Flow International Corporation (FLOW) F4Q08 Earnings Call July 9, 2008 11:00 AM ET
Executives
John S. Leness – General Counsel, Corporate Secretary
Charles M. Brown – President, Chief Executive Officer
Douglas P. Fletcher – Chief Financial Officer, Vice President
Analysts
Sid Parakh – McAdams Wright Ragen
Chuck Murphy – Sidoti and Company
Chad Bennett – Northland Securities
Alan Robinson – RBC Capital Markets
Mark Tobin – Roth Capital Partners LLC
Todd Wilson – Rock Point Advisors
James D. Padgett – The Boston Company
Operator
Welcome to the Flow International fiscal fourth quarter 2008 results conference call. (Operator Instructions) I would now like to turn the conference over to John Leness.
John S. Leness
With me this morning are Charley Brown, Flow’s president and CEO, and Doug Fletcher, Chief Financial Officer.
This call will include forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. During the call we will provide selected financial and performance results for the fourth quarter of fiscal 2008. Any statements about future events, trends, risks, and plans should be considered as forward looking. These are based on current expectations only. Actual results may differ from these forward-looking statements and are subject to risks and uncertainties as are detailed in our filings with the Securities and Exchange Commission.
Flow takes no obligation to update any forward-looking statements, whether as a result of new information on future events or otherwise.
With that introduction I’ll turn the call over to Charley Brown.
Charles M. Brown
We are pleased to report an excellent quarter and year in both revenue growth and improved profitability for Flow.
First I will comment on the results for the quarter and then the year, after which Doug will go through the financials in more detail. I will then offer some additional comments prior to addressing your questions.
For the fourth quarter ending April 30h our revenues were $63.3 million representing 21% growth versus last year; 15% organically and 6% from foreign exchange rate changes. System sales grew 23% while spare parts grew 17%.
Breaking down the systems sales further, our core standard system revenue for North America was up 18% for the quarter. Our standard system sales in Europe and Latin America each were up over 30% in Q4. In local currencies our standard system sales in Europe increased by 25%. These results were aided by the continuing roll out of the 87K product line. In Asia standard systems continued their return to historical levels with a 68% increase versus year ago.
Our consumables or spare parts business globally grew 17% for the quarter with consistent performance around the world. Our aerospace business grew 8% in the quarter finishing the year down 36% comprising about 5% of our business for the year. This has been a weak year for our aerospace business due to the delays of equipment purchases supporting major commercial airframe programs.
Our applications business segment sales in local currency were down 19% for the quarter and up only 3% for the full year. The impact of the weak domestic auto industry and our decision to exit the unprofitable non-water automation business impacted revenue in the quarter and for the full year. I will discuss the applications segment and our aerospace business in more detail in a few minutes.
Since early in fiscal 2008 we have communicated that revenue for the year would grow at least 10%, that operating profit would be three to four times higher than fiscal 2007, and that it would represent between 6% and 7% of sales. During our last earnings call we updated our revenue outlook to at least 12% growth. We reiterated our three to four times operating income growth projection and we also said that we expected to hold operating expenses to less than the prior year.
So how did we do against those targets? We delivered each of them as anticipated. Revenue growth for the year was 14% of which 10% was organic and 4% was from foreign exchange. Operating profit was right in the middle of the dollar range and at the high end of the margin range. Operating expenses were 1% below the prior year.
Flow benefits from having a diversified revenue profile that is spread across geographies and end users. Roughly one half of our revenue comes from customers outside the US and no single customer makes up more than 5% of total revenue. Additionally, we have a strong recurring revenue stream from spare parts that made up 28% of revenue in fiscal 2008. Our balanced portfolio allowed us to achieve this double-digit revenue growth this year with some businesses performing very well, notably North America, Europe, Latin America, while others were flat or declining, applications, aerospace, and Asia.
On a quarterly basis our revenue can be impacted by the timing of product launches, large contracts, or the relative strength of our businesses. During fiscal 2008 we were up about 9% in the first two quarters and then we jumped to 19% in the third quarter and 21% in the fourth quarter, all totalling 14% for the year.
From a profitability standpoint we have reigned in SG&A expenditures while still investing in critical infrastructure, including our new information systems project. SG&A declined 560 basis points year over year as a percent of sales. Gross margins were down 240 basis points in the first half of the year, but up 55 basis points in the second half. In total, operating income for the year was 6.9% of sales versus 2.2% in 2007.
I will now turn it over to Doug for further financial commentary.
