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Albany International Corporation (NYSE:AIN)

Q2 2008 Earnings Call Transcript

August 5, 2008 9:00 am ET

Executives

Joseph Morone – President and CEO

Michael Nahl – CFO and EVP

David Pawlick – VP and Controller

Analysts

Paul Mammola – Sidoti & Company

Ned Borland – Next Generation

John Emrich – Ironworks Capital

Arnie Ursaner – CJS Securities

Mark Connelly – Credit Suisse

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the second quarter earnings call of Albany International. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Instructions will be given at that time. (Operator instructions) At the request of Albany International, this conference call on Tuesday, August 5th, 2008, will be webcast and recorded.

I would now like to turn the conference over to our host, President and Chief Executive Officer, Joseph Morone. Please go ahead.

Joseph Morone

Thank you, Bob. Good morning, everyone. Welcome to the Q2 2008 earnings call for Albany International. As always, I’ll open with some commentary, and then we’ll turn the call over to Michael Nahl, our CFO and Executive Vice President, who’ll make some amplified comments about how we think about cash flow.

For the past two years, we’ve been pursuing a cash flow and growth strategy with two near term objectives, restore the long term cash generating potential of PMC and establish a family of new businesses with significant potential for sustainable and profitable growth.

As we’ve discussed in recent earnings calls, the primary near term measure of success for this strategy is strong free cash flow beginning in 2009. Our Q2 2008 results suggest that despite a weak North American paper industry and general economy, a weakening European paper industry and general economy, and growing pressure on costs from rising oil and commodities prices, we are on track toward realizing those two near term objectives and strong 2009 cash flow.

In PMC, our strategy for the past two years has been to offset the impacts of the maturation of the North American and West European markets by growing volume in these mature markets, growing with the emerging markets in Asia and South America, and reducing costs significantly through a company-wide three-year restructuring and process improvement program. This is exactly what took place in Q2.

Excluding currency effects, global PMC sales were up slightly, with increased volume more than offsetting declines in prices. Sales were strong in Asia and South America, which grew by 7% and 5%, respectively. And despite accelerating inflationary pressures, costs in PMC declined as the effects of last year’s plant closures and establishment of the European shared services center were clearly reflected in the operating income.

Excluding the costs associated with restructuring and performance improvement initiatives, Q2 2008 earnings per share and EBITDA showed strong improvement, compared to Q2 of 2007. About half of that improvement is due to lowering operating costs in PMC. Expenditures associated with restructuring and performance improvement activities that contributed to these lower operating costs will decline over the next few quarters.

SAP expenditures accounted for nearly 40% of the Q2 performance improvement initiatives that we’ve detailed on table three. As the project passed its toughest and most important milestone, the go-live in North America at the beginning of July, we’re now planning to accelerate SAP implementation through the rest of the enterprise. And we expect expenditures to decline from the North American go-live peak and for the project to be substantially completed by the end of Q3 2009.

Machine relo costs associated with the various plant closures accounted for a third of the performance improvement costs on table three. And start-up costs associated with the new capacity in Asia accounted for nearly 20% of that total. Machine relocation should continue through the year while the Asian expansion is entering a new and critical phase. Construction in the two plants in China and in the third plant in Korea should be completed this quarter, with operations starting to wrap-up no later than the start of the first quarter.

Our goal for these plants is nothing short of world-class products made with world-class quality, but that means that we’re going to have to go through a measured, deliberate, pace of scale up over the next few quarters, which will depress earnings in Asia because of higher depreciation and underutilized capacity. Once fully operational, these plants will dramatically enhance the long term prospects of our global PMC business.

Regarding the outlook for PMC revenues, as the Q2 increase in PMC volume suggests, our competitive position in North America and Europe continues to strengthen. And we have made good progress on the number of important contract negotiations in both markets. Nonetheless, the short term outlook for PMC remains clouded by the economic environment, the cascading effects of the rise in oil and commodities prices, and the impact of both on the already struggling paper industry.

In Q2, we did once again see the sharp slowdown in North American PMC consumption at the end of the quarter. And we now expect that pattern to continue through the economic slowdown.

