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Executives

Steve Tschiegg - Manager of IR

James W. Griffith - President and CEO

Glenn A. Eisenberg - EVP, Finance and Administration

Michael C. Arnold - EVP and President - Bearings and Power Transmission Group

Salvatore J. Miraglia, Jr. - President - Steel Group

Analysts

Eli Lustgarten - Longbow Research

Robert Schenosky - Jefferies & Company

Mark Parr - KeyBanc Capital Markets

Martin Pollack - NWQ Management

Melissa Cook - Calyon Securities

Holden Lewis - BB&T Capital Markets

Brian Carlson - Atlantic investment

The Timken Company (TKR) Q2 FY08 Earnings Call July 30, 2008 11:00 AM ET

Operator

Good morning. My name is Regina and I will be your conference operator today. At this time I would like to welcome everyone to Timken's Second Quarter Earnings Release Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions]. Thank you. Mr. Tschiegg, you may begin your conference.

Steve Tschiegg - Manager of Investor Relations

Thank you and welcome to our second quarter conference call. I am Steve Tschiegg, Manager of Investor Relations. Thank you for joining us today. And if after our call should you have further questions, please feel free to contact me at 330-471-7446.

With me today are Jim Griffith, President and CEO; Glenn Eisenberg, Executive Vice President of Finance and Administration and CFO; Mike Arnold, Executive Vice President and President, Bearings and Power Transmission Group; and Sal Miraglia, President of our Steel Group.

We have remarks this morning from Jim and Glenn, and we'll then all be available for Q&A. At that time, I would ask that you please limit your questions to one question and one follow-up at a time to allow an opportunity for everyone to participate.

Before we begin, I'd like to remind you that during our conversation today, you may hear forward-looking statements relating to future financial results, plans and business operations. Actual results may differ materially from those projected or implied due to a variety of factors. These factors are described in greater detail in today's press release and in our reports filed with the SEC, which are available on our website www.timken.com.

Reconciliations between GAAP and non-GAAP financial information are included as a part of the press release. This call is copyrighted by The Timken Company. Any use, recording or transmission of any portion without the express written consent of the company is prohibited.

With that I'll turn the call over to Jim.

James W. Griffith - President and Chief Executive Officer

Thanks, Steve, and good morning. Timken achieved another solid quarter of profitable growth. Sales and earnings were both records and exceeded our previous estimate for the quarter. Sales were up 14% from last year, while earnings were up more than 30%.

Glenn will take you through the numbers in a moment, but first, I'd like to provide some insight into the strategies that are driving our improved performance and give us confidence that we will achieve our long-range targets.

The bottom line is these results demonstrate that the strategic actions we've been taking are working. We have a very clear enterprise strategy: to grow in targeted geographies and channels where Timken can generate significant values, and to optimize the rest of our business, shifting the portfolio toward attractive global industrial sectors while continuously improving our execution.

We are growing globally. Half of our Bearing and Power Transmission sales are now outside the U.S. Our most rapid growth is taking place in Asia, and especially in Process Industries where we are capitalizing on the hot infrastructure-related demand. As a result, nearly 20% of our Process Industries sales now come from Asia, providing important market diversity.

We are beginning to leverage our recent capacity investments and expect that strong demand will continue to fuel our growth in Process Industries, where we have some of the best opportunities to capture the full lifecycle of profits.

Sales in our Aerospace and Defense business grew over 40% this quarter with double-digit margins. The Purdy acquisition has served as a catalyst to the strong growth in aerospace, as we continued to build our strategic position in the helicopter and defense sectors.

At the same time that we're growing in targeted areas, we are also optimizing our portfolio and driving better execution. At an enterprise level, we implemented the third phase of Project O.N.E. in early April. This project is streamlining our global business processes and significantly enhancing our systems' capabilities. We now have roughly two-thirds of the Bearing and Power Transmission business operating on one platform.

In Steel, we are relentlessly focusing on execution. A current example is our effectiveness of recovering rapidly increasing costs and related LIFO charges with price increases and surcharges.

Our Mobile Industries business is clearly benefiting from the realignment announced last fall. We're simply better managing across shared capacities across multiple industries.

And while the North American light vehicle market has weakened, the outlook for our overall enterprise has improved to more than offset this impact. Accordingly, we have increased our full year earnings expectations. We certainly were not surprised by the improvement of our earnings for the quarter as the strategy really is beginning to take hold. But the magnitude of the earnings improvements and the quality of our results exceeded even our own expectations. The first half results illustrate the combined power of profitable growth, structural transformation, and improved execution.

Going forward, we expect strong global demand for industrial products to continue. And that we will deliver record results for the full year.

Now I will turn it over to Glenn for a more detailed review of Timken's performance and results.

Glenn A. Eisenberg - Executive Vice President, Finance and Administration

Thanks, Jim. For the second quarter, the company's fully diluted earnings per share from continuing operations were $0.92. Excluding special items, earnings were $0.96. Special items consisted primarily of manufacturing rationalization and restructuring costs. The rest of my comments will exclude the impact of special items.

Sales for the second quarter were $1.5 billion, an increase of 14% over 2007. Strong demand across the company's broad industrial markets was offset by weaker North American automotive demand, increased sales resulted from pricing, surcharges, currency and acquisitions.

Gross profit margin for the quarter was 22.4%, an improvement of 30 basis points from last year. Favorable pricing, surcharges and mix were partially offset by higher raw material costs related LIFO charges, and manufacturing costs.

The company was also able to better leverage SG&A as the margin improved 60 basis points over last year to 12.7%. During the quarter, the company increased its reserve for automotive industry credit exposure by $7 million. While our current customer account balances are within normal levels, we felt it prudent to increase our reserve given the uncertainties within this industry. As a result, EBIT for the quarter came in at $147 million or 9.6% of sales, 110 basis points better than last year.

Net interest expense for the quarter was $10 million, up $1 million from last year due to higher debt levels resulting from the company's acquisitions.

The tax rate for the quarter was 32.7%, bringing our year-to-date effective tax rate to 33.5%, reflecting increased earnings from lower tax rate foreign jurisdictions. We expect to maintain the 33.5% tax rate going forward. As a result, income from continuing operations for the quarter was $92.4 million or $0.96 per diluted share, an increase of 32% compared to $0.73 per diluted share last year.

