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Hardinge, Inc. (NASDAQ:HDNG)

Q1 2008 Earnings Call

May 8, 2008 11:00 am ET

Executives

Pat Ervin - President and Chief Executive Officer

Rick Simons - Senior Vice President and Chief Operating Officer

Edward Gaio - Vice President and Chief Financial Officer

Analysts

Bob Schenosky - Jefferies & Company

Bruce Baughman - Franklin Templeton

Sheldon Grodsky - Grodsky & Associates

Brandon Austin - Sprott Securities, Inc

Gary Linhoff - Iron Works Capital

Operator

Please note that this presentation contains forward-looking statements within the provisions of the Private Securities Litigation Reform Act of 1995 that are based on current expectations, estimates and projections about the industry, markets and economic environment in which the company operates. Such statements involve risks and uncertainties that could cause actual results to differ materially from the results discussed in these statements. These risks are detailed in the company’s Annual Report in Form 10-K filed with the Securities and Exchange Commission.

Today’s call leaders are Pat Ervin, President and Chief Executive Officer; Rick Simons, Senior Vice President and Chief Operating Officer; and Edward Gaio, Vice President and Chief Financial Officer. Gentlemen, you may begin.

Pat Ervin - President and Chief Executive Officer

Thank you. Good morning everyone. We are pleased you could join us today. With me I have Ed Gaio, our Vice president and Chief Financial Officer and Rick Simons, our Senior Vice President and Chief Operating Officer. During the call this morning, we will comment on our first quarter results and update you on some key operational programs. We’ll then give you an opportunity to ask questions.

I will first comment on our reported first quarter performance compared to the same period of 2007. Let me start by saying that the weakening of the US dollar against the currencies in our key international operations had a profound impact on our operations and the translation of our financial statements into US dollars. The identifiable impacts of these changes were unfavorable to net income by $2.3 million or $0.20 per share. This includes $0.3 million favorable due to the translation of foreign subsidiary financial statements offset by $0.8 million and lower margins on products produced or sourced in one currency and sold in another, and $1.8 million in unrealized or realized transaction losses. These changes cloud some of our comparisons, and Ed and I will do our best to separate out these issues so that we can concentrate on true operational issues affecting the company.

If our explanations are not sufficient, please feel free to ask for further clarification in the question-and-answer portion of our call. The currency movement that has had the most significant impact on our financial statements was the strengthening of the Taiwan dollar and the Swiss franc against the US dollar.

The Taiwanese dollar strengthened suddenly in late February/early March and by the end of the quarter had strengthened by almost 7%. Due to commercial reasons, we sell our products manufactured in Taiwan, which account for more than 30% of our worldwide machine sales in US dollars. Similarly, the Swiss franc strengthened by almost 13% during the quarter. Approximately 85% of our sales made in Swiss grinding operations are carried out in Swiss francs. So, there was less of an impact on the income statement as a result of this change. However, the impact of translating their results into US dollars for consolidation has been significant.

As we comment on individual line items in our financials, we will provide comparisons with and without the impact of these currency movements. Ed will comment later on the actions we have taken or plan to take to mitigate the impact of currency movements in the future.

Our net loss for the quarter of 2008 was $700,000 or $0.06 per share. Weighted average shares were $11,323,000, up 28% in comparison to 2007 resulting from the company’s follow-on stock offering in April of 2007. Excluding the impact of the currency rate movements in the income statement, we would have had net income of $1.6 million or $0.14 per share. On a normalized basis, our results are disappointing and compare unfavorably to last year’s very strong first quarter, which generated a net income of $5.3 million or $0.61 per share.

Let me discuss in more depth the key drivers of performance on the quarter compared to prior year. I will comment on orders, sales and operational initiatives, and then I will turn the call over to Ed to comment on some gross profit, selling, general and administrative expenses, and our balance sheet. After our comments, we will open up the call to questions.

Net sales for the quarter were $85.6 million, a decrease of 2% versus prior year. Excluding the impact of translating foreign subsidiary financial statements, sales declined by $8.1 million or 9%. On a regional basis, sales in North America were $28.6 million, up 3% versus prior year despite the economic environment that is not favoring capital spending.

Although shipments in the first quarter were above 2007 levels, we’ve recognized that based on order levels and economic climate, the balance of 2008 for the North American region will continue to be difficult.