Moreover, in four of the last five years, PMC revenues were weaker in Q3 than in Q2 largely because of the effect of summer slowdowns in Europe. Still, the strong Q2 and our growing competitive strength suggest that we should seek continued improvement in year-over-year performance.

AEC, Albany Engineered Composites, also performed well in Q2. Sales were 96% ahead of last year and the business broke even for the second and third months of the quarter. New business development opportunities continue to emerge, and we remain optimistic about the near and long term growth prospects of this business. One indicator of those prospects is the array of customers that we are now working with, both on current revenue generating and future business development projects.

On commercial engines, our customers include Snecma, Rolls-Royce, Pratt & Whitney, Honeywell, and GE. Our current and future projects range from engine parts for business jets, to regional jets, to the next-generation single-aisle aircraft. For commercial airframe applications, customers include Messier-Dowty for the Boeing 787 landing gear struts, and Eclipse Aviation for the E500 Very Light Jet. Finally, for military platforms involving engine, airframe, and other applications, our customers include Boeing, Northrop Grumman, Rolls-Royce, the US Army, and the US Navy.

The primary challenge facing this business is to take full advantage of an expanding array of new business development opportunities, most of which won’t generate significant revenue until 2013 and beyond. Most of the costs associated with these new program development activities are included in corporate R&D rather than in segment earnings. So beginning next year, we’ll disclose the portion of corporate R&D expenses associated with these new aerospace composite development projects.

But for now, the important point is that our optimism about the future prospects of this business is based on a growing stable of new business development projects that are laying the foundation for significant, growing, and sustainable cash flows at attractive returns.

Albany Door Systems continues to perform exceptionally well. This business does have a seasonal cycle, with Q4 by far the strongest. But the top-line strength exhibited in Q4 of last year has continued through the first half of 2008, thanks to outstanding performance in Europe at both product and aftermarket sales.

We estimate the aftermarket in Europe to be roughly twice the size of the product market, with the potential for operating income at least three times as large. This business continues to demonstrate the ability to grow rapidly while generating cash. The only downside to the doors business right now is its vulnerability to economic slowdowns, which held back performance in North America in Q2, and which will likely affect Europe by the fourth quarter. The increases in energy and materials costs will also dampen results going forward.

The only major business that underperformed this quarter was Engineered Fabrics. Sales were held back by the weak housing market, which has a direct effect on about a quarter of this business. But with this one exception, each of the major businesses performed well despite a weak paper industry and economic environment and spiraling inflation. We believe this strong performance is indicative of the progress we are making both internally, through our restructuring and performance improvement activities, and externally, as we strengthen our market position. And it reinforces our confidence that we are on track toward strong cash flows in 2009. At the same time, because of the economic environment coupled with the seasonal effects in PMC, our short term outlook is cautious. Although, for all the reasons cited above, we do expect a continuation of the improvement in year-over-year performance.

Thank you, and now I’d like to turn the mike – call over to Michael Nahl who’ll amplify on some of the next points.

Michael Nahl

Thank you, Joe. Good morning. First, a reminder that the comment about forward-looking statements contained in the press release applies equally to our remarks in this conference call.

We said at the start of 2008 that there would be a lot of noise in the numbers this year. In our financial news release, we tried to help you through the noise by issuing a very comprehensive description of our second quarter financial and business results, 17 pages in length.

We’ve been incurring substantial expenditures for restructuring and performance improvement initiatives that have been positioning our Paper Machine Clothing business to assure that we will have a very competitive footprint to serve our global customers and to assure that we will be able to respond appropriately to any aggressive actions by our competitors.

At our news release, we tried to provide investors with sufficient information to calculate and begin measuring our progress in generating cash as we approach the year 2009, in which substantial cash generation is expected to begin. We introduced EBITDA as it’s clear that many of our investors are focusing on it as a key metric.

One measure of free cash flow is EBITDA minus capital expenditures and before dividends. We expect EBITDA to increase next year, and capital expenditures to decrease. We’ve invested very heavily in capital expenditures and restructuring in 2007, and again this year. Our 2007 capital expenditures were $149.2 million. And this year, we expect to spend another $150 million.