Now I'll review our business segment performance. Mobile Industry sales for the quarter were $628 million, down 1% from a year ago. Increased sales in the heavy truck and off-highway markets were more than offset by lower demand from the North American light vehicle market, which included the effect of a strike at one of our automotive customers. The company benefited from improved pricing and currency.

For the quarter, Mobile Industries EBIT was $12 million or 1.9% of sales, 200 basis points lower than last year. The benefit of improved pricing, mix, and currency were more than offset by higher material costs and related LIFO charges, an increase in our reserve for automotive industry credit exposure, and the effect of lower light vehicle demand.

For the second half of 2008, we expect strength in the heavy truck and off-highway markets to be more than offset by a lower light vehicle and rail demand. While second half results should be lower than the first half, we expect full year results to be comparable to last year.

The company continues to actively address the impact of the weakening North American automotive market through adjustments in manufacturing capacity and costs.

Process Industries sales for the quarter were $328 million, up 23% from a year ago. The company benefited from strong industrial markets as new capacity continues to come on line, as well as favorable pricing and currency.

For the quarter, Process Industries EBIT was $64 million or 19.4% of sales, 500 basis points higher than last year. The benefit of strong volume and pricing were partially offset by higher material and manufacturing costs.

Second half performance is expected to be lower than the first half, primarily due to anticipated higher raw material costs, but well above prior year levels.

Aerospace and Defense sales for the quarter were $106 million, up 42% from a year ago. The increase was primarily driven by the acquisition of Purdy at the end of last year. Excluding Purdy, sales were up approximately 14% for the quarter. The company benefited from favorable pricing and volume.

EBIT for the quarter was $12 million or 11.5% of sales, 590 basis points higher than last year. The favorable impacts of the Purdy acquisition and pricing were partially offset by higher material and manufacturing costs, including the start-up of the company's new facility in Chengdu, China.

Results for the second half should be slightly improved over the first half as the company continues to benefit from strong end market demand and added capacity.

Steel Group sales for the quarter were $520 million, up 26% from a year ago. The group benefited from strong demand across all market sectors with the exception of automotive. The group was also able to recover higher raw material costs through its surcharge mechanism. The increase in sales from the BSI acquisition was offset by the closure of the Desford tube manufacturing operation last year.

Steel Group EBIT for the quarter was $80 million or 15.5% of sales, 50 basis points lower than last year. The improved earnings resulted from strong demand, favorable mix and surcharges, which were partially offset by higher material costs and related LIFO expenses, as well as higher manufacturing costs.

Steel Group performance in the second half is expected to be lower than the first half of the year, due to seasonality and expected higher material costs, but well above prior year levels.

Looking at our balance sheet, we ended the quarter with net debt of $787 million, $18 million lower than the end of the first quarter due to strong cash generation from operations, which was partially offset by seasonal working capital requirements and capital investments in support of our growth initiatives. As a result, the company's leverage of net debt to capital decreased to 26.5% from 28% at the end of the first quarter.

The company expects to generate strong free cash flow for the remainder of the year, driven by record earnings and improved working capital management.

Capital expenditures for the quarter were $75 million or 4.9% of sales, above deprecation and amortization of $60 million. This spending level will increase over the course of the year as we continue to make investments in support of our growth initiatives.

We contributed $3 million to our global pension plans during the quarter, bringing our year-to-date contributions to $15 million. Our full year 2008 contributions are expected to be approximately $20 million, down roughly from $100 million last year.

In summary, we expect demand from our global industrial markets to remain strong, especially in key markets where we've invested for growth, and for the North American automotive market to be down with light vehicle production expected to be approximately 13.4 million vehicles for the year.

We expect to see higher profitability and margins for the full year compared to last year, benefiting from improved pricing, operating performance, and portfolio management initiatives, though constrained due to weaker automotive demand and expected higher raw material costs.

We recently increased our earnings per share estimate, excluding special items, to be in the range of $2.95 to $3.10 for the year, a record for the company. For the third quarter, we anticipate earnings per share, excluding special items, to be $0.65 to $0.75 compared to $0.51 for the same period last year.

From a cash flow standpoint, we expect to see higher free cash flow in 2008, benefiting from earnings growth, better working capital management, and lower global pension contributions. Capital expenditure should be comparable to last year as we continue to invest in growth initiatives while cash taxes are expected to increase.

This ends our formal remarks. And we will be now happy to answer any questions that you have.

Question And Answer

Operator

[Operator Instructions] Your first question comes from the line of Eli Lustgarten of Longbow.

Eli Lustgarten - Longbow Research

Good morning, gentlemen.

James W. Griffith - President and Chief Executive Officer

Good morning.

Eli Lustgarten - Longbow Research

Couple of quick questions; one, how much was foreign currency in the quarter, you get top line and bottom line impact?

Glenn A. Eisenberg - Executive Vice President, Finance and Administration

Yes. Eli, obviously we'll provide the top line. We normally haven't commented on the bottom line, but for the company, currency impacted us by around $45 million or call it around 3% of the 14% growth that we had.

Eli Lustgarten - Longbow Research

And I assume that it did help earnings to some degree, is that a fair statement?

Glenn A. Eisenberg - Executive Vice President, Finance and Administration

Yes, it is a fair statement. It does help earnings.

Eli Lustgarten - Longbow Research

And the tax rate, it looks like you added a couple... about $0.03 to the quarter and to get to 33.5% in the first half. Is that tax rate now going to the second half distribute into next year?

Glenn A. Eisenberg - Executive Vice President, Finance and Administration

I think at this stage of the game it's fair to use that for the remainder of this year and our current outlook of what next year would be.

Eli Lustgarten - Longbow Research

Okay. Now, in you guidance segment, you've got a reasonable third quarter, but it looks like an exceptionally weak fourth quarter shaping up versus what we have been seeing in the comparison. Is there anything going on other than conservatism or so because with you guiding $2.95 for $3.10 and sort of a $0.70 implied third quarter something in that range. But fourth quarter dropped off an awful a lot, just to get to the upper of your guidance, let alone if you don't get to the upper end of your guidance. I am just wondering is there anything going on in your outlook that's causing that bigger drop.