In Europe, net sales of $37.6 million were 9% below prior year. This decrease in net sales was primarily a result of an economic slowdown in the UK where the company has a significant presence, in addition to lower volume in Germany as a result of our decision to transition market coverage in certain product segments from distribution to direct selling. Overall, business activity in Continental Europe remains at high levels.

Net sales in Asia and other were $24.1 million, an increase of 9% for the quarter when compared to prior year. This reflects our improved performance in the Chinese market. China net sales were up 30% over the same quarter in the prior year. Growth prospects in China continue to be good despite a regulatory environment that is restricting imports of machines into the country. Based upon published results, machine tool imports into China decreased in absolute dollars in 2007 while consumption of machine tools in China increased by 17% for the year.

In addition, the production of machine tools in China increased by 40%, ranking China as now the third largest producer of machine tools in the world. We expect this transition to continue over time and we will continue to adjust outsourcing initiatives to keep pace with these changes.

Orders for the first quarter of 2008 were $93.1 million, a decrease of $2.4 million or 3%. Excluding foreign currency effects, orders declined by $8.8 million or 9%. On a regional basis, orders in North America were $25.7 million, a decrease of 24%. This decline was negatively influenced by the non-recurrence of $4.9 million order for grinding machines for use in turbine blade manufacturing that was recorded in the first quarter of 2007. Excluding that order, the North American demand was down $3.4 million or 12% compared to the same quarter last year.

Decreased orders is a result of our decision to make changes in our North American distribution model to more direct selling efforts were combined with difficult economic environment. We remain cautious on our outlook for 2008 as both the economy and competitors look and maintain market share in the North American region will provide a difficult market.

European orders were $43.3 million, a decrease of 4% compared to the first quarter of 2007. Our order performance in Europe has been steady for 18 months. However, we are seeing some softening specifically in the UK market. Overall, our European business activity levels continue to be strong.

Asia and other orders increased by $7.9 million to $24.1 million. This increase was exclusively driven by activity in the Chinese market. Our global diversification has allowed us to maintain a high level orders on a consolidated basis despite the softness in activity in the US and the UK.

Looking forward, we are preparing ourselves for continued softness in the US and UK due to economic conditions. We are looking closely at our spending levels and are making adjustments as market conditions warrant. We are optimistic that our strength in China and other markets will continue to provide meaningful shipment levels for the remainder of the year. We are taking steps to address the balancing of manufacturing activity at our main factories. Our Swiss operations are running strong with a high backlog of orders. The Taiwanese operation was temporarily impacted by the efforts to reduce worldwide inventory of machines.

As of the end of April, the inventories in their main machine lines are more inline with the demand in most end markets. Beginning in May, they are back to a more traditional production level. In addition, they are beginning to produce a new machine line.

In the US manufacturing facility, we experienced unusually low orders during the first two months of the year. Rather than build inventory for the sake of keeping people busy, we used those people to contribute to factory and machine maintenance and to assist field service representatives. While being the right thing to do, from an inventory build perspective, it did negatively impact our income statement. Stronger orders in March and April along with the final assembly of machines from a components provided to us from our Taiwanese suppliers, has increased the activity level in our factory here. It should have a favorable impact on margins in the second quarter.

We continue our progress in improving our production capabilities in China and our China manufacturing operations. The General Manager of our Taiwanese company has been placed in-charge of this operation and we are looking forward to continue expansion of our operations there going forward.

Before I turn the call over to Ed, let me make a quick comment about our inventory levels. As you look at our inventory growth from 158 million to 173 million, it is important to note that 8 million of the $15 million growth was due to translating foreign inventory into US dollars and therefore not real quantity growth. However, we are disappointed that we did not make more progress on reducing the overall inventory level during the quarter. We were able to reduce our finished goods inventory for turning the milling machines. However, finished goods in grinding machines increased.

The shipment of machines held in Switzerland at the end of the quarter due to delayed export documentation, we’ll ship in the second quarter and have a favorable impact on our overall inventory levels. We’ve implemented a more aggressive discounting program on stock inventory to accelerate the conversion of finished goods inventory in the cash.

As we mentioned, in last quarter’s conference call, this will have a negative impact on our gross margin in the second and third quarters, but should generate better results in terms of inventory levels and cash generation going forward. We anticipate that we will make good progress in the second quarter and the remainder of the year in generating cash from reductions in inventory.