Depreciation and amortization in 2007 were $57 million and $5 million, respectively. And this year, are estimated to be approximately $64 million and $7 million. Next year, with our core business strongly positioned globally, our capital expenditures are expected to decline to approximately $70 million, with roughly half of that for PMC, and the remainder for our faster growing other businesses. Depreciation and amortization next year are expected to be approximately $73 million and $9 million, respectively.

In 2008, our first and second quarter capital expenditures were $31.7 million and $41.9 million, respectively. We also incurred $28.5 million of cash costs in connection with the net restructuring charges, idle capacity costs related to restructuring, and costs related to continuing performance improvement initiatives.

An independent measure of cash flow that we find useful is based upon changes in net debt. Net debt is a financial tool measure used in calculating our leverage ratio for the purposes of our principal credit agreements with our bank group and with Prudential Capital group, and is defined as total debt minus cash and the cash surrender value of company-owned life insurance policies. Net debt increased from $363 million at the end of 2007, to $391 million at the end of the first quarter, and to $422 million at the end of the second.

During this period of high cash costs for capital expenditures and strategic repositioning, our leverage ratio, as defined as net debt divided by adjusted EBITDA described in our loan agreements, increased from 2.49 at the end of 2007, to 2.82 at the end of the first quarter, and 2.80 at the end of the second quarter. We had expected the leverage ratio to decline even more by the end of second quarter because we thought the sale of the Filtration Technologies business would have been completed in June. Instead, we received $45.5 million cash for that business in late July.

With capital expenditures of over $75 million planned for the second half of this year, we expect our leverage ratio will decline to approximately 2.7 at the end of the third quarter, and 2.4 at the end of the year. Our leverage ratio is important both because if affects our interest rates and because there are limits in our borrowing agreements as to how much leverage we can incur.

Our average interest rate on debt in 2007 was 4.06%, and was 3.72% at the end of the second quarter this year. Our marginal cost of borrowing under our revolving credit agreement with the banks, when the leverage ratio is between 2.50 and 3.0 as it is now, it’s 125 basis points over LIBOR. Three months LIBOR today is 2.80%. So a new borrowing under the revolving credit agreement would be 4.05%. When the leverage ration declines below 2.5, the spread over LIBOR will decline to 100 basis points. There are further reductions in the rates with the clients of the leverage ratio below 2.15, 2, 1.45, and 1.5. Next year, assuming we do not experience a major global recession or acquire borrowing for a strategic acquisition, we would expect the leverage ratio to decline to well under two during the year for an average spread over LIBOR of approximately 62.5 basis points for the year 2009.

That completes the additional information we thought you might find helpful in tracking our progress in a very important transitional year for the company. Bob would be happy to take your questions now.

Question-and-Answer Session

Operator

Sure. Thank you. (Operator instructions) One moment please for our first question. And we go to the line of Paul Mammola of Sidoti & Company. Please go ahead.

Paul Mammola – Sidoti & Company

Hi. Good morning, guys.

Joseph Morone

Good morning, Paul.

Michael Nahl

Hi, Paul.

Paul Mammola – Sidoti & Company

Are you seeing anything in China right now that would cause you to temper or alter your forecast for the region for the next two years?

Michael Nahl

No.

Paul Mammola – Sidoti & Company

Okay.

Michael Nahl

I think, no. (inaudible) answer.

Paul Mammola – Sidoti & Company

Okay. Fair enough. Is there any further color on why PrimaLoft is doing so well? I guess, given the current environment, it might be a little counter intuitive.

Michael Nahl

Well, there’s not that much more we can add unless we – if you look at the home furnishing segment, which is smack in the middle of – which is serving precisely in the middle of the retail markets that are being terribly hit by the economy. That clearly got hurt. So over the performance was in the outerwear segment with growth in other countries as well. And so you’d have to say that the performance is despite a real drag on top-line from really ugly retail (inaudible).

Paul Mammola – Sidoti & Company

Okay. Let’s move forward. And in terms of the VLJ, is there any material weakness you see in their backlog right now or anything that we should be aware of going forward?

Michael Nahl

No. No, I mean they’ve had a change in leadership. The outside investors from Europe who have infused large chunks of capital have taken over the leadership of the company. But no, we’re not seeing – we’re not seeing any impact on our order picture.