Douglas P. Fletcher
Before I discuss our operating performance let me touch briefly on backlog. Our backlog as of April 30, 2008, stood at $35.3 million, down slightly from the end of the third quarter and up 14% from the prior year. The aerospace systems backlog, which made up 21% of the total backlog, does not include any amounts for the recently signed Airbus contract. We expect our overall backlog to increase significantly over the next two quarters as we receive the individual systems orders under the Airbus contract.
Net income for the fourth quarter was $13.3 million or $0.35 per basic and fully diluted earnings per share. This compares to a net loss in the prior year period of $3.2 million or a loss of $0.09 per basic and fully diluted earnings per share.
During the fourth quarter we reversed the valuation allowance against our deferred tax asset in the United States and recorded a one-time benefit of $11.8 million. Excluding this benefit, an additional tax expense of approximately $1.9 million recorded in the fourth quarter to adjust our full-year tax expense. Our net income would have been $0.09 per basic and fully diluted earnings per share. For the full year that income was $22.4 million or $0.60 per basic and $0.59 per fully diluted earnings per share. Excluding the one-time benefit from the reversal of the US valuation allowance, net income was $0.28 per basic and fully diluted earnings per share. This compares to net income in the prior year of $3.8 million or $0.10 per basic and fully diluted earnings per share.
Our effective tax rate for fiscal 2008, excluding tax benefit from the valuation allowance release in the United States, was 34%. Much higher than anticipated due to the mix of earnings between our foreign subsidiaries and losses taken in Canada where we have a full valuation allowance.
Our gross profit for the quarter was 41.9%, up from the prior year quarter of 40.8% and 80 basis points below third quarter levels. The positive impact of operating improvements initiated during the year was offset by the impact of a change in product mix and the poor performance in our application segment.
As Charley mentioned, gross profit margins were down in the first half and up in the second half of 2008. But at 41.6% for the year they were down 90 basis points. This was mainly due to product mix and weaker application margins.
On an overall basis, SG&A expenses were $20.3 million in the quarter, down 19% from the prior year. Sales and marketing expenses were up 7% due mainly to higher commissions on increased revenues plus some additions to staff. Research and engineering expenses were down 6% due to the timing of new product launches and improved expense management.
Our general administrative expenses were down $5.1 million or 40% due to the cost of $2.9 million to amend the prior CEO contract reported in the prior year quarter and lower professional fees for patent litigation, external audit, and (inaudible).
For the year SG&A was $84.9 million, down 1% from the prior year as a result of improved expenses control, elimination of some large one-time expenses, and lower professional fees for audit and patent litigation. In fiscal 2009 we will continue to use caution with operating expenditures while making some significant, much-needed investments in our information systems.
Operating profit for the quarter was $6.2 million and operating margin was 9.8%. While we have improved significantly from the prior year, which was an operating loss of $3.5 million, core performance and one-time charges at our applications segment reduced operating performance. For the year, operating income was $16.8 million. Including the CIS business that has been re-casted discontinued operations, operating income was $17.5 million, the middle of the range that we previously communicated.
In other income expense we had a loss of $1.1 million in the fourth quarter driven mainly by unrealized foreign exchange losses. We experienced a lot of volatility during the quarter in a number of the major currencies we do business in, including the Euro, Swiss Franc, Japanese Yen, and Canadian Dollar. While we have some hedging programs in place, we will be expanding these in fiscal 2009 to reduce earnings volatility.
Free cash flow for the fourth quarter, defined as operating cash flow less cash CapEx, was $12.5 million; a significant turnaround from the negative $3.2 million in prior year quarter. For the year, free cash flow was $7.7 million, up from a negative $2.8 million in fiscal 2007. Cash from improved operating profit was offset by increases in net working capital and cash payments under the prior CEO contract amendment.
Cash CapEx was $6.2 million, down slightly from the $6.7 million in the prior year. During fiscal 2009, we expect to spend approximately $8 million on CapEx.
Our balance sheet remains strong with our net cash position of $25.8 million as of April 30, 2008. We had a $29.1 million in cash insured term and investments of which $15 million was held by our divisions outside of the United States.
Last month we announced that we had signed a new $100 million five-year secured credit facility which includes a $65 million revolving credit facility and a $35 million term loan that we may draw upon for the Omax acquisition. We are happy to be able to close this facility with good structure and pricing given the volatile credit markets.
Lastly I want to touch on our 10K filing this week. In the process of closing the books for fiscal 2008 we discovered some minor adjustments from early tax items that should have been reported in fiscal 2006 and had a carry-over impact on fiscal 2007. Because the earnings during those periods were relatively low, these adjustments when aggregated with other items discovered in previous periods that had been deemed immaterial were now material to fiscal 2006.