I will now turn the call over to Ed to comment further on our financial performance in the first quarter.

Edward Gaio - Vice President and Chief Financial Officer

Thank you, Pat. Good morning everyone. Since Pat commented on orders and for the first quarter compared to last year, I would like to make some comments about the other drivers of our operating performance.

Gross profit for the first quarter was $25.1 million, a decrease of $2.9 million or 10% compared to the same period of 2007. There were three primary factors impacting the reduction in gross profit for the quarter. The net impact to gross profit due to changes in foreign currency exchange rates as a result of the weaker US dollar was favorable by 0.9 million. This is comprised of 1 million unfavorable due to changes in exchange rate where a product is purchased or manufactured in one currency and sold in another. This is primarily attributable to product sourced from Taiwan that are sold around the world in US dollars, as well as product manufactured in Switzerland and imported and sold into the US market in US dollars. This was more than offset by $1.9 million related to the translation of foreign subsidiary financial statements in the US dollars.

Reduction in sales volume on a constant currency basis also accounted for $2.7 million of the decline in gross profits. The reduction in sales volumes also had additional negative impact on absorption of factory overhead expenses. The company is evaluating sources of supply and will be moving some existing outsourced volume into its US and Taiwanese facilities in addition to making any necessary adjustment to factory spending levels.

Gross margin for the quarter was 29.4% compared with 32.2% for the same quarter last year or 280 basis point reduction. As previously mentioned, products produced in Taiwan and Switzerland that are sold in US dollars resulted in 175 basis point reduction. The company has announced price increase that became effective in early Q2 that should restore margins to an historical level on a go-forward basis and products that were impacted by material cost increases and exchange rate changes.

Selling, general and administration expenses were $23.5 million for the first quarter 2008, an increase of $3.9 million or 20% compared to 19.6 million for the same period in 2007. SG&A expenses as a percent of net sales was 27.5% for the quarter, up from 22.6% in the same quarter of 2007.

The primary drivers for the $3.9 million SG&A increase in the first quarter was $1.5 million related to foreign currency translation effects; again as a result of the general weaker US dollar, $1.6 million due to previously discussed investments in direct sales in the US, Germany and the UK, and additional costs related to the company’s ERP system implementation in Switzerland.

Other income and expense was $2 million expense in the first quarter 2008 compared to other income of $0.6 million in the same quarter last year. The year-over-year change of $2.6 million was primarily the result of realized and unrealized foreign exchange losses. In light of recent changes in the financial market, the company has increased its hedging activities to minimize the volatility of changes in currency rates on net income in the future.

Net interest expense was $0.4 million for the first quarter of 2008 compared to $1.3 million for the prior year quarter. The decrease is due to the reduction in outstanding debt as a result of the company’s follow-on stock offering.

The company recorded a first quarter income tax benefit of $0.1 million compared to income taxes of $2.3 million in the prior year quarter. The effective tax rate was 9.6% for the three months ended March 31, 2008 compared to 30.6% for the same period last year. This difference was driven by the mix of earnings by country and by a discrete item, which occurred in the current quarter related to the recognition of accumulative tax effects of the completed derivative contract. This tax effect, a benefit of $0.6 million, typically is recognized through earnings over the duration and effectiveness of the hedge. However, due to our valuation allowance in the US, no tax benefit could be recognized through earnings until final completion of the contract. We expect 2008 effective income tax rate to be in the range of 25% to 27% inclusive of the effects of the discrete period items described previously.

I would now like to comment on liquidity and capital resources. Cash used in operating activities was $2.1 million in the first quarter compared to cash generated of $3 million in 2007. This represents a decrease in cash provided in operating activities of $5.1 million. The drivers to cash usage were a net loss reported in the quarter and increases discussed previously relative to inventory primarily driven by grinding shipments destined for China and India that were delayed due to export documentation.

Cash used in investing activities was 1.2 million in the current quarter compared to $0.4 million in the same quarter prior year. Cash provided from financing activities was $0.2 million for the first quarter compared to $6 million in 2007.

Debt outstanding at the end of March quarter was $29.4 million. Net debt was $15 million excluding cash. The company has additional borrowing availability of $92.6 million at March 31, 2008. The company believes that currently available funds and credit facilities along with internally generated funds will provide sufficient financial resources to fund ongoing business operations.

