113 positions.

The current market environment is tough, but our operating teams are meeting the challenge. They are focused on developing processes that will yield cost reductions and improve efficiencies which will make us that much stronger for the future.

The second half of fiscal 2008, Mueller Company’s financial performance will be dependent on the outcome of all the variables I just discussed. In addition, I want to remind you that we experienced approximately $5.5 million of under absorbed overhead costs in the fourth quarter of 2007 related to our inventory reduction plan. That is now behind us. Taking into account market demands, price increases, and raw material costs, operating income margins in the second half for our Mueller Company business unit could be down year over year.

During our last conference call we stated our expectations at US Pipe could possibly see lower operating income margins in the second half of 2008 than those in the second half of 2007. Given the recent trends, especially the unprecedented increases in cost for scrap iron and other key materials, we now believe US Pipe is very likely to see lower operating income margins in the second half of the year than those in the second half of 2007. Certainly our ability to implement price increases to off-set a highly inflationary cost environment is a key variable even with the expected savings from the Burlington closure.

Commercial construction spending is a driver for our Anvil business. And based on where demand for our products fall in the construction cycle, our outlook for this segment remains stable for the remainder of the year. We are anticipating modest top line growth for Anvil in fiscal 2008. And we expect to see a slight improvement in segment margins for the second half of the year as compared to the prior year second half.

The primary objective for fiscal 2008 is maintaining strong, free cash flow. As Mike discussed earlier, our first half 2008 free cash flow was $23.4 million, a $9.2 million improvement over 2007. We will continue to manage inventory levels and match production with market demand. We will also continue to focus on managing working capital with a significant component of our management in center programs being based on improving working capital.

Other key variables for 2008 are corporate spending of approximately $38 million. Our tax rate is expected to be approximately 42%. We estimate 2008 net interest expense to be within the range of $73 million to $75 million as we realize the full year benefit of our debt refinancing in May 2007 and the affect of lower interest rates. And we expect capital expenditures to about $80 million within the range of $75 million to $85 million.

With our cash on hand and the free cash flow we expect to generate in 2008 we have considered reinvesting in the business, paying dividends, repaying debt, repurchasing stock, and making strategic acquisitions. As I just mentioned, we expect to reinvest approximately $80 million in the business this year, including completing our automated, ductile iron pipe facility which remains on schedule. We anticipate the facility will begin operations by the end of this calendar year.

We will continue to invest in programs to provide a meaningful return. We evaluate the repayment of debt and repurchase of stock on an ongoing basis. It is important to note that in May 2007 we obtained financing at rates and with terms that are significantly more favorable than those available today.

We have also carefully examined the benefits of implementing a stock repurchase plan. Because we are confident of our strategy and our ability to execute it we believe our current stock price represents a compelling value. However, the decision to implement a stock repurchase plan as well as repaying debt is being balanced with the decision to maintain liquidity. At this time we believe we should preserve the flexibility our current liquidity affords us given the volatility of today’s economy.

There are a lot of uncertainties and challenges in the market, but we will continue to take decisive action, in particular reducing cost, matching production to market demands, and wherever possible implementing price increases to at least off-set rising raw material costs. However, we are committed to maintaining our market leadership positions and retaining the flexibility to respond to growth opportunities as they present themselves. And we are confident in the long-term prospects for the water infrastructure industry.

With that I’ll open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions). One moment please for the first question. Keith Hughes you may ask your question, and please state your company name.

Keith Huges – Suntrust Robinson Humphrey

Just wanted to drill into some of the numbers you gave on the Mueller sales. Did you say the brass products were down 41% in the quarter?

Greg Hyland

That’s correct.

Keith Huges – Suntrust Robinson Humphrey

Wow. What was there that made so much worse than the valve on the hydrant side?

Greg Hyland

A couple of things, Keith, one I think when you see the valve and hydrant side – our brass products are 100% correlated to housing starts. And secondly, on the valves and hydrants we do continue to see, you know, a repair and replacement market for valves and hydrants that we would not see on brass products. Sometimes too, and we had a price increase last year on brass products that we announced February 1st. And, of course, then our distributors placed orders in advance last January.

Keith Huges – Suntrust Robinson Humphrey

Right.