While the total impact of $0.02 per share over two years is small, we decided to restate fiscal 2006 and 2007. Specifically, the net change to fiscal 2006 reported net income was a decrease of net income by $733,000 or $0.02 per basic and fully diluted per share, and a net change to fiscal 2007 reported net income was an increase of $85,000 and no impact on earnings per share. Later today we will be issuing an 8K regarding this statement and the 10K to be followed later this week will include the restated numbers.
With that I will turn the call back to Charley.
Charles M. Brown
I will now address our plans for the businesses that make up the applications segment, the status of our Omax transaction, and then our outlook for fiscal 2009.
We have not been happy with the results of our applications segment, which lost $3.8 million in fiscal 2008. Last fall we announced our plan to exit the non-waterjet automation business that was closely tied to the domestic auto industry and had been losing money for the past few years.
Last month we announced that we would be closing the home of the applications business, our Burlington facility in Canada, moving manufacturing and engineering functions from there to the new advanced systems centre in Jeffersonville, Indiana. This rationalizes the manufacturing capacity for our cutting cell and slitting products, which Jeffersonville has also produced in the past, so we are confident the transition will be smooth. Our sales team will be retained and our after-market parts business will be served well from our corporate headquarters in Camp Washington.
Also included in the applications business segment is an additional, strategically unrelated, engineering consulting business called CIS. CIS primarily offers outsourced engineering design services to domestic automotive manufacturers, currently a very difficult environment. We have decided to financially classify CIS as a discontinued operation because we will now explore alternatives for this small piece of our business.
The result of these moves is that we have methodically unwound our applications business placing the strategically important and financially viable pieces of business elsewhere in flow where they can flourish. This allows us to reduce our manufacturing footprint and overall cost structure while actually increasing our focus and capability to address the needs of the advanced systems customer segment.
The cost to close the facility and move cutting cell and splitter production to Jeffersonville will be about $2.7 million. We originally expected to complete the move in the fall, but now expect to complete most of the move by the end of July. Approximately $2 million of the estimated expenses are expected to be recorded in the first fiscal quarter of 2009.
Ninety-seven-thousand dollars of charges related to fixed-asset impairment were recorded in the fourth fiscal quarter of 2008. The one-time costs in 2009 will be in the range of what the business lost in fiscal 2008 and we expect to begin realizing the savings in fiscal 2010.
This project is an example of how we planned carefully to deliver on our commitment of 20% compounded EBID growth on a revenue stream growing at one half of that rate.
I want to now touch briefly on our pending Omax merger. As we have previously said, in February we received a request for additional information and documentary material from the Federal Trade Commission in connection with their review of the proposed transaction. We have continued to work closely with the FTC and we hope to have a favourable resolution very shortly. Beyond that, we cannot comment further at this time.
Turning to our outlook for fiscal 2009, I want to first comment on our aerospace business. Two weeks ago we announced the largest program commitment in Flow’s history with Airbus appointing Flow as the provider of the entire order for the new composite machining centres for its A350 program. This wide-bodied aircraft will use state of the art carbon fibre materials to reduce weight and increase fuel efficiency. By choosing Flow waterjets over many competitive cutting and trimming alternatives Airbus is reaffirming that not only are waterjets the best solution, but Flow offers the best technology and support in the world for these applications.
The Airbus commitment is the result of years of work by our aerospace team and is a key strategic building block to delivering our company-wide annual growth rate of 10%. The contract covers an initial order for nine systems, including two systems that we had previously worked on before the original A350 program was cancelled. This is a remarkable achievement because it represents a clean sweep of all systems ordered on this contract. No competitor received a single order for any waterjet systems for the A350 program.
Our nine systems will cut a wide variety of parts at seven different factories across Europe. Revenue from these initial purchases will exceed $30 million and will be recognized over the next 18 to 24 months beginning later this year. Engineering and manufacturing for these products will take place in our recently announced advanced systems technology and manufacturing centre which is an expansion of our Jeffersonville, Indiana, facility.
Finally, I’d like to comment on the US economic slowdown and its impact on our business overall. We are seeing a decline in North American system orders so far this fiscal year and anticipate this will continue, at least for the first half of the year. Interestingly, we are achieving solid growth in our North America aftermarket business, but not enough to make up for the softness in system sales.