And now, I will turn the call back to Pat for closing comments before we open it up for questions.

Pat Ervin - President and Chief Executive Officer

Thanks Ed. I also wanted to comment on the announcement of Kyle Seymour’s appointment as Chairman of the Board. This appointment of an outside director as Chairman is not only in accordance with the best practices in corporate governance but, this allows Kyle to take a more active role in the leadership of the company. His extensive experience in the machine tool industry and in managing business will serve Hardinge’s and its shareholders well.

Let me summarize with comments about the year ahead of us. For the remainder of 2008, we will be focusing on cash flow, our profitability, and how to better leverage the growth opportunities that are available to us from regional diversification. Bearing any unforeseen events, we anticipate returning to profitability in the second quarter.

Now, Ed, Rick and I will entertain any questions you might have.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Our first question comes from Bob Schenosky. Bob, your line is open.

Bob Schenosky

Good morning.

Pat Ervin

Good morning, Bob.

Bob Schenosky

Thanks. I have actually a couple of questions here. Can you talk a little bit about the investments that you've made in the direct sales for us and whether or not you continue to look at the numbers that you have in place, are those the right number people giving slowing sales in the US and UK and whether or not you expect the benefit of those individuals to really start escalating the sales numbers?

Pat Ervin

Okay, real good question, Bob. First of all, when we look at the number, we deal with it by market. When I look at in the US/North American market, we have seen an improvement now when I deal with sales and especially order mix where it is starting to move to a more of a direct percentage than a distributor. Our direct percentage is growing as a percent of our total from a sales point. So, we are starting to see them being effective in some of the regions now Bob in North America. We have taken a look at the original level that we were going to be put in place and have paired that back some based on the current economic conditions. So, we have not been saying it differently. We have not changed the strategy or what regions we were planning to deal with on a direct basis versus distributors and just in the areas where we were direct, salesmen will have larger territories now than they were before. So, I still feel very strong, the strategy is the right strategy we’ve been implementing. The benefits are starting to be seen in orders from those regions by the new salesmen and we have taken it back some in some areas as a result of the current economic conditions.

UK virtually mirrors that. We were direct sales traditionally in the UK. We have looked at adding some resources and have cut those back some instead of doing adds, have looked at what is the right levels of business in the UK market. The only other area we have made some transitions is in Germany. In Germany, we have brought on additional salesmen over the last probably a quarter or two as we move more towards direct level in Germany and we anticipate that will help us as we go forward.

Bob Schenosky

Okay. In Europe, are you seeing any weakness anywhere else besides the UK?

Pat Erivn

Bob, there is a lot of comments about it, but I have to say we haven’t seen it really yet. I mean activity levels were strong. When I look at Europe in 2008, do I anticipate the type of growth levels? No. That had been occurring, but I think it’s going to stay as a strong market.

Bob Schenosky

Okay. And then so, the way to think about the SG&A dollars then is if you have already made the cutbacks during the first quarter or any changes in the number of people that you think is correct, and the dollar value would be similar as we move forward then?

Pat Ervin

Well, let me say -- let me just rephrase that a little bit. You asked specifically on the sales and marketing side?

Bob Schenosky

Right.

Pat Ervin

Or the sales side specifically. And so, what we have done is the cutbacks on the sales side where we weren't adding plant heads or didn’t replace ahead of it, we had a turnover have occurred. Other SG&A expenses continue to be looked at in determining what we have to do based on how weak a market may get. So, there is quite a bit activity going on in both the US and the UK market as we have cutback some SG&A already, but we got to continue to monitor and decide what level of cutbacks are necessary if any additional ones are based on our new order activity.

Bob Schenosky

Okay, thanks. And then on the inventory issues, do you see this as an overbuild issue that took place during the quarter or how would you profile it?

Pat Ervin

No, I think that’s a good one, Bob. I think two things, the inventory issue first, I know we mentioned it, but the delay in the shipments of the grinding machines was substantial. I think when we look at the inventory growth of the -- and I am doing this off the top of my head, 14, $15million, probably 90% of it plus dealt with either currency translation changes or the delay in the grinding shipments. Those shipments have already taken place and we will. So, that will clear out in the second quarter. I think, for the most part, the production levels now are pretty well matched. We didn’t move as much of the finished goods inventory as we have hoped during the quarter, but that is happening. So, I think in a production level, we are in pretty good shape now. We hoped to have move more as I think I commented, turning and milling was down so, we’ve already started that to eat into the finished goods levels there and expect to continue to do so during the second and third quarters.