Glenn A. Eisenberg - Executive Vice President, Finance and Administration

I guess, it's clearly the uncertainties that are out there, but our fourth quarter while being low for the full year is still expected to be higher than the same period a year ago. We do expect that within at least the different groups, mobile should be down in the second half just given what's going on within the auto industry albeit we are leveraging well on the declining volumes.

Similarly, we just, from a more macro level, are seeing or expected to see higher material costs negatively impacting or constraining the margins across really all the rest of the businesses. So the only group, if you will, or the only segment that we really see the positive second half versus first is within the aero group. But all of the group should be better second half versus the same period a year ago. So we view it pretty positively. To your point, given the uncertainty that's out there, we feel good about where we are right now and we will wait to see as we progress through the year and see if that will change our outlook from where we currently are.

Eli Lustgarten - Longbow Research

And do you have any estimate of how much your material cost impact will be on second half, either across the company or by sector if you want to be insane and give it to us?

Glenn A. Eisenberg - Executive Vice President, Finance and Administration

Well, I don't think we will be insane to give it you other than just direction. We like I am sure the consensus out there is that material costs are expected to increase, but again, it's to some extent a variable we don't control, but clearly we believe that we can absorb those costs.

Eli Lustgarten - Longbow Research

Do you have any measure of the impact of it on the second half of the year, any ballpark estimate of what the magnitude that we are looking at?

Glenn A. Eisenberg - Executive Vice President, Finance and Administration

No, not on the magnitude other than directionally. We do expect it to be higher than what we experienced in the first half, which is again is constraining to some extent some of the margins and profitability in the second half.

Eli Lustgarten - Longbow Research

And do you expect mobile to stay profitable for the next two quarters or is it a possibility that that could go into the red? The third quarter is ugly, I know that. And I am not sure what the fourth quarter is like, heavy truck going down both quarters. So.

Michael C. Arnold - Executive Vice President and President - Bearings and Power Transmission Group

Hi, Eli, this is Mike. Yes, we expect it actually to stay profitable for the next two quarters. Again, very much driven by still downside on this whole light vehicle side from a North American perspective, but we have still got very strong markets in the remainder of the mobile side of the business.

Eli Lustgarten - Longbow Research

Okay. And can you give us one indication of how much incremental capacity do you expect to have available in 2009 in bearing versus 2008?

Michael C. Arnold - Executive Vice President and President - Bearings and Power Transmission Group

Well, we've been on a clip of about $75 million a year or so, Eli. That's been pretty consistent. Actually our ramp up of the manufacturing facilities are going very well. We're actually trying to accelerate those ramp-ups through the remainder of the year, which will probably put a little bit more cost into our business, but it will pay off both in revenue and profitability because most of that capacity is directed at constrained markets and yet very strong markets. So it's lining up very well.

Eli Lustgarten - Longbow Research

Okay. And one final question Project O.N.E. costs, I mean you're... should we expect more material charge in the second half of the year and into '09 in the Project O.N.E. area?

Glenn A. Eisenberg - Executive Vice President, Finance and Administration

No. I think as we've talked about before that given where we are with the project, the cost associated with Q1 is kind of peak. So for this year it should be, call it, comparable maybe to last and then we would expect those costs to go down into '09 and beyond.

Eli Lustgarten - Longbow Research

Okay. I will let somebody else ask some questions. Thank you.

Glenn A. Eisenberg - Executive Vice President, Finance and Administration

Thanks, Eli. I think that was more than the one question and follow-up. Okay.

Operator

Your next question will be from the line of Bob Schenosky of Jefferies.

Robert Schenosky - Jefferies & Company

Good morning.

James W. Griffith - President and Chief Executive Officer

Good morning.

Robert Schenosky - Jefferies & Company

Two questions. First one is given the capacity additions in non-automotive, how small, especially with the drop in volume, how small is auto now as a percent of the total business, overall company?

Michael C. Arnold - Executive Vice President and President - Bearings and Power Transmission Group

Well, we don't talk in terms of auto anymore. If you want to look at light vehicle systems, light vehicle systems now would be less than 20% of the total company.

Robert Schenosky - Jefferies & Company

Okay, great.

Michael C. Arnold - Executive Vice President and President - Bearings and Power Transmission Group

From a bearing perspective.

Glenn A. Eisenberg - Executive Vice President, Finance and Administration

Yes, the Steel business is about 23% of total sales. Actually we're about in that range, 25% total.

Robert Schenosky - Jefferies & Company

Okay.And then the other one is a lot of the other reporting companies have not shown the same type of strength in aerospace that you have. And even excluding Purdy, can you highlight some of the areas of strength that you're seeing?

Michael C. Arnold - Executive Vice President and President - Bearings and Power Transmission Group

Sure. We're continuing... Bob, this is Mike. As you know, all the aerospace businesses are very different in the types of applications that they serve et cetera, and we are very much focused on the defense industry, certainly the aftermarket from a growth perspective and not as much on commercial aircraft.

So we're seeing the strength certainly from our acquisitions and in particular Purdy, but also we've got some volume gains and still strength in the defense markets. So overall, it's hanging in there very well and our older books are extremely strong. We're still constrained on the capacity of the products that we produce to go into that market.

Robert Schenosky - Jefferies & Company

Okay. So for the back half of the year, you... is it fair to assume then that you anticipate that defense will be the key?

Michael C. Arnold - Executive Vice President and President - Bearings and Power Transmission Group

And we project at this point that it'll remain strong.

Robert Schenosky - Jefferies & Company

Terrific, thanks.

Operator

Your next question will come from Mark Parr of KeyBanc Capital.

Mark Parr - KeyBanc Capital Markets

Thanks very much. Hi, guys.

James W. Griffith - President and Chief Executive Officer

Hi, Mark.

Glenn A. Eisenberg - Executive Vice President, Finance and Administration

Hi, Mark.

Mark Parr - KeyBanc Capital Markets

It was really a surprise on the quarter, I'm kidding, great. Very strong results, one thing I wanted to ask as far as the nuance, did you use in the April call an '08 auto build assumption of somewhere around 14 million to 14.2 million vehicles?

James W. Griffith - President and Chief Executive Officer

From an auto build perspective?