Our North American customers are using their waterjets, but in general those considering a new system are very cautious. Fortunately we are not seeing this behaviour in markets outside of North America, which represent roughly one half of our revenue base. As shown in our fiscal 2008 Q4 and full-year results, our growth is derived from a variety of countries and multiple end markets. Our foreign markets remain robust and our aerospace business will clearly provide a strong lift later this year.
Overall, we expect to see flat to low single-digit growth in the first half of the year with a rebound in the second half lead by aerospace, all balancing to eclipse our 10% growth target for the year. However, if the US economic slowdown becomes wide spread globally our aerospace gains may be unable to keep our growth north of 10%. Absent that scenario, we anticipate achieving 10% revenue growth for the year.
While global economic trends could conceivably impact our growth rate we have more control over our profitability and we remain very confident that we will deliver EBID growth this year at least 20% higher than 2008. However we slice it, we consistently come back to our belief that this business can sustain compounded annual growth in revenue of 10% and in operating income of 20%.
I will now turn it back over to the operator to cue up the questions.
Question-and-Answer Session
Operator
(Operator Instructions)Your first question comes from Sid Parakh - McAdams Wright and Ragen.
Sid Parakh – McAdams Wright Ragen
I heard you talk about you’re seeing weakness in North America, but if you look at Q4 numbers it seems like you grew 17% year over year. Can you help me reconcile what you’re seeing and how the numbers are coming up?
Douglas P. Fletcher
Yes, as you’re correctly stating, North American system sales continued very strong through the end of the fiscal year and into the fourth quarter. As we rounded the corner and came into first quarter this year is when they started to pull back some. As I said, our customers are still using waterjets.
It looks like they have good business because we’re seeing some growth in our parts business, which when they use our machines they have to continue to buy the consumable parts. It’s just that it appears that our customers may be reading some of the same headlines that everybody else is and they’re just a little bit nervous to make additional capital investments at the rate that they were doing through the full previous fiscal year.
Sid Parakh – McAdams Wright Ragen
Would you say there was any seasonal impact that benefitted Q4 or would you say that was really, no seasonal impact there?
Douglas P. Fletcher
No seasonal impact.
Sid Parakh – McAdams Wright Ragen
Can you maybe talk about strength in the other international businesses, Europe and South America, and what segments of the market are you seeing that strength in?
Douglas P. Fletcher
It’s pretty broad spread. The segments of the market, start geographically, as I mentioned earlier, we are seeing good growth in Latin America as well as in Europe. We are able to see that growth across a pretty wide variety of end user markets. I wouldn’t point out one that’s up or one that’s down in those markets other than the fact that some of the stone applications globally tend to be a little bit softer right now and the metal working tends to be a little bit stronger.
Sid Parakh – McAdams Wright Ragen
On the margin front, are you seeing more pressure on the component cost side or is that something that you think is baked into the model?
Douglas P. Fletcher
It’s all baked into the model, but we are, it’s the world we live in. There is continuing pressure on commodities. We’ve worked that in. We’ve got a global supply team that is working well and putting in contracts that give us a pretty good deal of foresight into our cost structure.
Sid Parakh – McAdams Wright Ragen
On the aerospace side, you’ve received this large order from Airbus. I’m trying to get to maybe a run rate for what your spares consumption might be over time. I would tend to think that they have a pretty high consumption of spare parts and that should help spare consumption grow over time. Can you give us a sense for what you think how that might play out?
Douglas P. Fletcher
I think the way to think about the aerospace spare parts is to just keep it included in everything else. It’s not something you can pull out. Let me give you the math on that. Those aerospace systems are multimillion dollar systems each. But they have one pump driving them. What generate the spare parts are the high-pressure elements in the pump and in the delivery system of the high-pressure water to the cutting surface.
It’s not, the correlation between dollars of spare parts and dollars of system revenue is very different in the aerospace world than it is in the normal systems world where we sell a system for $250,000 and generate $10,000 of spare parts. Now we’re selling systems for multimillion dollars and the generation of spare parts is not dramatically different.
Operator
Your next question comes from Chuck Murphy - Sidoti and Company.
Chuck Murphy – Sidoti and Company
Can you say what your aerospace revenues were for fiscal 2008?
Douglas P. Fletcher
Yes, I believe we mentioned that. It was $3.7 million for the quarter and $13 million for the year.
Chuck Murphy – Sidoti and Company
I know you mentioned the $30 million for this Airbus order, what the total aerospace backlog is?
Douglas P. Fletcher
Well, the aerospace backlog, as I mentioned, was 21% or $7.4 million as of April 30th.
Chuck Murphy – Sidoti and Company
So the $7.4 million plus the $30 million? Is that fair?