Bob Schenosky

Okay. So, is it fair to characterize this, then as the margin issues were exacerbated because they didn’t relate to the sales but should have taken place and rather in the second quarter yet would flip because your sales would arguably be a bit higher because you’ve got this finished goods inventory in place?

Pat Ervin

With the grinding stuff, yeah I would say that’s a fair assessment, Bob.

Rick Simons

Bob, this is Rick Simons. Just I do have a couple of numbers. On the turning and milling products, the finished goods went down a little over $4 million, and as Pat said, the Swiss machines obviously offset that and then also we did have some raw material increases as we were unable to shut off all of the vendors from shipping end material on our production facility in Taiwan, but that will be down in the second quarter.

Bob Schenosky

Okay. And that would lead into my next question then, how are you characterizing moving forward here in terms of your pricing environment as it relates to increases in your raw material costs?

Pat Ervin

Very good question, Bob. As you know, raw material costs throughout the world will continue drastically. I mean they have been difficult in our industry like everyone else's, the only really thing we recognize everybody in our industry is going through the same thing. So, we have implemented price increases effective really April 1, a lot of them became effective in Europe. Europe is almost difficult place to do price increases and it’s the hottest market as we speak as far as volume, because most of our distributor contracts, you have got a 90 day clause. And so, the price increases really will take an effect for new orders placed after April 1 in most cases. So, those increases are in place now. We will be seeing the improvement of those margins in the second quarter, but price increases are heavy and as far as cost increases from vendors price increases are heavy. It’s a tough time out there right now in the commodity side for purchasing materials.

Bob Schenosky

Okay. And then that relates to my last question. You have talked about the increasing difficulty in the competitive environment, which as everybody try to place machines and you are doing discounting. Can you talk about how that’s all going to play in, the potential for these increases to stick and any margin degradation because of that?

Pat Ervin

Yeah. Well, first of all, we’ve talked about the discounting side. Let me try to characterize that. What we are looking is some of the models that we have acquired over time in what I call configurations that haven’t moved, we’re really trying to target those machines that have been in inventory for a while, let’s get rid of them for the discounting side. I think we have targeted there might have been up to $5 million or so of that type of inventory around the world that we are saying let’s flush out, not replace.

Bob Schenosky

Okay.

Pat Ervin

So, the discount and try to give you an idea of for inventory movements would really be on about $5 million of sales. Now, back to your other question, okay, in reality in the world, costs are going up, markets have gotten softer in North American and the UK, and people try to hold on. That doesn’t make for good environment when trying to pass on price increases. So, we are going to -- even though I can tell you I don’t anticipate there will be significant discounting for normal order business, it will be tough. I mean I don’t see where we are going to get an advantage of better margins for pricing in the market right now. But, if we could have maintained our historical relationship percentage that would have been good, but it will be interesting to see just how aggressive the markets get around the world.

Bob Schenosky

So the UK could leak into Europe then?

Pat Ervin

I mean anything is possible. I think the UK is pretty self-contained though, myself, in my own mind.

Bob Schenosky

Okay. All right. Thanks for all the help there, Pat.

Pat Ervin

Okay, Bob.

Operator

Thank you. Our next guest is Bruce Baughman. Bruce, your line is open.

Bruce Baughman

Thank you. The sales in Asia are catching up the sales in North America now. Can you walk us through the different margin characteristics and give us a feel for what kind of margins you are realizing in China?

Pat Ervin

Well, let me -- let’s first talk Asia, big picture. Asia overall right now is about 49% of the world's consumption comes from Asia. So, from a macro business point of view, we would fully expect over time as we continue to strength our operations throughout Asia that Asia will go beyond North America in terms of our business model from a sales perspective. I mean that just the world is so weighted in Asia, driven primarily by China obviously; we are trying to being by far the number one consumer machine tools in the world. That area is critical as we move forward.