Mark Parr - KeyBanc Capital Markets

Yes, I mean, your assumption... I mean, when you were giving full year guidance for '08 at then end of the first quarter, I thought that your embedded production assumption was 14 million to 14.2 million, is that right?

James W. Griffith - President and Chief Executive Officer

That's correct.

Mark Parr - KeyBanc Capital Markets

Okay. So I guess the conclusion I'm coming to here is that you have increased your full year earnings outlook despite a reduction in your automotive... your North American or your U.S. automotive production outlook. Is that fair?

James W. Griffith - President and Chief Executive Officer

That's correct, Mark.

Mark Parr - KeyBanc Capital Markets

Okay. Another... okay so... that's very encouraging, I guess. One other question I had on the steel sector. We've been seeing a lot of other steel companies work aggressively to get all the raw material costs pressure pass through. It looks like your commentary would suggest that you might still have a little more work to do in that regard. Can you give a sense of kind of where you are in that process or how you will be grading yourself and what potential upside opportunity there might be for steel profitability over the next several quarters?

Salvatore J. Miraglia, Jr. - President - Steel Group

Hi, good Morning, Mark, this is Sal.

Mark Parr - KeyBanc Capital Markets

Hey, Sal, hey, great quarter.

Salvatore J. Miraglia, Jr. - President - Steel Group

Thank you very much, we appreciate that. I don't know where you got the impression that we weren't passing most raw material cost increases through in steel. We are probably got close to that earlier just because of the profile of our contracts back several years ago, and that's continued today. In fact, you may recall, you and I had a conversation at the end of the first quarter where you were pushing me on, don't you think that scrap prices are going to be even higher for the end of the year and you ought to be up in LIFO. Well, we've capitulated and we did... and we've taken a bigger LOFO hit too. So... but all of the value that is caused by that, we're kind of passing right through with our surcharging mechanisms, and also taking some strong inflationary costs into account in getting returns on that too.

Mark Parr - KeyBanc Capital Markets

Was the change in the year-over-year margin more than explained by the change in LIFO charges?

Salvatore J. Miraglia, Jr. - President - Steel Group

The margin, I think, is... the answer is yes, but also because of the general inflating value of the sales, while we're making very good, but same profits. So, we're seeing... you are seeing the margin dilution because of the sales inflation more than anything. In fact, if you look at --

Mark Parr - KeyBanc Capital Markets

You mean it's a pure pass through as opposed to having a mark up on the surcharge. Is that fair?

Salvatore J. Miraglia, Jr. - President - Steel Group

At this stage that is a pure pass through as opposed to having a mark up on the surcharge. Yes.

Mark Parr - KeyBanc Capital Markets

Okay. Alright. Okay, look, I appreciate that extra color and congratulations all the progress. One other question, if I could, on the aerospace business, it seems... if you look at, Glenn, I think I heard you say that the aerospace business ex-Purdy was up 14%. Is that right?

Glenn A. Eisenberg - Executive Vice President, Finance and Administration

That is right.

Mark Parr - KeyBanc Capital Markets

Okay. Is there something... most of the aerospace commentary that we've been getting from other companies has been relatively subdued. It's kind of may be flattish or it's up may be a couple of points or it's down a couple of points. Is there... what's driving the growth in your aerospace business so aggressively in the current marketplace?

Michael C. Arnold - Executive Vice President and President - Bearings and Power Transmission Group

Well, Mark, this is Mike.

Mark Parr - KeyBanc Capital Markets

Hi, Mike.

Michael C. Arnold - Executive Vice President and President - Bearings and Power Transmission Group

Again remember where we have focused much of growth. We've had a historical aerospace business that we're supplying antifriction type products into original equipment manufacturers and we have expanded that business significantly into the aftermarket. So we are making a much broader range of products that we hadn't produced in the past. And that was came through some inorganic growth. So we made several acquisitions then in addition to Purdy. So to certain extent, we are getting a lot of growth because of the expansion of our product line in the markets that we serve.

Mark Parr - KeyBanc Capital Markets

Alright. So this, I guess... if I just wanted to summarize it succinctly, could I say that you are having success with internal organic growth initiatives?

Michael C. Arnold - Executive Vice President and President - Bearings and Power Transmission Group

Yes.

Mark Parr - KeyBanc Capital Markets

Okay. And is that something that... I mean, we are on the front end of or is that something that you would see persisting for an extended period of time or are we basically seeing the completion or the tail end of these programs?

Michael C. Arnold - Executive Vice President and President - Bearings and Power Transmission Group

No, we have a strategy to continue to grow in those selected markets, especially with regards to our MRO expansion. And so we are in the market both from an organic growth perspective leveraging the investments we have already made in the acquisitions, but also looking at other opportunities to acquire capabilities.

James W. Griffith - President and Chief Executive Officer

Mark, this is Jim. If I just tie back to a previous comment Mike made, the comment he made is that our markets focus more heavily on defense than commercial.

Mark Parr - KeyBanc Capital Markets

Okay.

James W. Griffith - President and Chief Executive Officer

And if you look at the relative strength of the two markets, the defense markets held up a whole lot more than the commercial market. So that explains a part of it, and I think gives us more opportunity to grow. I think it's also important to note that our aerospace business is a relatively small business to be broken out separately, part of the reason that we broke it out --

Mark Parr - KeyBanc Capital Markets

Yes, that's fair.

James W. Griffith - President and Chief Executive Officer

Is because of the strategy of growth.

Mark Parr - KeyBanc Capital Markets

Right.

James W. Griffith - President and Chief Executive Officer

That's a business that we intend to grow.

Mark Parr - KeyBanc Capital Markets

Okay, alight. And there is just... Mike, while I got you here and I have got your attention, could you just give us an update on the contract pricing momentum that you're seeing in the Mobile Industries and just how that whole accelerated focus on loss reduction in some of the old automotive contracts is progressing?

James W. Griffith - President and Chief Executive Officer

Yes, it's actually progressing very well, Mark, appreciate you asking about it. We've been very aggressive in the marketplace across the Mobile Industries. We would have seen that in our bottom line performance, had we not such a significant reduction, I think we were down about 19% on our light vehicle volume. So, that took a significant amount of volume out of the business, but that's progressing very well. And as you know, there is an opportunity only to renegotiate a certain percentage of our contracts on an annual basis. So, some of those that were not open for renegotiation, we have had the ability to open those up on discussions to make sure we are getting recovery on material costs increases, ala surcharges et cetera. So, overall, I'd say that's progressing very well, in fact, probably ahead of our plans.