Greg Hyland

And we later, if you recall, we later rescinded that price increase. We are not the market share leader in that product. The market share leader did not increase prices. We found that we were under some pretty extreme pressures so we rescinded that. So we think we may have some year over year noise in what happened to order, because this year on February 1st we did not announce the price increase in brass products. But as I just mentioned, we did announce one effective this week, as did the market share leader on that product.

So I would say that the key reason is that we would expect to see brass products drop more than valves and hydrants, because brass products are driven 100% by housing starts. Valves and hydrants we have a repair and replacement demand. And I would say that if you look at last January there was probably some noise in terms of as year over year comparison, because of the price increased that we announced on brass products last year February 1 and not this year.

Keith Huges – Suntrust Robinson Humphrey

How much of the Mueller segment does that represent in terms of revenue?

Greg Hyland

That’s about $110 million.

Keith Huges – Suntrust Robinson Humphrey

$110 million.

Greg Hyland

Yes, and that was in ‘07.

Keith Huges – Suntrust Robinson Humphrey

Okay. The price increases you discussed are pretty significant increases coming here in the next couple months. Given how weak parts of your [inaudible] or markets are at this point is it going to take a full year to get these truly implemented until we see the benefits?

Greg Hyland

That’s a good question. And that certainly is a variable that I think that we need to see how that plays out. I think that for the pipe we will – we should start seeing that. Again, let met go back and say that. Certainly all the variable and the raw material costs that we’re seeing our competitors are seeing. Not one of us has an advantage. We do not believe in raw material purchases. And we all use about the same amount of raw material in our products. So clearly we believe our competitors will be having the same raw material pressures.

On the Mueller price increases, if you notice that I said that that was not effective until June 2nd. When we announce the price increase we typically give 45 to 60 days notice, because a number of our distributors – our distributors have a number of outstanding quotations and we just do not think that that would be fair if they were quoted one price and then they have to buy it at another price. So we give them that time to protect those quotation. So when we see the price increase effective in June 2nd, I would think we would not start seeing the benefit of that maybe until the fourth quarter.

I think on our brass products, I think we would start seeing that probably at the end of this quarter, possibly, you know, early in the fourth quarter. And our pipe, we’re hopeful we will start seeing that sooner, maybe late third quarter into the fourth quarter. But I think that you are right, given what is going on in the marketplace. If you look at what we have in our backlog and so on and so forth, we would not expect any of the price increases we just announced to start really falling through until the fourth quarter. But as we said on the last conference call, the price increases that we announced in February that we would not – and in January for pipe, February for Mueller, that we would not see any benefit of those in the second quarter. We would expect to start seeing the benefits of those now in the third quarter.

Keith Huges – Suntrust Robinson Humphrey

Okay. And final question, you had mentioned a 20% increase in quotation activity in US Pipe. Does that have to do with given the fact that the industry is going up pretty significantly again in price?

Greg Hyland

I am sorry, Keith, I said that was on our public works quotations for US Pipe. And on a year over year basis that was a decrease.

Keith Huges – Suntrust Robinson Humphrey

Which is just – okay, I am sorry. I misunderstood what you said, Mike. Thank you very much.

Greg Hyland

Yes. Thanks Keith.

Operator

Thank you. Our next question is from Mike Schneider. You may ask your question and please state your company name.

Mike Schneider – Robert Baird

Thank you and good morning. It is Mike Schneider from Robert Baird.

Greg Hyland

Morning Mike.

Mike Schneider – Robert W. Baird & Co., Inc.

Good morning I guess if we could stick to pricing for a second. So as we look into the third quarter the price increase of January and February to start roll through. So when you look for example, starting with Mueller Co. that is, they had pricing of positive 2.89 million this quarter, raw materials hit them by 4.2. Would you expect that gap to actually increase or decrease given that you’ve got the start or the beginning benefit of the prior price increases, yet raw materials have headed, substantially higher?

Greg Hyland

Yes. What we have seen in our backlog right now from Mueller is we’re starting the impact of the increase in February. To date, if you look at, we announced a 5% price increase on valves and hydrants on February 1st. Right now our backlog is showing about a - we’re achieving about a 100 basis points of that and we’re still early.

I would think certainly a year over year basis given the increase that we’ve experienced in raw material that the price increases in February, that we announced in February, would not offset the impact of raw material costs on a year over year basis.

Mike Schneider – Robert W. Baird & Co., Inc.