Now, one other things and this is where you get into SG&A percent versus gross margin, in reality the gross margins that people obtain are able to obtain in the Asian region are generally lower on a percentage basis than the other parts of the world, but the SG&A to support those regions is also significantly lower due to the different pay scales in that region. So what we've seen these operating margin percentage that comes out of Asia is pretty similar to what we have been able to obtain in the other parts of the world as a result of those two dynamics. So, we don’t see anything at this point where the weighting of China business and operating margin point of view would negatively impact our business model going forward financially. Does that help?

Bruce Baughman

Yeah, that helps.

Pat Ervin

Okay.

Bruce Baughman

And would you characterize that results in China is contributing at this point?

Pat Ervin

Absolutely, no question about it.

Bruce Baughman

Okay, thanks.

Pat Ervin

You are welcome.

Operator

Thank you. Our next guest is Sheldon Grodsky. Sheldon, your line is open.

Sheldon Grodsky

Yes. With the fluctuation in currencies, are you finding that there's a threat any of your operations are going to become economic -- become uneconomical, perhaps Switzerland they got a strong currency for about 40 years now. Is that posing a threat to that operation?

Pat Ervin

Okay, let’s deal with one at a time. First of all, from a Switzerland point of view, no. Our Switzerland business is really a very specialty business and high performance grinding. And the good news for us our main competitor is also Switzerland. So, in that business that we play in grinding, we are in the boat together, I guess I will say. But it’s such a niche and specialty business that even though customers, I’m going to say are happy about price changes that occur, they are willing to accept them because the two key competitors had the same problem.

When you go and you start looking about currency changes again and I will pick out Taiwan because those are the two we mentioned as our biggest issues, there is a lot of Taiwanese suppliers of machine tools in the world and they've all run into exactly the same situation. So, Taiwan now compared to some place else, you could argue. But I think as the weakness in the dollars occurred around literally to multiple currencies, I don’t see that as an issue of a longer term problem being, we won’t that region or our businesses there won’t be competitive. I mean the wild card long-term that we have to watch for is as China continues to grow its own manufacturing, I think right now China believe I mentioned is up to third largest producer of machine tools in the world, only about 16% of China’s production is exported. They will be the wild card on how the currency in China impacts the rest of the world from a competitive business point of view is one we have to continue to monitor and obviously why we continue to grow our manufacturing operations in China. So, China is the one currency that I think is going to have the biggest potential impact on this industry over time.

Sheldon Grodsky

Thank you.

Pat Ervin

You are welcome.

Operator

Thank you. Our next guest is Brandon Austin. Brandon, your line is open.

Brandon Austin

Hey guys. How are you doing?

Pat Ervin

Hey Brandon, how are you doing?

Brandon Austin

Not bad. Just I wanted to ask you I guess you are trying to execute a turnaround and at the same time talking about a deteriorating economic environment. I just wanted to grill on a few questions that, first of all with regards to the economic environment right now be it in the states, sometimes I talked to the company that I hear that well, we kind of already hit the bottom and now we are sort of stable and hopefully looking up and I guess if you have any comments around Europe the same way. Do you feel that we’ve seen the bottom it's just going to stay low or do you feel things are actually going to get worse for yourselves in the US right now?

Pat Ervin

Another really good question. Let me put about three different dynamics on the table when you look at our business model. The first dynamic is the changes in movement we’ve done in the distribution network where we have gone more to a direct versus a distributor network in certain key regions. From a historical point of view, we gain a greater market share in direct regions than we do distributor regions. So that lever I will call it should be same, our sales will grow in North America as our direct operations become stronger, get in place and customers realize where we are at in their region, that’s one lever.

The second lever that I believe is still very, very real is the weakness of the US dollar allowing you as manufacturers selling their products around the world to be in the better competitive position than the historically you have been in. That would be another level that lever the that should be positive for US manufacturing that is now one would terms around very you now paradigm but overall as people do investments in ability to compete internationally that’s another positive. Now those two levers offset by the lever of the US economic slowdown, here is how do those three interrelate, and I don’t want to say you know, as really talked to determine, I don’t see the US economy being no position where it’s going to turnaround quickly. But, I also see the other two positive levers being real. So, I think in the US the type of business level we did in the first quarter we feel we should be able to maintain from an orders point of view it’s not improve on, and just depends on how much the economy goes down. But, the other positive levers are there for both our channel side and the exporter business. So, the US…

Brandon Austin

Okay. So, from an order perspective then you don’t feel that you are having to sort of do a double down on cost cuts or something just so you have got the transition and economy, you just feel that you guys can maintain this level and maybe fix your operations at the current quarterly bookings run rate. Is that a fair statement?