Mark Parr - KeyBanc Capital Markets

Okay, terrific. Well, thanks again for all the color and look forward to talking with you again next quarter.

James W. Griffith - President and Chief Executive Officer

Okay, Mark.

Operator

Your next question comes from Marty Pollack of NWQ Investment Management.

Martin Pollack - NWQ Management

Yes, hi guys, a nice quarter. Two questions. One on mobile, I know you promised us more transparency as far as the auto business even after the new restructuring, but when I look at last year's fourth quarter, it was pretty tough quarter for auto as you reported $35 million loss for that single quarter. So obviously when you're saying this year's numbers will be better than last year's, it does seem to be in context to a very weak automotive number. Can you give us some idea again with that transparency what automotive would look like this year in terms... or could look like this year and at least in that fourth quarter, would it be much better, much improved from that number?

Michael C. Arnold - Executive Vice President and President - Bearings and Power Transmission Group

Yes, Marty, it's Mike. Let me give you some insight to that. We expect year-on-year, if you take a look at the old auto, which of course we don't talk about any longer, there will be an improvement year-on-year. And that would mean that there will be an improvement year-on-year in the second half of this year.

Now, the interesting thing is because the way we have restructured and refocused our business and the strategy as to the markets we're going to serve. What you won't see in the mobile side of the business is the impact of our ability to shift capacity that traditionally had served the automotive industry and it is now actually serving the process industry. So some of the upside that we're seeing in the Process Industries performance is as a result of the movement of that capacity directed to those growth markets where we're obviously more profitable in what we sell.

So you're going to see a combination of a couple of things: one, we are offsetting the reduction in volume in the light vehicle side of the North American industry, right, which is significant. We have good growth in our heavy truck to our off-highway, our rail and our automotive aftermarket businesses. And so that's all attractive. And then we also have this additional piece that we've actually moved capacity to other markets, which is helping the overall corporate results.

Martin Pollack - NWQ Management

Yes, actually that led to my second question because the process margins were spectacular. I mean, you were around 19% and when you look at incremental Q1 or the first half, your incremental margins look to be around 40%. So presumably you're saying even if auto looks weaker, the reality is that if you were to look at the impact of the shift, you're saying you're seeing that now in those margins. So the question is are process margins at these levels temporarily spiked by this shift? Because 19% is well above anything you produced historically and I would imagine that maybe it's a temporary benefit while automotive is temporarily stifled by the problems it has.

Michael C. Arnold - Executive Vice President and President - Bearings and Power Transmission Group

Yes, Marty, what I would tell you is if you look at the first half of 2008, clearly, when we went through the reorganization last year, the comments that we made in the previous calls is that we would begin to shift very aggressively that capacity that we could from one market to another. And that would fit with our strategies. That has been successful. And so in the first half you've seen the efforts of that capacity that's easily changed and refocused on other industries.

Now we get into the point where we start looking at the rest of our fixed assets as to what else can we move, what will be the effort to do so, and what will be the demand from those light vehicle systems markets that will allow us to make those moves even more aggressively. So, yes, there was certainly some benefit in the first half of that initial move.

Martin Pollack - NWQ Management

Okay, thank you.

Operator

[Operator Instructions] Your next question comes from Melissa Cook of Calyon Securities.

Melissa Cook - Calyon Securities

Good morning. I wanted to see if you could give us some update please on your capacity rollout in China and India. How is that going? And could you talk about some customer orders, end market demands, and give us some color in terms on what you're seeing in those markets? Thanks.

Michael C. Arnold - Executive Vice President and President - Bearings and Power Transmission Group

Sure, this is Mike again. Actually the capacity ramp-ups in our new Asian facilities are going very well. I think we've been relatively public with regards to those investments over the last several years. The three newest facilities we have is a facility in Chennai, which is focused on industrial markets, that's in Chennai, India. That ramp up has gone very well. In fact, we will accelerate that ramp up over the next six months. We think we'll see more benefits for it.

The Chengdu facility, which is an aerospace product based facility in China, the ramp up there was slowed as... as many of you know, the earthquake situation in China, and that was very close to the epicenter of that. So the overall infrastructure around there to be able to continue on got slowed down, but other than that, the ramp up will go very well and will be on target for there.

And then of course, our large bore manufacturing facility, which is targeted right at the growth markets across the world, the infrastructure build in Asia, wind energy markets and other energy markets, has gone very well. And in fact, we think that that ramp up will exceed expectations in the remainder of the year. So we are accelerating that. So, I'd have to tell you overall it's been very good experience for us.

Melissa Cook - Calyon Securities

And how about end market demand?

Michael C. Arnold - Executive Vice President and President - Bearings and Power Transmission Group

Very strong.

Melissa Cook - Calyon Securities

Are you seeing any slowdown?

Michael C. Arnold - Executive Vice President and President - Bearings and Power Transmission Group

We are not seeing any slowdown at this point because those end market demands are very much focused around energy, the infrastructure build throughout Asia, and then, of course, everything to do with mining and these sorts of things. So, no, we've got them, those investments pegged very closely to high growth markets of which at this point we've not seen any degradation in demand. And the geographic focus of it being Asia, obviously, we haven't seen any degradation of demand there either.

Melissa Cook - Calyon Securities

Okay, thanks.

Operator

Your next question comes from Holden Lewis with BBT.

Holden Lewis - BB&T Capital Markets

Good morning.

Michael C. Arnold - Executive Vice President and President - Bearings and Power Transmission Group

Good morning.

Holden Lewis - BB&T Capital Markets

Can you comment on your distribution business, I know you send a fair amount of your products through distribution and we've had some companies report that the distribution side of things tend to be a bit more... general industrial has weakened somewhat. Can you talk about setting aside the infrastructure, getting into the general industrial pieces of distribution, what you're seeing in that channel?