Okay and that 5% price increase that went in Feb. 1. Is it - you’ve realized 100 basis points of it so far, is that because of timing or is it - and would you expect to actually recover the next four points or indeed are you getting pushed back in the market at where you’ll likely back off of the four or five points and netting something less than that.

Greg Hyland

Yes I think that it’s a combination of timing and probably upfront, a little back off; however, I think with these next round of price increases that the 15% that we announced on the valves and hydrants and we had competitors announce similar price increases that I think that makes us very confident that we will get that full 5% and then of course, get some of the 15.

So I think what’s happened on this last round of price increases gives us, as a I said, confidence that we will be achieving all the first price increase and we would expect to get some of the second.

Mike Schneider – Robert W. Baird & Co., Inc.

And this may be same question a different way than what you just stated but so if you’re not entirely successful in the first round of pricing with the next round of pricing does that at least account for what you expect to fall short on the first round of pricing.

Greg Hyland

No not necessarily. I think if you look at our second round of pricing was really just focused on what we have seen happen on raw material costs. So we – I think if we look back and hindsight is 20/20, we should have gone out with a higher than a 5% price increase on effective February 1 but I don’t think even at the time, certainly at the time, we announced that price increase that we had any expectations that we would see in a two month period the rapid increase on raw material costs.

So our 15% was really focused on what we saw happening to raw material costs and our belief that justified. And in fact, on this 15% we were the price leader on the 5% price increase we announced in February. It was actually one of our competitors that led this second round of price increases to 15%. So we followed on the 15%.

Mike Schneider – Robert W. Baird & Co., Inc.

And if you are not successful entirely on the February 1 price increase and this is just a third way of putting I guess what I am trying to determine is must you be successful fully in the first and second round of price increases at Mueller to be made whole or is there a cushion built into those?

Greg Hyland

If we would achieve both those price increases we would more than offset rising raw material costs based on where raw material costs are today.

Mike Schneider – Robert W. Baird & Co., Inc.

Okay and then US Pipe, it looks like it barely achieved any positive price in the quarter. So the 15% that was put in in January I would have thought would have already been flowing substantially during this quarter. Again, can you give us some more color on the timing of that increase and then again, if you are not fully successful in both round of price increases where do you stand relative to raw materials today?

Greg Hyland

Actually on our last conference call we said that we would not see any impact of that January 25th price increase. Typically we run with about a six or seven week backlog in US Pipe. So when we announced that price increase our shipments, most of our shipments for Q2 were already scheduled. What we have seen to date in our backlog in April is that, of that 15%, we are up about, we have seen about 500 basis points.

So in our backlog we have achieved about a third of that price increase and Mike, so that is a combination of timing too because there were quotations outstanding when we announced that price. Our distributors had quotations outstanding; we had quotations outstanding where we honored the price that we had quoted at the time that we issued the quote.

So that’s also timing. A little push back, I think, in the marketplace also but again I would say that with this latest round of price increases and we did take the lead on this 10% but our competitors, as I have said, announced similar price increases. I that gives us a lot more confident that we should achieve most, if not all of that, initial price increase and we are hopeful that we will get some this second price increase too.

Again it is the same situation if based on where raw material costs are today, if we would achieve both those price increases we would more than offset the raw material costs. I think right now that we can say that I think we are really reasonably confident that we will see the – achieve the 15% that we announced in January and are hopeful on the other 10% because again, our competitors are faced with the same rising raw material costs.

The only thing that could possibly differ between us if they have an expectation that scraps going down they may react a little differently. Right now we have no expectation that the cost of scrap is going down so we are going to be very disciplined on our pricing.

Mike Schneider – Robert W. Baird & Co., Inc.

And in the valve and hydrant business the 17.6% decline there this quarter. Can you give us a sense of what you believe repair and replacement was up this quarter and was it sequentially softer?

Greg Hyland

You know that is on a quarter to quarter basis that is hard for us to tell because – to be able to determine that as I said, those orders come through our distributor. I can tell you that, as I said earlier, that we had a $27 million decline year over year in January and what that told us certainly was our distributors were ordering less before the price was in effect than they did a year ago.

We think two factors. One was certainly the weaker but two, I think, they elected to say instead of protecting that price they were just going to manage their working capital a little closer and wait until the construction. And just to see to what extent demand would rebound in the construction season.

That is a preamble to say that when we look down, we were down in every one of our regions year over year, sales region. We were down a lot less in our Northeast region and again, our Northeast region is more closely aligned by repair and replacement.