Pat Ervin

I think, trying to look at the operations at a current quarterly run rate is a good way to say it. In addressing the operational levels to that, I mean as we also said though the same time we are moving some production into Elmira's facility and into our Taiwan facility that will increase production levels there for products that we were sourcing outside.

Brandon Austin

Okay. So if I am looking at -- yeah, sorry.

Pat Ervin

No, no. Go ahead I’m sorry

Brandon Austin

Okay. If I am looking at the US operations then, in terms of the weakness, how much of that is it a 50/50 self-inflicted versus economy and when I say self inflicted, I mean this change from indirect to direct sales. Would you say that that's accounting for maybe half of the weakness right now?

Pat Ervin

I wouldn’t necessarily go half, if I had to put a percentage wise, say maybe 25%

Brandon Austin

Okay. And with regards to the UK, is it kind of the same thing that you said the UK is looking weak, but you are also changing your sales force up a bit in the UK also, is it kind of the same or 25% that’s really could you guys make some internal changes in 75% of that economy?

Pat Ervin

No. On the UK, we have traditionally been a direct sales force. So, in UK, it’s really only. We had been direct before and it’s a matter of what is the right level of, I will call it direct coverage needed for the market. So, that one…

Brandon Austin

How much?

Pat Ervin

I’m sorry, go ahead.

Brandon Austin

How much was the UK down year-over-year and in pound sterling?

Pat Ervin

I don’t have -- I am going to totally guess probably 10, 15%.

Brandon Austin

Okay, so it's not too bad. And then in Germany, I guess you were talking about Germany and you said Germany had a sales transition issue there?

Pat Ervin

Right.

Brandon Austin

So, was Germany sort of economically, was that fairly strong and continue to be good and you guys just have to change your sales force and you take advantage of that or do you see Germany weakening off as well?

Pat Ervin

What I see is when you look at the Europe as a whole but driven by Germany obviously is the key market. The Europe growth has been phenomenal. I mean it’s just been over the last couple of years, it's just been fantastic. Germany is similar to what we have done in the US. Traditionally in Germany, we were selling certain niche products on a direct basis where the direct sales were necessary, but the majority of our sales in Germany were dumped through a distributor or distribution network. What we are in the midst of right now is building the direct force and we’ve worked on eliminating our distribution network there and doing it ourselves. So that’s in the early stages of, I will call it potential opportunities, to grow sales through better penetration of direct sales coverage. In the Germany itself, I think the market is going to remain strong. I mean even if the market declined, let's say 5%, it's still going to be a very strong business environment in Germany. So what I envision is we are going to see a continued strong level of business environment throughout 2008 in Germany even if it was down though slightly. I think it’s going to be a positive for us with the changes we are making that will get good business out of that region.

Brandon Austin

Okay. So, that's interesting. So as Germany, is it just a very -- is it not as competitive versus just the changes that you are making?

Pat Ervin

No, Germany is very very competitive. I mean (inaudible) competitive, I think the difference is as I said in the US, it mirrors Germany. Whoever were on a direct sales basis in the world, we have a better market share. And the logic that Germany is the driving market in Europe and the logic that we are going to be moving to more direct sales in that region, I fully expect we will be picking up better market share in Germany. Now these changes don’t happen overnight. I mean this will take us nine months to a year to really get it where the customers are understanding, we are now direct sales in regions, we’ve got the support network, but we’ve been building up the support service network probably back to last three quarters or so to position ourselves and able to do this.

Brandon Austin

All right, thanks a lot guys. Good luck.

Pat Ervin

Thank you very much.

Operator

Thank you. (Operator Instructions). And our next guest is Gary Linhoff. Gary, your line is open.

Gary Linhoff

Thank you. Pat, can you comment, gross margins above 30%, below 30%. Historically we've kind of looked at the 30% mark as the floor if you will and we expect going forward with the changes you’ve made in selling that they will improve in understanding that Q2/Q3, there were some issues that you mentioned earlier that will impact them. Where should gross margins be when the business is running the way you think it tends?