Paul Mammola – Sidoti & Company

Okay. And obviously, oil is a primary component of the polymer strand. I guess, are we looking for that make its way into the model of the cost, into the model through say at the fourth quarter into early ’09 because like we’ve said before, there’s a lag in terms when some of these costs actually make its way through.

Michael Nahl

I think your timing is right. We’ve been fairly – in past calls, we’ve been fairly optimistic about our ability to handle raw materials increase its price. None of us foresaw the huge spike in oil prices that we’ve all experienced for the past couple of quarters. It has to hurt. It has to have an effect, but your timing is right.

Paul Mammola – Sidoti & Company

Okay. Thank you, and Michael, just one last thing, how is available on your revolver right now? Obviously, a lot of good color in terms of what you’ll do, but is there – what’s available there?

Michael Nahl

Based upon the Prudential cap on the leverage ratio, it’s about $45 million, and on the revolving credit, $525 million.

Paul Mammola – Sidoti & Company

Okay. Great. Thanks, guys.

Michael Nahl

Excellent.

Operator

And the next goes through the line of Ned Borland, Next Generation. Please go ahead.

Ned Borland – Next Generation

Guys. Let me start with PMC. Joe, can you give me a sense for the new capacity in China, how this ramp is going to play out? I mean you say the ramp is going to accelerate in the fourth quarter. I mean can we sort of quantify in terms of operating rates? I mean we’re looking at 0% to 25% operating rates in the third quarter, getting up to maybe 50% in the fourth quarter, and then building from there in the first half of ’09.

Joseph Monroe

I think that’s about right. There are a couple of pieces to this. We’re actually adding capacity for that plant in chunks. So we’ll add one chunk of capacity, ramp that up in roughly the pace you described. As we’re ramping up that first chunk of capacity, we’re adding a second, which will ramp up faster than the rate you described. And as we’re ramping up the second chunk, there will be a third, and even a fourth over a course of three years, so.

But the toughest stretch, and the one where the toughest ramp up, and the one where we need to be most careful to get it right from the start, is the first one because this is (inaudible) plant with a new key. And the learning curve will be steepest on that first ramp up so that we get progressively easier, progressively more efficient.

Ned Borland – Next Generation

Okay. And then, in the maturing markets, it sounds from your comments that you picked up a little bit of share. Is this the result of pricing actions or were there other factors involved?

Joseph Monroe

Well, Ned, what our strategy is, it’s a combination of a slew of factors. We drive our performance in the market based on ability to differentiate and add value to the customer. And our approach on price is then to – as I described a few quarters ago, manage the price premium. We hold the price premium around the world. If somebody tries to grab dividends from us by radically dropping prices, we’ll manage the premium down because we’re not going to walk away from this – from accounts that we consider critical, from strategic accounts.

And that’s not going to change. But our philosophy and what drives our behavior in the market is differentiate, add value, open the product and the service.

Ned Borland – Next Generation

Okay.

Joseph Monroe

What we’re seeing – if we’re seeing that you think we’re seeing, and we think we see the same thing. It is driven a lot more by the value we bring into the market and our careful management of our price premium than it is about anything else.

Ned Borland – Next Generation

Okay. And then switching over to the Composite business, I mean tremendous growth in the quarter. Seems like there’s a lot more players mentioned in the aerospace arena in the release. Are there any near term opportunities that you can talk about, that could make the growth rate better than say the five-year average that you’ve talked about at 35% a year?

Joseph Monroe

(inaudible) We’re expected this is a 55% per quarter for the next five years. No, just kidding. We’re holding to the 35% per annum compounds average annual growth rate. From the base of last year, we haven’t really provided any new suggestions with the potential of this business. And so, based on performance to date, you have to assume that that 35% per annum is front-loaded and that’s the way it’s looking right now. We’re not – we don’t want investors to extrapolate from this quarter.

Ned Borland – Next Generation

Oh no. I definitely understand you can double as the quarter.

Joseph Monroe

In our minds, the big question about this business has to do with what occurs after the five years, from 2013 to 2018. And that’s what I was trying to get out in my commentary that the expenses we’re incurring today, on development projects, the R&D expenses, the non-recurring engineering tooling expenses, on projects that are going to play out in the next years.