Michael C. Arnold - Executive Vice President and President - Bearings and Power Transmission Group

Sure. We will give you a specifics, Holden. But let me give you... see if I can give you enough color to give you some insight what's going on there. Our growth in the distribution markets, especially in the industrial side has been double-digits in 2008. So that has been very strong for us. There has been a combination of things there that have helped. One, certainly the demand across the world has been strong in distribution.

Secondly, the shift of capacity away from the old automotive industries in to industrial markets has specifically benefited our ability to serve the distribution markets and there was some pent-up demand in those. The concerns going forward that you hear from the marketplace primarily are North American-based and they continue to be based on the general economy and the overall construction industry, again of which is not that big of an industry for us.

It is important for some of some our distributors, but for our products and our growth and where it is targeted, it is not that critical of piece. So overall, our distribution sales have been strong. They have been positively impacted with regards to the mix changes that we're making from a strategic perspective across the business and it continues to look that way throughout 2008.

Holden Lewis - BB&T Capital Markets

And then trying to get a little bit more of a color in terms of what was going on in steel, primarily because if you read the description of what's going right and what's going wrong this quarter, it looks at lot like the description that you gave last quarter. Yet rate of growth obviously got better, the margins got substantially better. You are kind of talking about price being mostly a past through, it is actually pressing down on the margin to some extent in terms of how that math networks. It just seems like from Q1 to Q2, you almost flipped the switch and all of a sudden it went from doing okay to doing great. I'm just kind of curious what was the cause of that switch flipping?

Salvatore J. Miraglia, Jr. - President - Steel Group

Holden, this is Sal Miraglia, good morning. Yes, I mentioned last year... last quarter that really we're going to have to take a look at the first half as a whole because if you will recall, as we were getting into the first quarter, we saw spiking... really extreme spiking going on in the raw material costs. And as I made the point, I said, while we have the direct pass through, there is a timing issue. And the reality of it was that the timing issue, as we collected for that in the second quarter.

So if you take a look and just average the first and second quarter of this year over... instead of looking at them individually, you'll see we're just slightly ahead of, a little better than last year, which were two record quarters that we had last year, and we're just ahead or better than that on average. So, it's just a timing issue more so than anything else. The only other thing I would say is that it's a slight better result from last year with a substantial LIFO reserve that's required because of the value increase in the raw materials. Did that make any sense?

Holden Lewis - BB&T Capital Markets

Yes, you just were behind in Q1 and you caught up in Q2.

Salvatore J. Miraglia, Jr. - President - Steel Group

That's exactly right.

Holden Lewis - BB&T Capital Markets

Okay. And if we not taking this question and one follow up that seriously, can you comment on working capital as well? Certainly Q1 to Q2 looks like your used... working capital was significantly increased on the asset side and we just wanted to get a little bit color as to what was driving that?

Glenn A. Eisenberg - Executive Vice President, Finance and Administration

Yes, Holden, obviously from a seasonality standpoint, we tend as a company to build up working capital and obviously we've seen good top line growth within the company as well over that period of time. As we look to the second half of the year, we expect to see those levels come down due to seasonality. But also just very active working capital management within the plant with the benefit of P1 going through, dealing with the fact that we've get lower volumes now coming from our light vehicle plans and so forth.

So, as we track the metric on days and percent of sales, we are kind of tracking where we expect to be, but to see improved performance in the second half.

Holden Lewis - BB&T Capital Markets

Okay. And those working capital initiatives, are there anything sort of new in there? Have you sort of put new things in place to try to capture that? Can you put some color to?

Glenn A. Eisenberg - Executive Vice President, Finance and Administration

Just, I think again part of... as you can say, a part of reorganization, but just relentless focus that we know we have high levels of working capital in the company. We realize that we need to take amount and we have a lot of programs, both discrete and broad that are geared to taking down our working capital levels.

Holden Lewis - BB&T Capital Markets

Okay. Were any of those kind of put in place or sort of hustled in place in or around Q2 or is it just the same stuff that you've been working on all along?

Glenn A. Eisenberg - Executive Vice President, Finance and Administration

Again, they were things in the second quarter, but it is a continuation of what we're doing. We benefited in the second quarter. We'll continue to benefit through the second half of the year, but again, you really have to look at it as a relative basis of the seasonality and look at it on again percentages or days basis. And we are continuing to see some progress. But again we are ramping up in certain parts of the world. You got to really look at each thing pretty discretely. Where we want to take it out and where we are aggressively trying to take it out, we're being successful. At the same points, there may be places where we are actually adding inventory because we want to build up the availability of product in the markets that we want to grow or ramping up capacity.

Holden Lewis - BB&T Capital Markets

Alright. Thanks guys.

Operator

[Operator Instructions] Your next question comes from Brian Carlson with Atlantic Investment.

Brian Carlson - Atlantic investment

Hi, guys. Thanks for taking my call. A couple of points I just wanted to ask about that were commented on the last quarter. Mike, I think that you said last quarter pass car [ph] was down 8% globally. Can you tell us what that would have been in this quarter?

Michael C. Arnold - Executive Vice President and President - Bearings and Power Transmission Group

Yes, down19%

Brian Carlson - Atlantic investment

Okay.

James W. Griffith - President and Chief Executive Officer

In North America.

Brian Carlson - Atlantic investment

Right.

James W. Griffith - President and Chief Executive Officer

He said globally. That's our overall light vehicle sales.

Brian Carlson - Atlantic investment

I am sorry, can you clarify that? So globally pass car down 19%?

Michael C. Arnold - Executive Vice President and President - Bearings and Power Transmission Group

That's correct.

Brian Carlson - Atlantic investment

Okay. And I think there was a mention of $7 million auto credit reserve. Do you anticipate needing to take more as a reserve because clearly the margins in the mobile division would have been 3%, if we take that 7 million out. So I am just wondering if... I mean, the continued sort of weak profitability in that division has any impact from auto credit reserves going forward?

Glenn A. Eisenberg - Executive Vice President, Finance and Administration

A couple of things. The $7 million build up in the reserves was for the whole company. So we obviously have auto exposure within the Steel Group as well as within the Bearing and Power Transmission. So, but clearly the bulk of it or the majority of it would have been in the mobile group.

It's our best assessment of the marketplace. We've tried to be looking at our all of our accounts. We are not seeing any deterioration in it. So it was purposely just say... meant to say that we see that the markets are coming down, there is risk out there and that we thought it would be prudent to reserve against it. We look at different metrics such as insurance and being able to sell those receivables, and what it would take to do that. So believe we're as current as we can be relative to what reserves are needed.