Pat Ervin

I mean I’m full to believe it, when we talk about our traditional levels, and we are going to be in the 32, 33% level. I mean the one area Gary that I don’t want to minimize as the comment I have made, let’s assume for a minute that Hardinge sometime in the future. Now, I don’t know if that's a year or five years, mirrored the world economy from a consumption point of view. And the reason I say that is back to the 49% Asia. If our volume is at that 49% Asia, the real focus is got to be on that operating margin because of gross margin versus the SG&A in that region.

Gary Linhoff

Yeah.

Pat Ervin

I mean that’s a big -- it’s going to hit us, but if we are able to ever give us to that level 49% of our sales came from Asia, we really should focus on making sure that the operating margin were not losing and we’ve been able to prove that we can maintain same operating margins in that regions as the rest of the world. That’s going to be critical, so I just don’t want to just focus on the gross margin percentage side as a result of that.

Gary Linhoff

That’s a fair statement. Let me ask the question differently. Where should that operating margin then be?

Pat Ervin

I mean I envision 10, 12 is I would guess that where we would be in that range.

Gary Linhoff

Okay. And can you -- in talking about working capital inventory specifically, can you give us some better sense how do your operating units, what are the targets that they are looking to operate that in terms of working capital? Are you measuring inventory turns by product type, how are they incentivized if you will and how are you measuring where that inventory is versus where you would like to see it over time?

Rick Simons

Actually, this is Rick Simons. We obviously look at inventory turns. We do have differences in the types of business. The Swiss operation is very uniquely integrated. The Taiwanese operations are more of an assembly operation, but actually it’s a very good question because this one of the things that I have come in and want to start doing is developing some very specific realistic metrics for each of the business units that we can start targeting and we are kind of bringing that working capital back. We’ve recognized that it is too high right now. We have to look at perhaps final assembly of machines near the end used markets. We have to look at branded warehouses in some places over sharing machines. We have to look at having machine fit all the worldwide safety requirements and so specific machines targeted for a specific market so there is a lot to do things we are going to do and among those certainly we are coming up with some very real metrics that we can hold people accountable for.

Gary Linhoff

Okay. Is it fair again utilization, I mean historically you have been able until recently that turn inventory, I mean it’s not a high turns business, but you have been able to turn your inventory close to twice a year, you are running well below 1.5 now, is the two times inventory turn realistic to expect from the business?

Rick Simons

I think it’s realistic and I think it's absolutely a mandate to that level. Certainly when you are comparing it to the end of last year and the first quarter of this year, and Pat has mentioned before there was an inventory build up of machines specifically from some our Taiwanese manufacturer. So you are looking -- if you look at year end numbers or even at the end of the quarter because of the Swiss machines, you are looking at as a difficult comparison time, but certainly longer-term, I'm not going to ensure you for any longer term, medium term, a two times turn is what we have to get to.

Gary Linhoff

Okay, great. Thanks guys.

Pat Ervin

Sure.

Operator

Thank you. (Operator Instructions). And our next guest is Bob Schenosky. Bob, your line is open.

Bob Schenosky

Thanks. I just had one follow-up.

Pat Ervin

Sure.

Bob Schenosky

Pat, is it fair to characterize as a direct sales force starts to get some traction here, China continues to grow a strong demand, you deplete your inventory that’s in place, is it fair to assume that the first quarter looks to be the bottom?

Pat Ervin

Let me answer this way. If the economic conditions of the world don’t change from where they are now and you guys can be the experts on what are the regions going to do then I think that’s a very good statement.

Bob Schenosky

Okay, thank you.

Pat Ervin

You are welcome.

Operator

Thank you. And we have no other questions in queue.

Pat Ervin

Okay, Betty. Thank you.

Operator

You are welcome.

Pat Ervin

As we look forward into the remainder of 2008, we know there will be significant challenges we must face, especially in light of the deteriorating economic conditions in the US and the UK. However, we are a geographically well-diversified company. I am very confident that Hardinge organization throughout the world is up to these challenges and as we continue to improve our business performance. We are committed to simplifying our operations to become even better focused on addressing our customers’ needs to fully take advantage of our unique worldwide presence. We look forward to you updating you on the next conference call. Thank you for your time and have a good day.

Operator

That concludes today’s conference. Thank you for participating. You may now disconnect.

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Source: Hardinge, Inc. Q1 2008 Earnings Call Transcript
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