Douglas P. Fletcher
Well, let’s just, the way we record backlog is that once we receive a purchase order, a firm commitment, it enters backlog. That contract was signed only last month and as they give us individual POs under that contract that will go into backlog. So that will build over time. But the intention under that contract is for deliveries over 18 to 24 months.
Chuck Murphy – Sidoti and Company
As far as the guidance, looking at what you’ve done the past three quarters for operating margin, it’s averaged about 10% or so. Is there any reason to think that will come down some in the next few quarters?
Douglas P. Fletcher
Well, obviously comparison as you do year over year comparisons are comparison in the first half of the year in fiscal 2009 versus 2008. It’s going to be an improvement because there are some one-time charges that we had in 2008. I think we come back to our target of 10 and 20 and that means that over time we will improve our margins and we’re more focused on improving our operating income number by 20% per year. So I would expect the margins to improve over time, but that’s the full year outlook. Taking any one particular quarter, Chuck, as we’ve mentioned on previous calls, is difficult to pinpoint.
Chuck Murphy – Sidoti and Company
I’m just trying to get at is if let’s say I assumed that your 10% up margins would stay intact for fiscal 2009 and I assumed that you were going to do 10% top line growth, I get to substantially higher than 20% operating income growth. I’m just wondering if there’s something I’m missing there.
Douglas P. Fletcher
Well, as we’ve mentioned in previous calls, we plan to reinvest some of the savings that we realized from the one-time expenditures into our information systems project, which is very important for our long-term growth. We would like to do better than 20% certainly, but clearly we believe we can hit 20% this year.
Charles M. Brown
There’s also a follow up point there, Chuck, and that is we’re extremely excited about the aerospace business. Given that the waterjet portion of the revenue streams there is relatively small compared to when we sell a waterjet system, the ability to drive the higher waterjet related margins as a total mix within an aerospace system is also difficult. So I think you’re aware that the aerospace margins tend to be a little lower than the rest of our business. So there will probably be some mix shift as we go from 2008 where aerospace was 5% of our business, that’s going to be more than 5%. I’m not going to comment on how much more, but there will be some mix shift in terms of gross margins.
Chuck Murphy – Sidoti and Company
Can you repeat what the, how much currency helps sales by?
Douglas P. Fletcher
On a top line basis we, for the quarter, we did 15% organically and 6% from foreign exchange for the total of 21%.
Operator
Your next question comes from Chad Bennett - Northland Securities.
Chad Bennett – Northland Securities
Doug, can you talk about, and you may have touched it a little bit on this, but the amount of restructuring charges in the quarter which I assume hid under G&A. Then if there were any acquisition related costs that we could segment out?
Douglas P. Fletcher
The only real identifiable IM which I mentioned was approximately $100,000 out of our application segment. When we announced the closure of that facility we had to take a reserve on fixed asset impairment. We did that in the fourth quarter. Most of, and I’m sure there could be some charges that weren’t capitalized, but most charges related to the acquisition and merger with Omax are capitalized at this point. So that didn’t have an impact.
I think the point I would make about G&A is what I just said previously. It’s to pinpoint one quarter and predict an exact amount is difficult. As I mentioned on previous calls, typically our fourth quarter and first quarter are higher in G&A expenditures because it’s just typically a higher quarter for professional fees and some other items.
So that, if you compare our G&A expenses to third quarter they’re up quite bit, but you have to adjust the third quarter because we had almost a $500,000 insurance recovery on our theft losses the prior year. So probably on a quarter-over-quarter basis we are up a little over $800,000 of which about $100,000 of that was the application write down. And then some of the other increases is just normal seasonality that we see in G&A.
Chad Bennett – Northland Securities
What’s the absolute dollar amount that we should use to grow off on the operating income or EBID guidance that you give? For fiscal year 2008 that just ended.
Douglas P. Fletcher
Based upon the number that we mentioned on, the 416. Well, I’ll go back to my, be sure we’re very clear on this. We had $16.8 million, and that is on a continuing operations basis. That’s the number we’re targeting.
Charles M. Brown
I think it’s important to point out, and I say this every time, that we don’t classify our comments as guidance because guidance, that word to me implies an ongoing update and some other obligations. We’re happy to give insight and share our anticipated going forward numbers, but I would not put it in the category of guidance.
Chad Bennett – Northland Securities
Doug, how should we look at tax rate next year?