And the question that we’re grappling with and continue to grapple with over the next year is how big does this thing get in those second five years. And we don’t know yet. We don’t know yet because it remains to be seen how some of these development projects play out, and how successful we are on some of the new platforms, and when will those new platforms like the single-aisle aircraft get accelerated given all of the pressures on the airlines from the recent oil prices, or whether they get decelerated.

So there’s a lot of wiggling going on in the growth prospects for this business, but it’s all in the second five years. We don’t yet have enough visibility on that to provide guidance or provide some sense of potential. But for the first five years, we – what we see is what we’ve told you last time that we tried to paint the picture of the growth potential.

Ned Borland – Next Generation

Okay. And just on some of those longer term projects, I mean when – since the lead times are pretty long in this business, are there – what do you think you’re going to know about some of those single-aisle opportunities?

Joseph Monroe

I think there’s so much going on now in the aerospace industry. Boeing Airbus is under intense pressure to help solve the airline – the airline’s crunch from oil prices, but they need to come up with some solution. And if it’s not moving up to single-aisle, it’s going to have to – it could well be a new improved versions of engines that bridge them to – more fuel-efficient engines that bridge them to the single-aisle. So stay tuned. As soon as we have a better sense of what’s coming, we’ll let investors know.

Michael Nahl

And, Joe, it’s kind of a long to give investors a better sense of just how consonant we are in the future of this business by including that list of customers. To try to give you as much of an indication of just how deep the opportunities are, these are real programs that are being worked on with considerable potential.

Joseph Monroe

So far, what sets (inaudible) competition still holds. The main competition we’re seeing for what we do is other materials. It’s how fast these composites penetrate parts that in the past have been handled by Bell [ph]. And that rate of penetration of composites into new components, which works to our advantage, is really a function of how – how much risk the Oyens [ph] are willing to take with moving toward entirely new generations of parts, of (inaudible).

Ned Borland – Next Generation

Okay. Thank you.

Joseph Monroe

Thanks, Ned.

Operator

And next we go to the line of John Emrich of Ironworks Capital. Please go ahead.

John Emrich – Ironworks Capital

Hi, Joe. Hi, Mike.

Michael Nahl

Hi, John.

John Emrich – Ironworks Capital

I think I may have figured out that I was confused by a coincidence. If I look at the idle capacity cost and performance improvement initiatives that are in cost of goods sold and as TG&A, respectively, they both come out to about 7.9 million each.

Joseph Monroe

That’s correct, John.

John Emrich – Ironworks Capital

Okay. That’s helpful. What was the $2.155 million of other expense in the quarter?

Joseph Monroe

John, where are you looking?

John Emrich – Ironworks Capital

On the consolidated income statement, below the operating income interest expense on –

Joseph Monroe

I’m sorry. Those are mostly currency gains and losses.

John Emrich – Ironworks Capital

But $2 million in net losses, not net expense.

Joseph Monroe

Yes.

John Emrich – Ironworks Capital

Okay. And what was the fully diluted share count we were using in the quarter?

Joseph Monroe

I’ll check that, just one second. We’ll get back to you on that, John.

John Emrich – Ironworks Capital

All right. Thank you.

Operator

Next, we go to the line of Arnie Ursaner of CJS Securities. Please go ahead.

Arnie Ursaner – CJS Securities

Good morning.

Michael Nahl

Hi.

Arnie Ursaner – CJS Securities

I noticed in your prepared remarks you seemed quite cautious about the PMC segment. The question I have is two-fold related to that. Is it based on specific trends such as order rates or backlog work down, or is it a more general macroeconomic concern? And very specifically, with (inaudible) in May much more likely to survive, is it a fact that it’s changed the competitive dynamic for you?

Joseph Monroe

That’s a really interesting question, Arnie. And unequivocally, the caution is due to the general macroeconomic environment. The way we look at Q2 is it gave – it gave everybody a window into what’s going on with the underlying – our underlying competitive position, which is getting stronger. And we think this quarter gives you a window into the long term dynamics, but that window gets fogged over by the short term general economy.

Arnie Ursaner – CJS Securities

Again, I’m not sure if I’m being specific enough. Had you seen quite a bit of perhaps ordering activity in Juan [ph] and a building backlog when people were concerned about (inaudible) –?