But if there is a further deterioration, it could mean that we do build it up further, it could mean that at some point we free theme up as the market will change, but it's as of today our best assessment

Brian Carlson - Atlantic investment

Okay. And then Sal, just within the Steel segment, I mean as we talked about margins, first half margin for last year, I believe, were 16.4%, if I do the EBIT and sales for the first two quarters together. And this year it will be 14.8%. That's down. Is that just higher raw material costs?

Salvatore J. Miraglia, Jr. - President - Steel Group

That is the inflating pass through of raw materials at the equivalent profitability levels. So as we are inflating the sales figure without pumping the bottom line, although we did do better than we did last year as we attempt to recover other inflationary costs. So we did very comparable the last year first half.

Brian Carlson - Atlantic investment

Okay. Yes, comparable, yes, just on a total EBIT dollar basis, you mean.

Salvatore J. Miraglia, Jr. - President - Steel Group

Correct and close, in terms of... if you look at it on a return... on invested capital basis, it's still very, very positive.

Brian Carlson - Atlantic investment

And would you expect that... I mean it seems like taking into account the guidance you have given for profitability better than last year, but not as strong as first half, I believe, then we should see sort of a nice step-up in EBIT dollars in the second half versus the first half for Steel.

Salvatore J. Miraglia, Jr. - President - Steel Group

We agree with that. That is what our projection... we will do better than last, we'll do better than 2007, but not as good as the first half of 2008. And we have structurally things going on in the second half. We will, for example, take a relatively large shutdown as we install, connect and start-up the new small bar mill, which will position us for better and more sales next year.

Brian Carlson - Atlantic investment

Can you talk to us a little bit about sort of what revenue impact would be from that shutdown?

Salvatore J. Miraglia, Jr. - President - Steel Group

It's in our forecast, the numbers are there. I mean, we're not breaking these numbers out, but our forecast --

Brian Carlson - Atlantic investment

I am just trying to get a sense for what I could add to 2009 to normalize for that.

Salvatore J. Miraglia, Jr. - President - Steel Group

I am afraid, we wouldn't want to break it out to that level.

Brian Carlson - Atlantic investment

Okay. Finally, Jim, I'll just... you sort of alluded to this in your first comments with regard to feeling comfortable with long-term outlook. I just wanted to give you a chance to sort of concretely comment that you still feel comfortable with the 15%, 20% EPS growth outlook that you guys have for the next couple of years.

James W. Griffith - President and Chief Executive Officer

You know Brain, we are comfortable as we look forward that we have a continuing program that is shifting the company to focus on markets that are driven by global demand and that allows us to continue to implement a strategy that will improve our earning going forward.

Brian Carlson - Atlantic investment

Okay. And the very last thing, Mike, if could just ask within process, I believe that if we have $75 million of capacity coming online on an annual basis and assume that also happen in 2009, and we have price increases for several particularly larger end bearings going through at sort of high single-digit rates, if I understand correctly from the channel. That will suggest that 2009 growth could be, I don't know, double-digit in that business. Is that crazy?

Michael C. Arnold - Executive Vice President and President - Bearings and Power Transmission Group

Well, we certainly haven't forecasted 2009 yet publicly, but if you just take a look at the first half of 2008 versus 2007, yes, we would be well in excess of that, right.

Brian Carlson - Atlantic investment

Yes. Okay.

Michael C. Arnold - Executive Vice President and President - Bearings and Power Transmission Group

And we expect that these are our highest growth markets. And we are absolutely strategically aligned to those markets and this is where we have been putting our capacity. And so most of this would very good news from a growth perspective.

Brian Carlson - Atlantic investment

I absolutely agree. Thanks very much guys.

Operator

Your next question comes from Marty Pollack of NWQ Investment Management.

Martin Pollack - NWQ Management

Yes, just a couple of items. Certainly these would suggest a very high improvement in quality of earnings [indiscernible] clean numbers, but if... when you look at impairments and restructuring, those number... that number has come down very significantly for the first half and first quarter, and down sequentially now for three quarters. Similarly also the restructuring charges, wondering whether second half will be more of the same and what is accountable, sort of, to what looks like this much cleaner numbers?

Glenn A. Eisenberg - Executive Vice President, Finance and Administration

Marty, obviously when we provide the outlook for the year, we exclude special items. So, from a forecasting standpoint, we really don't speak to it other than just to recognize your comment that we have seen the number come down because the restructuring primarily related to the reorganization that we went through and the shoring up of our capacity relative to demand that we saw within the mobile or at least the auto industry, in particular, and some industrial moves that we have made.

So it's fair to say that it's come down and barring other moves or gain loss, those types of things, we don't forecast it, but from just the restructuring of rightsizing in the operations, clearly it's going to now a very small level of... and hopefully at some point obviously even soon will be going away.

Martin Pollack - NWQ Management

I was just wondering on the impairment and restructuring itself, you would think certainly even within that the mobile, the auto area, there would be some impairment of assets despite shifting some of that capacities. So that number, 1.8 million, was very low, should... I mean, basically second half should be more or less the same type of trend line.

Glenn A. Eisenberg - Executive Vice President, Finance and Administration

I think it's fair to say that if there is a new initiative, we would comment on that we're seeing. There is not, so we're managing through the business without additional restructuring. Again, a distinction between a special item of restructuring versus just managing through lower volumes and what actions you would take from taking out costs and so forth.

Martin Pollack - NWQ Management

Okay. Thank you.

Operator

[Operator Instructions]. Your next question comes from Holden Lewis with BBT.

Holden Lewis - BB&T Capital Markets

Thanks guys. Just some things that you commented on last week, I don't think... or last quarter that we haven't done so far. How much were the LIFO charges this quarter and can you split that between Automotive and Steel?

Glenn A. Eisenberg - Executive Vice President, Finance and Administration

We can. The LIFO charges for the quarters were around $45 million for the company. And the biggest piece, as you would expect, would be in Steel. I'll give you just some surrounded numbers, call it around $25 million of it within the Steel Group, and call it around $10 million of it within Mobile, and the rest spread between Process and Aerospace.