Douglas P. Fletcher
With the reversal of the US valuation allowance we’re looking probably in a normalized rate around 38%. That may go up or down. It may go up a little bit in some quarters because we have some foreign jurisdictions, specifically the largest being Canada, that has generated some significant losses that we can’t take the benefit of those losses because we have a full valuation allowance against our Canadian operation. So we can see some quarters that would go up into the low 40s.
Chad Bennett – Northland Securities
Charley, you’ve given incremental colour on what you’re seeing out there in the marketplace just to make sure we can understand the qualitative remarks. So looking at the first half of this year, are we just talking about a material moderation in North American standard system sales or are we actually seeing maybe declines out of that region for that segment of the business?
Charles M. Brown
Let me pinpoint it and make sure that I’m answering your question. You’re talking about system sales in North America, right?
Chad Bennett – Northland Securities
Correct.
Charles M. Brown
And so in context that is not all of North America because we’ve got parts sales which are up, so far this year, and then we’ve got systems and parts in all the other parts of the world, which is another half of our business. So we’re talking about a portion of our business. It’s a very significant portion and on that portion I would anticipate that sales would actually be declining versus year ago where we’ve had some very strong comps. So the answer to your question is it’s not just a slower growth rate, it’s probably actually a decline for that piece of our business against some strong comps.
Chad Bennett – Northland Securities
In terms of the consumable piece of your North American business, it seems like it’s still plugging along very well, so utilizations must still be fairly high on your systems. Is there any way, have you seen any shifts in trends there or as the growth rate remained consistent, even to date?
Charles M. Brown
Just to address that fairly we’ve had incredible growth. Very strong growth as we’ve reported 17% growth in our global aftermarket business in Q4 for the year is a strong number as well. That number for the North American piece probably won’t be quite as high from what we’re seeing right now. I would anticipate it to be mid-to-high single digits probably as we go through the first half of the year.
Chad Bennett – Northland Securities
What portion of your North American systems business is dependent upon some financing by the customer? Is there any way to look at that?
Charles M. Brown
I don’t have an exact number, but it’s certainly north of half of it. Maybe as much as two-thirds of it. So that’s an important part of what’s going on out there.
Chad Bennett – Northland Securities
Are you seeing some financing impact on the customer side? Or you haven’t heard of any?
Charles M. Brown
No, what we hear is it’s just a lot more work to get a loan these days. And these are small businesses. They may have five or 10 or 15 people. They don’t have a staff of accountants to pull three years of records and things. They get to the point where they’re reading the newspaper and then they go to the loan, the bank to get a loan and it’s going to take them three days to process more paperwork and they say it’s not worth it right now. I’m too busy doing other things. I’m not saying that to every case, I’m just giving you some colour around the types of things that are going out there anecdotally.
Chad Bennett – Northland Securities
Did we see any, if you’d like to comment, did we see any Boeing 787 related revenue during the quarter?
Douglas P. Fletcher
Yes, some of the revenue that was in the $3.7 million of the quarter was working on some business for the 787, yes.
Chad Bennett – Northland Securities
Is the majority of that though still in front of us?
Douglas P. Fletcher
I’ve given up trying to even begin to predict what’s going on with the 787 program.
Operator
Your next question comes from Alan Robinson - RBC.
Alan Robinson – RBC Capital Markets
Just regarding the North American system sales again, are you providing any incentives or changes to your incentive program to try to stimulate sales there? Or are you just rolling with where the market’s taking you there?
Charles M. Brown
Rest assured, we have a high degree of focus and a long list of what we call countermeasures to go out and take every order that we can find.
Alan Robinson – RBC Capital Markets
Would those incentives include providing finance in house for your customers?
Charles M. Brown
No.
Alan Robinson – RBC Capital Markets
And in terms of this, if you could talk a little about material price increases, could you remind us of the extent to which steel costs impact your costs of goods for your systems?
Douglas P. Fletcher
Obviously steel, Alan, is an important component to our systems, especially some very specialty stainless steel, the 15-5 bar of stainless which is used in the ultrahigh pressure components. What I would say is with that, given the work done by our global supply chain and the long-term commitments that we’ve put in place, we think we’ve done a good job to hedge ourselves as best as possible. I would say, I don’t have the number off the top of my head of what stainless steel is as a component of our material costs. I would be guessing to tell you on the phone.
Alan Robinson – RBC Capital Markets
In terms of the aerospace contracts that you have in place with Airbus and others, are these generally fixed price contracts or do you have provisions in them for cost pass throughs should you experience higher material costs?
Charles M. Brown
I understand why you’re asking the question, but I just have to respectfully decline to answer. These are private contracts with other companies. It is a highly competitive situation and we’re not at liberty to divulge the details of that.