Joseph Monroe

We’re feeling good. The backlog is good. And the combination of orders at hand and what we know about orders on the way from the results of contract negotiations leaves us feeling optimistic about our longer range competitive strength. So the caution you’re hearing, which is very deliberate and absolutely real, is all about the macroeconomic environment and its impact on what is already a weak paper industry.

Arnie Ursaner – CJS Securities

I can throw this down further, but I –

Joseph Monroe

Oh you go ahead. Keep going.

Arnie Ursaner – CJS Securities

If I can try one more time? Did you see cancel – in other words, when your clients place orders, typically, they can accept delivery three to nine months later. Are you seeing cancellations or stretch outs of expected deliveries? Is that part of your concern?

Joseph Monroe

No, no. When we saw this – I’ll give you one example. We saw this pattern of fall off in the last couple of weeks of the third month of each quarter it was a new phenomenon for us. So we went back and did a little digging. And sure enough, as these things have weakened, it’s their recorder. And it means that the customers, our large chunk of customers, are stretching out the life of their paper machine clothing longer than they would – they normally would to get them through the quarter.

So that’s the kind of – that’s the kind of effect we see that gives us pause. The European paper industry, likewise, especially the Finnish paper industry, which is – for so long been an engine of the European paper industry, is under real stress right now. The combination of factors, from currency to Paris, that Russians are putting on exports of timber, to over capacity in Europe. So we look at our performance. We look at what we have set out to do over the last couple of years, both internally and in the market. And we’re seeing a lot of progress. We’re feeling increasingly confident about our position. We look at the general headwinds around us, and whether it’s inflationary pressures, which will certainly bite into our profits, have a weak economy spreading over the year coupled with an already weak paper industry. And we look at each other and say we’ll have to be anything but for the short term, cautious for the long term.

Arnie Ursaner – CJS Securities

You’re feeling –

Joseph Monroe

We’re feeling very good.

Arnie Ursaner – CJS Securities

I actually have one more question. You’ve had a goal – an articulated corporate goal of matching capacity with demand by geography. With the likelihood of the China facility, which was one of your most significant to date, opening in the early part of ’09 and ramping, you’ve done a pretty good job cutting capacity out of the mature markets. When you open China, should we expect some more significant facilities, rationalization perhaps in places like Europe where you have been supplying China from?

Joseph Monroe

The most precise I can be is to say we’ve just – we’re nearly two-thirds through a planned out, deliberate, three-year process. Those Asian plans are very, very important, in many ways the critical piece of the three-year process. It’s all designed to optimize our performance. And I don’t want – I can’t go any deeper than that.

Arnie Ursaner – CJS Securities

Thank you very much.

Michael Nahl

Thanks, Arnie. Operator, before we go to the next question, I’d like to give the answer John Emrich’s question. Our weighted average number of shares used in calculating diluted earnings per share for the second quarter was $3.051 million. Operator, we’ll take the next question.

Operator

Thank you. (Operator instructions) And we go to the line of Mark Connelly from Credit Suisse. Please go ahead.

Mark Connelly – Credit Suisse

Thank you, Michael and Joe.

Joseph Monroe

Hi, Mark.

Michael Nahl

Hi, Mark.

Mark Connelly – Credit Suisse

A couple of things to follow-up on this. Can you give us an update on how quickly the CapEx falloff in China? You mentioned that the ramp starts in Q3. I think I remember earlier you saying that the CapEx would falloff closer towards the end of the year rather than Q3, or is it even into Q1? I’m just not remembering.

Joseph Monroe

It’s into Q1, and the reason is – what I alluded to I think where I referred to in response to one of Ned’s questions. We’ve got our first module in place, and we’ll start ramping it up shortly. But even as we’re ramping that up, we’re moving in the final pieces of equipment for a second module that will double the capacity of that – of that plant. And as we’re ramping that one up, we’ll be finishing off the equipment that will add another 50% of capacity. And then we’ll be one more module after that. But the bulk of the investment will be completed by Q1.