So I think that right now it is still for us to tell on a quarterly basis exactly what happened to our shipments on the repair and replacement side.

Mike Schneider – Robert W. Baird & Co., Inc.

Okay. Thank you I will get back in line. Appreciate it.

Operator

Thank you. Our next question is from Kevin Maczka. You may ask your question and please state your company name.

Kevin Maczka – BB&T Capital Markets

Good morning. BB&T Capital Markets.

Greg Hyland

Morning Kevin.

Kevin Maczka – BB&T Capital Markets

Good morning. Greg how much share loss have you experienced? Because it seems like you have been pushing the lever pretty hard on pricing and in some cases, it has stuck, in other cases it has not and you have even had to rescind price increases. With your volumes down so much, how much of that is related to share loss?

Greg Hyland

Kevin, we get industry data, obviously trade association data every month on our valves, our hydrants, and our pipe products. And actually our market shares are, we are up 1%, down 2% and flat. And I am not giving you exactly what products because that could be sensitive competitive information but what it is to say in total is market shares are remaining stable.

Kevin Maczka – BB&T Capital Markets

Okay. And just let me switch over to the municipal side if I could. It looks like a pretty dramatic change in some of your distributors’ behavior and in some of the municipal spending commentary that you gave in your prepared remarks. I guess my question is when you look at the channel inventory with your distributors and maybe what some of what that pipeline looks like. How do you view the channel inventory situation?

Greg Hyland

Prior to our February 1st price increase for – first of all there is very little buckle in our pipe in our distributors’ inventory if any. They are just not equipped to handle [inaudible] pipe. So we even though we may bill the distributor and the distributor invoices the end user, we will ship directly to job sites.

So when we talk about inventory we are talking primarily valves, hydrants and brass products. Prior to our February 1st price increasee, we were pretty comfortable that our distributor’s inventories were inline and because they had brought down inventories pretty significantly throughout 2007.

We will typically see a little blip in their inventories in February and March as we ship the product that on the orders that they brought forward to put the orders in before the price increase. As we said January is typically our largest order month for our valves and hydrants and it was again this fiscal year.

So I think there is a little bit of blip but we do not believe that there is a big, large amount of inventory out there that is slow moving. We think that they took those down pretty significantly in 2007. Relative and I do not want – certainly we can try to give as much insight as we can. One of our best indicators that we have internally is our quotation activity as we have said to public works and we do have a better line of sight definitely on pipe products. As we have said, that we are not ready to conclude that that is a trend, that 20% other though it is one that we need to on a year over year basis to see that decline to be aware of.

So, I think to summarize that yes there is a little blip in our distributor inventory now as we ship the orders that they placed in January before the price increase was effect but we do not, right now, see is a – what we would say is a significantly overstocked situation in the channel.

Kevin Maczka – BB&T Capital Markets

Okay. And then just finally if I could on your slide on the uses of cash you give five items there. The first three you are doing. The second two you are not. And I guess my question, as it relates, to the buybacks but more importantly the acquisition front is this a case where to consider something like that you have a certain idea in mind of your balance sheet of improvement you would like to see there before you could tackle something like that? Or is it more a case that there is just so much going on in your current business now that tackling any kind of acquisition would be just too much of a distraction right now?

Greg Hyland

Kevin I would have to say it is a combination of all the above. Certainly I think we would be very prudent on any acquisition but then again, there are certain acquisitions that have such a strong, strategic fit and especially how we think that the market will play out over the long term that if they would become available we would have to look very closely.

But I think it is safe to say that we will be very disciplined and take into account certainly the condition of our balance sheet as well as the potential targets. So I know that that is not specific but I mean it would all depend on what would be the acquisition target and the factors at the time. But certainly I would say the – we think that it is very prudent for us to be very disciplined.

Kevin Maczka – BB&T Capital Markets

Okay that is fair. Great, thank you.

Greg Hyland

Thanks, Kevin.

Operator

Thank you. Our next question is from Brent Thielman. You may ask your question and please state your company name.

Brent Thielman – D.A. Davidson

Good morning. Brent Thielman with D.A. Davidson.

Greg Hyland

Good morning Brent.

Brent Thielman – D.A. Davidson

I’m just curious. Maybe just turning to anvil for a little bit. Can you talk a little bit about the demand environment there and sort of, maybe some clarification on what supports outlook for slight improvement in the second half for that business?