I do want to make, I want to underscore and put in context our aerospace business, however. Remember that in 2008 it was 5% of our total. We expect with the types of numbers that we’ve told you about, the Airbus contract over the next 18 to 24 months, we expect that portion of our business to contribute well to our 10% growth as a company and, as I mentioned in my opening remarks, that’s a key part of our strategy to get there. But there are times when it’s easy, I’ve seen it in the past, it’s really easy to let that 2008 5% of our business shout a lot louder than the other 95% of our business.
Alan Robinson – RBC Capital Markets
And then given this environment we have of higher material prices, can you discuss how that is impacting your gross margins between system sales and consumable sales? Is it impacting those areas equally or is the spread between those gross margins increasing now as systems are more beholden to material cost increases?
Douglas P. Fletcher
We haven’t seen much of a shift. Relative to the last years our margins haven’t shifted that significantly in the range of our standard systems. Obviously new product launches and timing impact that. Same is the case with spare parts. One of the things we touched on in the prepared remarks is we’ve spent a lot of time focusing on operational improvements. We have a lot more work to do in the area of global supply chain and our manufacturing footprint and we’re working on those items. What we’ve seen this year with the margins is that we didn’t fully anticipate the issues that we would have with the application segment. Which really brought the margins down and probably amassed some of the improvements that we’re making.
Alan Robinson – RBC Capital Markets
What do you have on the cards in terms of new product developments? Are you seeing the competition catch up to you in terms of your 87K hydropressure pump?
Douglas P. Fletcher
No, we haven’t seen anything from the competition that rivals our 87K and we’re not going to discuss publicly our secrets.
Alan Robinson – RBC Capital Markets
But I presume there is a pretty full investment pipeline for your product development. You’re not scaling back there, are you?
Douglas P. Fletcher
No.
Operator
Your next question comes from Mark Tobin - Roth Capital Partners.
Mark Tobin – Roth Capital Partners LLC
I know that a lot of your competitors don’t have the benefit of aerospace and the international exposure. Can you just comment on what you’re seeing competitively and in the context of talking about flat to declines within North America? Can that still translate into increased market share?
Charles M. Brown
We believe it absolutely can. There’s a time like this in North America you have to start looking at dollar share and unit share and get a little more granular. Our strength is certainly not at the lowest end of the food chain of water jets. It may be the case that some customers decide to buy lower specified lower cost products. We have an offering there and we are doing well with that offering.
That may be where the competition shifts short term a little more heightened than it would in the normal environment. Our biggest strength over the years has been in adding to the technology base of the product and pushing the envelope, which helps us in terms of average price per system sold that we’ve been able to drive up over the last five to 10 years continually. That helps our dollar share. We look at it a lot of different ways and we feel that on either of those variables we feel we’re in good position.
Mark Tobin – Roth Capital Partners LLC
Are you starting to see some of your competitors scale back significantly as a result of the macro environment?
Charles M. Brown
Nothing that we’ve noted to date.
Mark Tobin – Roth Capital Partners LLC
Doug, on the ERP system roll out, can you give an indication of how much of those expenses are being capitalized versus expenses?
Douglas P. Fletcher
Well, I would say it’s two parts, Mark. One, I would roll back and say a couple years ago, and Charley’s mentioned this on previous calls, we did not have a very robust technology team, information technology team here at Flow. So part of the expenditure has been under the new CIO who joined us over a year ago is to really improve that staff and add staff to that group. So there has been an operating expense increase and will be into this year, as I mentioned earlier in terms of investments. So there’s a portion there. With regard to the project, a large portion of the project will be capitalized.
Let me just comment briefly on the project. A lot of the work initially for the last 12 plus months, which I will call the first phase, a lot of it has been infrastructure. We had not made any major investments in infrastructure in years. So a lot of the work has been spent on infrastructure and really planning around the move up to a new improved information system overall. Going forward, a lot of the investments for the next two years, probably through the end of fiscal 2010, is going to be on the information system side and the ARP side.
Operator
Your next question comes from Todd Wilson - Rock Point Advisors.
Todd Wilson – Rock Point Advisors
Historically, years where you’ve attended the IMTS show have had a good bump in system sales later that year. Do you expect to have a significant presence at the show again this year?
Charles M. Brown
Yes.
Todd Wilson – Rock Point Advisors
That’s been modelled into your expectations.
Charles M. Brown
Yes.
Operator
Your next question comes from J. D. Padgett - The Boston Company.