Mark Connelly – Credit Suisse

Okay. Fair enough. Back to your earlier account about the significance of China, rather than looking at it in terms of your global capacity amount. I don’t really care how much capacity you’ve got. I’m more concerned about what your margins are. And historically, you haven’t made as good a margin in China as you’ve made elsewhere. And I wonder if you can talk about the potential impact and progression you might expect. I’m thinking back to the period when we had the Mexico currency devaluation where all your competitors were effectively blown out of the country, and I’m thinking about the longer term positioning of being a local producer there, both short term and long term. I’m wondering about the matching of production to the geography of sales and how significant that’s going to be in – as we think about the margins for that.

Joseph Monroe

That’s a really important issue that you’re getting at, Mark. And the short answer is when we produced in China for the Chinese market, our margins – we expect our margins to be as good as they are when we produced in North America for the North American market. Prices are quite a bit lower in China, but historically it is. And our price premium is twice as high there as it is anywhere in the world. We’re working hard in a growing market to get those prices up. But when we make it there and sell it there, the margins are good.

The margins had not been good to date because we’ve been making Europe in Euros, selling into China the lower-priced market, and selling in dollars. And you can’t make money that way. Well the first step in this process is we stop shipping from Europe into China, and start supplying China from China. So you get a double benefit. Not only do we get the growth in China when we’re supplying from China, but we eliminate the imports from Europe.

The margins should be good.

Mark Connelly – Credit Suisse

Okay. I wonder if we could just stay with Europe for a second. Your volumes are up over 8%, which is a lot.

Joseph Monroe

Yes.

Mark Connelly – Credit Suisse

And you lower prices, and I’m curious, are those lower prices a function of the contracts that you signed two years ago the last time your volumes went up or is it a more going on? Michael talks about being vigilant about actions from competitors. Some people think you’re in this better to survive. But I still look at the European market and say somebody might not be in the position to survive if you guys are gaining that kind of share. So can you give us some better sense of what the competitive landscape in Europe is right now?

Joseph Monroe

Yes. Let me try to give you the big picture on pricing and the competitive landscape in Europe and North America because we’re feeling like it is more predictable, we have a lot more visibility about it, and our ability to manage it from – our ability to manage any effects of price instability are much greater and we’ll get all the greater as those Asian plants come on the string. But here’s the key point. As the paper industry in North America and Europe consolidates into fewer and fewer players, and in Europe, Stora and UPM now accounts for about 25% of the market.

In North America, if you look at the effects of (inaudible) merging IT warehouse or (inaudible), the top five accounts for more than 40% of the market. What that means is each contract negotiation – there are fewer negotiations. And each negotiation becomes much more intense and much more important because in the past, competitors could trade share. You could loose in one place. You pick it up at another. Now, with fewer, bigger negotiations, you loose it there, there’s nowhere else – that there are fewer places to make it up. So it gets more intense, which would suggest a greater potential for price swings during those contract negotiations. But they’re fewer of them.

Secondly, there’s a trend – as sophisticated procurement practices wash through this industry, there’s a trend to go towards fewer suppliers, and sometimes as many six PMC suppliers to three, both in North America and Europe. So you get fewer negotiations, in which fewer industry suppliers are picked. So that’s a lot more intense into the negotiations.

That’s the bad news. The good news is, the contracts that result from those are tenured to be longer termed. In Europe, they used to be only a year, but now they’re starting to trend to two to three years. In North America, they tend to be three to five years. And then the other piece of good news is we demonstrated in Q2 we are able to offset the lower prices that result from people trying to grab our business. We’re able to offset it with volume and lower cost. And as these Asian plants come on the stream, we’re going to be – and as the – all the effects of the cost cutting come on stream to North America, we’re going to be even more able to offset those lower prices if competitors drive the prices down.

So bottom line, we think where the pricing situation is going, both North America and Europe, they’re about three big contract negotiations, less one in Europe, two in North America over the next year, year and a quarter. Once we get through those, we expect the period of relative stability because of the longer contracts and the likely – and the likely results of those contracts.

That gives you –

Mark Connelly – Credit Suisse

I mean, Joe, when I listen to all that and it sounds to me like somebody is getting get hurt. And then others maybe convinced it’s not Zurion [ph], but are you concerned that we may go into a period, that maybe it will play out differently and people won’t just aggressively cut prices. But if you’re picking a base percent share, somebody’s getting seriously hurt. And the consolidation that you’ve talked about in the past is just becoming more and more inevitable. And I’m just curious whether you’re not concerned that me might see a big hiccup in earnings again like we did last time.