Holden Lewis - BB&T Capital Markets

And I think the comparable number was $17 million in Q1, is that right?

Glenn A. Eisenberg - Executive Vice President, Finance and Administration

That's right. For the Steel numbers, I believe, is what we had provided or at least the question that had come up in the first quarter.

Holden Lewis - BB&T Capital Markets

What was the Mobile number in Q1?

Glenn A. Eisenberg - Executive Vice President, Finance and Administration

The Mobile number, well, in total, we had around 30 in the first quarter as a company. Again, the bulk of that... the number you quoted coming from Steel, the other biggest piece would then come from Mobile.

Holden Lewis - BB&T Capital Markets

And can you talk about sort of what assumption you're making in terms of scrap in the steel side with these new charges?

Glenn A. Eisenberg - Executive Vice President, Finance and Administration

Well, I think it's fair to say that our expectation is that material costs will continue to rise over the second half of the year. So we've effectively charged from a LIFO basis what we expect the full year to be and the obviously we're accruing to that on a quarterly basis and the increase over the first quarter reflecting the fact that we had higher material costs in the second quarter. And again, at this stage, we don't see that abating right now. But obviously it could go up or down, but at this stage, we expect it to be at relatively high levels.

Holden Lewis - BB&T Capital Markets

But that's a little bit different from Q1 when you... if I remember correctly, you stepped the LIFO charge to sort of assume that scrap was at the, I think, the May level, which is when you kind did your conference call. Right? So this time you sort of built in a little bit more flex, I guess, for the second half.

Glenn A. Eisenberg - Executive Vice President, Finance and Administration

That's fair.

James W. Griffith - President and Chief Executive Officer

Flex or you can it simply recognizing the fact it's going to be higher value than what we thought it was going to be.

Holden Lewis - BB&T Capital Markets

Okay. I guess that's rapidly becoming a fact.

James W. Griffith - President and Chief Executive Officer

Turnaround, I'm surprised with how big the number gets.

Holden Lewis - BB&T Capital Markets

Can you talk about the impact as well of the strike in the quarter on the mobile business?

Glenn A. Eisenberg - Executive Vice President, Finance and Administration

I'd say just a couple of things in general. It clearly had a big impact on the revenue line. Sales came down, but we're able to leverage that very well, as Mike said, taking advantage of being able to reallocate that product to sort of the process side of the business. It did have a negative impact overall, but not a meaningful number frankly to have even brought it out in our explanation of our results.

Holden Lewis - BB&T Capital Markets

And so, I think in Q1 you are saying you are expecting $15 million to $20 million per month and it was down for two months, and any kind of thought that 20% leverage off that, I guess the revenue happened, but the leverage was not that bad. Is that the way to look at it?

Michael C. Arnold - Executive Vice President and President - Bearings and Power Transmission Group

The revenue turned out to be between $30 million and $35 million total impact on the second quarter.

Holden Lewis - BB&T Capital Markets

And then last, corporate-wide pricing impact, I know you talked about ForEx, but price impact corporate-wide?

Glenn A. Eisenberg - Executive Vice President, Finance and Administration

Again, we don't break out the level of pricing other than to say that a lot of the driver of the improved performance in margins has been on putting price across the board, across all of the different segments.

Holden Lewis - BB&T Capital Markets

Okay. And then you gave the revenues contribution from Purdy. What was the revenue contribution from Boring Specialties in the quarter?

Glenn A. Eisenberg - Executive Vice President, Finance and Administration

It was again we talked to the fact that it was offset by the decline in the... from the sales from existing in Desford. But both again rounded would probably be around $15 million in revenues.

Holden Lewis - BB&T Capital Markets

Got you. $15 million, and when does Desford anniversary?

Glenn A. Eisenberg - Executive Vice President, Finance and Administration

Well, probably at the end of this year because at the end of last year that it was gone. So, to your point, we'll start to see a build up towards, let's say, the latter part of the year with Boring contributing to more than Desford would have come off.

Holden Lewis - BB&T Capital Markets

Okay, thank you guys.

Operator

Your next question comes from Brian Carlson of Atlantic Investment.

Brian Carlson - Atlantic investment

Getting tired of hearing my questions, I suppose. Sorry, I just wanted one more clarifying point. One might have the assumption that the strike reduced light vehicle demand and that allowed more capacity to be available to process in the quarter. And may be with the strike ending that that may not be true going forward. But my impression would be that continued weakness in particularly in larger vehicles like SUVs and trucks will continue to make the larger end of the machinery you have available for production in automotive more or less available for other end markets ala process. Is that the right way to think about it, Mike?

Michael C. Arnold - Executive Vice President and President - Bearings and Power Transmission Group

Yes, we have not reversed any mix change moves that we've made as a result of any reductions in that marketplace.

Brian Carlson - Atlantic investment

Okay. And then the other thing is, in Q1 there was some commentary about the potential impact of pre-buy relative to people pursing [ph] ahead of SAP implementation. Can you talk to us about what impact that had or ended up not having in Q2?

Michael C. Arnold - Executive Vice President and President - Bearings and Power Transmission Group

Well, most of that worked its way out through the quarter. We talked about pre-buy in the first quarter and then we actually have seen sales remain very strong in the second quarter. So you didn't see it come out, which meant that the market is probably a little stronger than may be we had forecasted originally and our sales remain strong. Again speaks towards, I think, our position in the marketplace... that if we can continue to put additional product in there from the capacity increases we're making, we'll continue to garner the sales.

Brian Carlson - Atlantic investment

Okay, super, thank you very much.

Operator

There are no remaining questions at this time. Sir, do you have any final comments or remarks?

James W. Griffith - President and Chief Executive Officer

Alright. Again, thank you for your interest. Obviously, we had a good quarter, but underneath the covers of the good quarter we continue to pursue a strategy that is showing success in shifting the company to markets with strong demand and investing in the ability to achieve profitable growth in those markets. We look forward to bringing another good quarter in in the third quarter.

Glenn A. Eisenberg - Executive Vice President, Finance and Administration

Thank you

Operator

Thank you for participating in today's Timken Second Quarter Earnings Release Conference Call. You may now disconnect.

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Source: The Timken Co. Q2 2008 Earnings Call
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