James D. Padgett – The Boston Company
Question was just trying to answer the applications business a little bit better. Over the past 12 months, I know there is some business within that that you’ve allowed to naturally erode and then you’re breaking out the CIS business. I’m just trying to understand, what are the intentions with CIS? Do you think there’s value there to a seller? And then, how does this business look six, 12 months out in terms of some things you’re doing consolidating facilities and getting a cost structure in line?
Charles M. Brown
When you say this business are you referring to applications?
James D. Padgett – The Boston Company
Exactly.
Charles M. Brown
The first part of your question, CIS, we’re early in the stages of exploring that. There’s a whole range of things that could happen with it. We hope to get some value out of it, but it’s a tough time going forward. The numbers, the expectations are a lot lower than the historical track record in a business that’s doing consulting for forward-looking manufacturing in the domestic automotive business. So our expectations are relatively low in terms of what we can realize for that business, but we’re trying to keep the best interest of both our shareholders and our employees in mind and figure out what’s the best way to go.
James D. Padgett – The Boston Company
And we can see from the discontinued operations that was profitable for last year, but in this last quarter it wasn’t all that profitable.
Charles M. Brown
The rear-view mirror looks better than the windshield right now, and then the rest of your question again.
James D. Padgett – The Boston Company
There was some other business within that that you’ve allowed to naturally run its course, right?
Charles M. Brown
Let me talk about the applications overall to your question. It had, it was a business unit that was centred in Burlington, Ontario, just outside of Toronto, that the CIS reported into. We just discussed that. It has a spare parts business, which is very profitable like the rest of our spare parts business, which just happened to be administered out of that office. We’re going to administer that out of our Camp Washington base where we do the rest of our North America parts. So you pull that part back in.
Then it has the manufacturing of robotic cells and splitters, some more specialized systems that have some engineering content to them in more what we call the advanced systems segment. And the manufacture and engineering of those products took place in Burlington. That’s what will shift down to Jeffersonville, Indiana, which is where we’ve got a core team that is very, very good at that type of production and engineering because that’s where all of our aerospace business is designed and manufactured. That’s also where our XY tables, the motion portion of our waterjet machines, is manufactured. So we pull that down into that home for that portion of the business.
And then there was the other part we discontinued, which is the non-waterjet automation business. We stopped taking orders last September and are just living up to the customer commitments to totally unwind that.
We’ve taken the applications business and carved it up into its constituent pieces and then chosen the right solution for each piece to maximize shareholder value.
James D. Padgett – The Boston Company
So what we see in this most recent quarter, the $2.3 million in revenue, that’s a good baseline to think about for the business going forward.
Charles M. Brown
I would think so.
James D. Padgett – The Boston Company
I don’t know if you will share this in the cave, but is there a segment profit or loss associated with that?
Douglas P. Fletcher
Yes, there is. At this point in this particular case it’s still going to be listed as a separate segment.
James D. Padgett – The Boston Company
And is it profitable right now at this, in its current configuration?
Douglas P. Fletcher
No. The segment itself is not profitable. One of the reasons why we are shutting down the facility is as we have scaled back that facility just running that revenue through that size facility with the overhead doesn’t make sense. That’s one of the reasons why we moved the engineering and production of these advance systems, slitters, robotic cells, etcetera, to our Jeffersonville facility and are shutting Burlington.
Charles M. Brown
And if you look at the sum of the numbers on the 2008 fiscal profitability operating profit line the non, the CIS is a plus of about $600,000 and the rest of applications is a minus of about $3.8 million. So like I said, we’re pulling it apart and putting the profitable portions where they can be run profitably and getting rid of the overhead.
James D. Padgett – The Boston Company
So will that, you think, at some point through this fiscal year, that segment be break even or profitable.?
Douglas P. Fletcher
It’s hard to say exactly the timing of everything. What we said in our opening remarks is that we think the cost of getting out and the benefit of getting out will probably about balance for this year and we’ll start seeing the benefit next year. Which again, that’s one of the things that we’re looking forward for making sure we can deliver operating profit growing at twice the rate of our sales, 20% versus 10%.
James D. Padgett – The Boston Company
The facility closure alone, how much does that save you?
Douglas P. Fletcher
I’m not sure we’re going to get that granular.
James D. Padgett – The Boston Company
But hopefully it’s something that you can work toward contributing at a segment profit level over time would be the goal. And that was the reason that gross margin was down was just because of the shortfall and profit, the headwind from that segment this past quarter?
Douglas P. Fletcher
Primarily.
Operator
We have no further questions.
Charles M. Brown
Thank you all for your interest. We don’t have any further comments. So have a great day.
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