Mike Vollmokker

Yes. Again I know we discussed this. Where we fall in the construction cycle and again it is when the buildings are maybe two-thirds of the way complete, when we will start seeing our products being installed in HVAC systems, fire protection.

When we look and see that the backlog of, I would say, projects that are existing that we think for the next six months that the demand should be sufficient to what – where we will not see a, we will not see a – the impact of potentially what may happen in ‘09 and 2010.

Certainly I think that some of the forecasts that we are seeing, though some of the forecasts still projecting not only growth this year but a slight growth for next year. I think where again, where we fall in the construction cycle that what is driving demand for our products is the backlog or the big increase, I think in investment that we saw over the last 18 months.

Brent Thielman – D.A. Davidson

Okay. That is great. And then you have talked about the US Pipe quotation activity and I am just maybe curious your thoughts but do you have any sense of how much an impact, higher construction material costs is having on public sector demand?

Greg Hyland

That is a – we probably cannot say that we are absolutely – our demand for our products are inelastic but again when pipes need to be replaced, they need to be replaced. We might be very well on what is happening in the general inflation [inaudible] environment.

We are finding some municipalities or water systems saying that if there is a project that can be postponed they might very well be, very well doing that. I do not think that we can point to that specifically for what impacted our quotation in the second quarter. I think we will not have better insight on that probably for, at least, another couple of more months.

But again, when the pipe needs to be repaired they need to repair them so I think it is too soon for us to say that the increase in raw material costs and what we are doing to pricing is having much of a significant impact on these projects. And again, it is important to point probably the largest dollar item or largest expenditure on these projects, still on labor. So it is not as much on material as it on labor.

Brent Thielman – D.A. Davidson

Okay, I appreciate that. And then one final question. With the new facility, the new Ductaland [ph] pipe facility at Bessemer, can you remind if any, will this facility help you reduce your dependency on scrap?

Greg Hyland

In a roundabout – not directly. The biggest savings will generate from the automated plant for US Pipe will be a reduction in labor costs. It will take it from about four man hours per ton to two. Where we will see a pick-up is that we will have less of a scrap rate with the controls on the new equipment that we are installing that we expect that are good tons of pipe produced the first time will go up significantly. And that should help us on our scrap.

So when I say that, it will just be a marginal. It will be a marginal improvement because anything that we scrap on a ductile iron pipe business we put it back into the furnaces and remelt it. So no I would say that it really will not help us too much on scrap. The big savings will be on the reduce, reduction in man hours per ton on the labor side as well as probably allow us to carry less inventory.

Brent Thielman – D.A. Davidson

Okay thanks a lot guys.

Greg Hyland

Yes.

Operator

Thank you. Our next question is from Matthew Ermous [ph]. You may ask your question and please state your company name.

Matthew Ermous

Morning. Just a couple of quick questions. Can you take us through what happened in the Canadian operations on the SG&A line and how that is expected to progress through the year?

Greg Hyland

Well, the SG&A we talked about. There was one distributor, customer that ran into financial difficulty, so there is a 1.1 million write-off during the quarter that impacted that. We are reorganizing the anvil Canadian operations to structural split the manufacturing from the distribution and that added a $1 million to the SG&A line this quarter.

And we had that in the first quarter as well. And then just the movement in the Canadian dollar year over year impacted the rest. Last year there was a bit of a gain the pay down of an inter-company note that triggered a gain last year.

So that impacted the delta. Just the inflationary effect – the Canadian dollar year over year strengthened 10% versus the US dollar. So that inflated the SG&A up in our Canadian operations. That is largely 75 to 80% of the impact of the SG&A growth.

Matthew Ermous

Right. And you can state it quickly on a sequential basis how much of the increase in SG&A was seasonal versus these other factors?

Greg Hyland

Other than, that comparative impact, on that FX settlement gain last year, which is about $700,000, it is all pretty much running rate.

Matthew Ermous

So when I think about it, obviously first quarter at 61 was lower than the run rate. This feels higher than run rate. Is it, is this more or as a percentage of sales basis? Can you kind of give a sense of what the normalized run rate should actually be?

Greg Hyland

I would take the first half to smooth out any aberrations that – from quarter to quarter and look at that as a half year run rate.