Joseph Monroe

Well first of all, I agree with your basic premise that somebody’s going to get hurt. (inaudible) is not somebody we talk much about. What we’re talking all about is a smaller, regional product – some PMC supplier in Europe, precisely the sort that was really bottom feeding the prices. They filed for bankruptcy. And we think it’s a direct effect of the kinds of trends that we’ve been seeing, that we’re talking about. We’re feeling, Mark, that there’s a big difference between what happened in ’06 and what is likely to happen with the remaining big contract negotiations over the last year.

In ’06 we were blind sighted, and we – and really the next year, we were at the – uncertainties about pricing were a wildcard, we really weren’t sure what was coming. We have a much clearer sense of the picture now. We know when the window opens. Trend stability is going to be around three big negotiations. We know it’s at stake, and we know what we need to do to offset any price instability with volume. And, everybody in the industry now knows – I hope they know that if they try to grab business from us by dropping price, it’s going to hurt everybody, but they’re not going to get the business.

So you could see – you would be – I think it would really be prudent for me to see – we’re not going to see a couple. That’s impossible to see some of those shots to earnings as a result of the contracts, but we think what comes out of that over the quarters that follow, those contract negotiations is what you’ve seen in the last three quarters, an ability on our part to offset price with volume cost. And we expect to see more stability because of the longer contracts, fewer contracts, and fewer suppliers to the big – to the big customers once we get through this next big contract.

Mark Connelly – Credit Suisse

Okay. I just have two more questions and they’re simpler ones. First, why is European Door business doing so well when everything else in Europe?

Joseph Monroe

Well, it’s a great business, isn’t it, Mark? The combination of new products serving West – where the merge is a new market segment for machine protection. So imagine you’ve got a – you got laser equipment in the plant that needs to be protected and we’re finding that high performance door has turned out to be – that turns out to be a great application for high performance doors, number one. Number two, growth in the aftermarket as we’ve discussed. We’re systematically trying to expand our presence in the aftermarket. And as we do – it takes time to set up these service operations, but as we do, we see the results. And unlike the product business, we see the results a lot more quickly up – dropping to a bottom line.

Mark Connelly – Credit Suisse

But, Joe, that’s more of a change in your strategy over the last couple of years.

Joseph Monroe

Yes.

Mark Connelly – Credit Suisse

To focus more heavily now aftermarket, and so basically, what you’re saying is that that shift in focus is starting to pay off.

Joseph Monroe

Correct. It’s the channel – the channel strategy is starting to pay off particularly in Europe. But with that said, we’re seeing very strong performance on the product side as well.

Mark Connelly – Credit Suisse

And just the last question for Michael. You know how much I appreciate it when you breakout consultant expenses. Can you confirm that the consulting expenses are finished or that they will be finished soon? And can you give us a rough estimate of when the timing of the SAP charges will finally roll off?

Michael Nahl

Yes. I’ll take the first part, and David Pawlick will take the second. With regard to the consulting expense that Mark is referring to, it was in connection with setting up our procurement organization, and that expense is complete. There is no more. And Mark, I love those expenses just as much as you do. With the regard to the rolling off of the other expenses, David.

David Pawlick

Mark, the non-capital SAP expenses is as we described in the earnings release. We’re expecting that Q3 and Q4 would be around $4 million per quarter, and that’s in comparison to $5.3 million this past quarter, decreasing to about $2 million in Q1 and Q2 of 2008. And at that point, we did substantially complete with the implementation.

Mark Connelly – Credit Suisse

Okay. Perfect. Thanks very much.

Michael Nahl

Thanks, Mark.

Joseph Monroe

Thanks, Mark.

Operator

There is no one else in queue at this time. Please continue.

Joseph Monroe

Thank you all for participating on this call, and we’ll see you next quarter, if not before. Thank you.

Operator

Ladies and gentlemen, replay of this conference call will be available at the Albany International Web site beginning at approximately noon Eastern Time today. That does conclude our conference for today. Thank you for your participation, and for using AT&T executive teleconference services. You may now disconnect.

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