Matthew Ermous

You talked very briefly about, not briefly but certainly at length about the year over year movement in margin. Kind of backed away from the improvement in margin, now think margins are going to be weaker in a year over year basis.

Can you talk, if you roll forward on a sequential basis, how you view the ability to stabilize your margins and what it would take to stabilize the margins based on where raw materials are today?

Mike Vollkommer

Our year over year impact, as we said on margins, the biggest impacts were two-fold. One is the decline in the volume and the higher raw material costs. And as Greg had mentioned in his prepared remarks and answering later question, the ability to get the price increases that we have announced will help overcome the impact of what we are feeling with raw material.

Volumes, obviously volumes surely demand driven and a market recovery when those volumes come back on with all the cost savings that we are putting in place and lean manufacturing focus. That we would expect those margins will return. We will have further margin expansion as we add volume.

Greg Hyland

Matthew just to add a little more color to what Mike was saying. That yes I think that is the case that certainly our ability to achieve the price increases and what percent will have the biggest impact. But we would think with the seasonality of our business as our production should pick up in the next several quarters that sequentially we should higher margin in Mueller brand products, our pipes and our anvil business in the second half of the year.

Matthew Ermous

Great. And the last question. Can you give just a few brief comments on the health of demand currently as it stands today? You mentioned in January down 27 million in the hydrant and valve business. Can you talk to what the delta was in February and March? Did that narrow from a year over year basis? –

Greg Hyland

It did. When we look at our, especially when we were talking specifically about our Mueller brand of products. In March we were flat year over year and just down slightly this February. So when we look on orders on a year over year basis for this quarter. The big drop off was in January.

Matthew Ermous

Great. Thank you very much.

Mike Vollkommer

Thank you.

Operator

Thank you. We have a follow up question from Mike Schneider from Robert W. Baird. You may go ahead sir.

Mike Schneider – Robert W. Baird & Co., Inc.

Could you comment just on production levels in the second half? I know you have talked about inventory levels but would you expect production levels to match your incoming orders and demand during the second half? Or do you believe you have even got to ratcheted back just in an anticipation or an attempt to cut inventory internally?

Greg Hyland

Mike, when we look at our production levels on what we would expect on a year over year basis and I will look again – I will talk Mueller. We will see a bit of an uptick in production in third quarter over the second. But it will, still I think well below the production that we had in the third quarter last year.

We would expect in the fourth quarter that, on a year over year basis, production could be comparable. In our pipe business, and that gets back again to the big reduction in inventory that we had in the third and fourth quarter last year. On the pipe business that – we will see it, an uptick in production in Q3 probably not equal to what demand because if you recall that when we closed Burlington that we built a buffer inventory.

The last thing we could have afforded to done there was exit a plant in the Northeast and have any of our customer service fall down. So we built inventory and moved it up there in the distribution center to make sure that we did not fall down at all. And fortunately we have kept all of our customers there and that seems to be going to smoothly, that move.

But I would think that we will be working down some inventory that we built on the pipe business, though we would still see on, at least second half of the year versus the first half of the year, production pick up a bit.

Mike Schneider – Robert W. Baird & Co., Inc.

Okay. And then as you look out into fiscal ‘09, Greg, let’s assume these markets. Year end markets goes sideways during ‘09 and you begin to see the savings out of Burlington and many of the other moves you have made.

Just conceptually, what do you think and I guess the key assumption is you get full price recovery here in the second half? What do you think the run rate profitability of this business is today, either EBIT or EBITDA just given the incredible changes that have gone in this marketplace?

Greg Hyland

Mike, I will not be able to give you an exact number but I will talk about that – I will try to address the variables. First of all that we think when housing bottoms and housing starts and the – we went into this year, in fact last conference call we said that we still expected the continued decline in 2008 though probably I think it is still declining at a faster rate than anyone expected.

When housing starts at least bottom out or stabilize we will lag that recovery and we have talked about that in the past because it is the real development that drives demand for our products. But we would expect to see then still top line growth coming from the repair and replacement sector.

So I would think that once housing starts bottom we would start seeing some top line growth. Anvil, I think right now as we look going out, that is still a question mark because commercial construction, I think that all the indicators are that we might start seeing it slow down in commercial construction.

And while we think we are solid for the second half of this year, that still – that I think becomes a question for 2009. But we have taken out a significant amount of fixed costs. The variable costs we have taken out. The 113 people that I referred to at our pipe plant, we took out the last four weeks. That was a change in our production philosophy going to a just-in-time that we think that we will be operate when demand comes back with those fewer people.

So you are right, we will get those costs benefits. I have to say right now that the real variable for us is what is going to happen to raw material costs and assuming that we can offset that, I would expect them when we bottom out that we should start seeing margins improve and we get the benefits of all the fixed costs reduction and the change in the processes.

Right now, I think that to put an exact number on that, I think I would like to just see a little more of what happens the next quarter or two but I do think that we would obviously see an improvement because we have taken a lot of costs out of the business.

Mike Schneider – Robert W. Baird & Co., Inc.

I guess maybe a different way to phrase the question is if you, let’s say we settle in at this 1.7 billion in revenue or there about. Do you think that the business, stable at that revenue, can re-achieve say the 11% operating margin range you were running at a couple of years ago because of the fundamental changes to the cost structure? Or do you think 1.7 billion is just insufficient to reach that range.

Greg Hyland

I would feel confident that I would – expect that we could get to the 11%. The, when I think, what I think is the 1.7, the $1.8 billion range that we have in this quarter all the negative impact of reduce reduction in terms of unabsorbed overhead. We offset with cost reduction.

So relative we would have lost the margin. We would have lost the absolute profit dollars on the reduced volume and when you think about that a year over year basis for us on our reduced volume costs us about $17 million on a year over year basis consolidated.

We offset all of the impact of the reduced production relative to unabsorbed overhead; we offset that with cost reductions. I think that the only thing, that ran away from us and the industry, I think, is what is happening to raw material costs. We are, as I said, we are running as fast as we can to try to recover those and taking the lead in the marketplace with disciplined pricing.

So I think relative to the reduction and a 1.7 billion level, I think we will offset that overhead unabsorption with lower costs. So I am confident that the margins, if we offset raw material costs, that that 11% margin is very reasonable.

Mike Schneider – Robert W. Baird & Co., Inc.

And the 17 million in unabsorb/absorption.

Mike Vollkommer

That was not unabsorbed overhead. That was just the pure profit we lost on reduced volume.

Mike Schneider – Robert W. Baird & Co., Inc.

Okay. So the equal amount was cost reductions though would you characterize, or could you characterize what amount of that would be fixed or structural reduction in costs versus just, what I will call variable cost reduction whether it is overtime or temps?

Greg Hyland

Yes I can. And about 3 million, 2.5 to 3 million were just pure head count reduction. I think a lot of that is from profited improvement. We had another $2 million from what I will say is lean, lean six-sigma improvement.

And so when I look at the bulk of our cost savings I think that will know – they will repeat but if you categorize, of course you categorize headcount and variable, if you look at that between fixed and variable the way that you have traditionally clarified.

We think about our cost reductions this quarter probably around 30% came from the fixed, 70% from the variable but we think a good portion of those variable costs will not come back because they are result of process improvement rather than just pure headcount reduction related to downturn in production.

Mike Schneider – Robert W. Baird & Co., Inc.

Okay. And final question, Mike, on the balance sheet the goodwill balance of over a billion. Have you done an analysis of that and are you comfortable that you do not need to do any reassessment of the value?

Mike Vollkommer

Well, you know we take a look at that each year and we look at that in the fourth quarter to assess the carrying value of that. With the downtown we will probably just take a look at that a little sooner this year than the fourth quarter. But at this point and time we have not made any conclusions with respect to the intangibles.

Greg Hyland

Just to follow up on that Mike and that is obviously a very good question, insightful question. We had that discussion with auditors just this past couple of weeks with our audit committee and as Mike said, that we are confident in the business, they are confident in the business but we will do that evaluation probably next two or three or four months.

Mike Schneider – Robert W. Baird & Co., Inc.

Okay. Thank you again.

Greg Hyland

Thank you. Okay, at this time we do not see any further questions. We do, Rob. I think we have one more question.

Operator

One moment please.

Greg Hyland

Yes.

Operator

Mr. Malloney [ph] you may ask your question please.

Greg Hyland

Okay I may have been wrong. And we do not have any more questions. So again thank you very much interest and we will conclude our call.

Operator

Thank you. This concludes today’s conference. Thank you for participating. You may disconnect at this time.

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Source: Mueller Water Products Inc. Q2 2008 Earnings Call Transcript
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