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Colfax Corporation (NYSE:CFX)

Q2 2008 Earnings Call

August 5, 2008 8:00 am ET

Executives

Mitsy Reynolds - Vice President, Investor Relations

John Young - President and CEO

Scott Faison - Chief Financial Officer

Analysts

John Inch - Merrill Lynch

Jeff Hammond - Keybanc Capital Market

Michael Schneider - Robert W. Baird & Co., Inc.

Shannon O'Callaghan - Lehman Brothers

Operator

Welcome to the Colfax Corporation second quarter earnings conference. (Operator Instructions) At this time I would like to turn the conference over to Mitsy Reynolds, Vice President of Investor Relations.

Mitsy Reynolds

My name is Mitsy Reynolds and I am the Vice President of Investor Relations. On the call today, we have John Young, our President and CEO and Scott Faison, Colfax's Chief Financial Officer.

I would like to point out that our earnings release and 10-Q are available in the investor section of our website, ColfaxCorp.com. We will also be using a slide presentation to supplement today’s call which can also be found on the investor section of our website. Both the audio of this call and the slide presentation will be archived on the website later today and will be available until the next quarterly call. In addition, a replay of this call will be available until approximately August 22. The replay number in the US is 888-203-1112 and internationally it is 719-457-0820 and the access code is 8865744. This information is also listed in the press release.

I would also like to note that in order to help you understand the Company’s direction, we will be making some forward-looking statements during the call, including statements regarding events or developments that we believe or anticipate will or may occur in the future. These forward-looking statements are subject to a number of risks and uncertainties, including those set forth in our SEC filings. It is possible that actual results might differ materially from any forward-looking statements that we might make today. The forward-looking statements speak only as of the date that they are made and we do not assume any obligation or intend to update any forward-looking statements except as required by law.

During the presentation we will describe certain of the more significant factors that impacted our year-over-year performance. Please refer to the accompanying slide presentation and the MD&A section of our second quarter 10-Q for details regarding additional factors that impacted year-over-year performance.

With respect to any non-GAAP financial measures during the call today, the accompanying information required by the SEC regulation G relating to those measures can be found in our earnings press release under the investor section of the Colfax website. References in this presentation to adjusted net income, adjusted net income per share, adjusted operating income and adjusted EBITDA of all non-GAAP measures and may exclude asbestos liability and defense cost income and asses its coverage litigation expense as well as a legacy legal adjustment and one-time initial public offering related cost.

Adjusted net income also reflects interest expense as if the offering had occurred at the beginning of the period and present income taxes at an effective tax rate of 34%. Organic sales growth and organic order growth also a non-GAAP measures excludes the impact of acquisitions and foreign exchange rate fluctuations. Now, I would like to turn it over to John.

John Young

Before I get started I would like to formally introduce Mitsy Reynolds as our new Vice President of Investor Relations. Welcome to the Colfax team, Mitsy.

Mitsy Reynolds

Thanks, John.

John Young

Good morning, everyone. This is our second quarterly earnings call since we began trading on the New York stock exchange on May 8. Today, I will start by covering some of the second quarter’s more significant highlights and some of the key performance measures that we achieved. I will follow that with the review of our strategic end markets. Finally, I will review the financial results and then we will open it up for a question and answer session.

As we announced in the press release issued this morning, Colfax had a strong second quarter. The adjusted net income was $13.9 million or $0.32 per share; a 53% increase over last year second quarter. Net sales for the quarter were a $161.4 million, an increase of 32% including organic growth of over 18%. Organic sales growth was particularly robust in the power generation end market which was up 61% as well as the general industrial market which was up 26%. Adjusted operating income increased 43% to $23.6 million. Driven by the increase in sales, adjusted operating profit margin increased to a 110 basis points to 14.6%.Adjusted EBITDA increased by 32% to $27.5 million.

Turning now to year-to-date numbers, for the first six months, adjusted net income was $24 million or $0.55 per share, an increase of over 48% over the first six months of 2007. Net sales for the six months were up 23% to $292.1 million. Organic sales grew just over 10%. Adjusted operating income increased 34% to $41.9 million while adjusted EBITDA increased 27% to $49.5 million. We continue to see strong growth on our order rates and backlog during the quarter.

Order rate has grown steadily on an organic basis over the past several years and into the first half of this year. Year-to-date orders were up 36% with organic growth of 21%. Backlog was $384 million at the end of the second quarter and this is an all time high. We have just stated five strategic and diverse end markets which are commercial marine, power generation, oil and gas, global navy and general industrial.

The commercial marine market as our largest single end market was 21% of our second quarter sales. Organically, commercial marine's order growth was 6% for the quarter and 37% year-to-date. Organic sales grew 14% and 6% for the quarter and year-to-date respectively. We expect that growth in international trade, regulatory changes and high demand for oil and commodities will continue to drive demand for container ships, tankers, bulk carriers, supply vessels and FPSOs.

We also continued to see incremental after market activity in the commercial marine market. Oil and gas sales were 11% of our total sales for the quarter while comprising 14% of our orders. Year-to-date sales were down 15% on organic basis due to an unusually large project that was delivered in the second quarter of 2007. On an organic basis, orders were up 63% for the quarter and 11% for the first six months. We expect the activity in the oil and gas markets to remain favorable as capacity constraints and continued growth in global demands keep oil prices elevated. We believe that this high oil prices will continue to drive development of heavy oil reserves and that project size will continue to increase.

In the power generation market, we expect the activity in Asia and the Middle East to continue to be robust as the economic growth continues to drive significant investment in energy infrastructure projects. For the second quarter, sales into the power generation market were 15% of our sales and 10% of our orders. On an organic basis, sales were up 61% for the quarter and are 47% higher year-to-date. Similarly, orders were up 31% for the quarter and 19% year-to-date.

Finally, sales into the global navy market for the quarter were 4% of our total sales and orders were 7% of our total orders. Organic sales were down 31% year-to-date while organic orders were up 20%. We anticipate increase in navy revenue in the second half of this year in support of the US Navy’s new ship construction program. Despite the recent announcement that the DDG-1000 program will be terminated after the initial two ships, we expect the US to continue to appropriate funds for new construction of naval vessels as order classes are decommissioned.

As an example, this past week it was announced that the US Navy will recommend to Congress that eight more units of the DDG 51-class Destroyer be built between the years, 2010 and 2015. We also believe that demand will increase for integrated fluid handling systems such as our SMART valve system that reduce operating costs and improve efficiency. In addition, we expect nations outside of the United States to continue to expand their fleets to address national security concerns.

We believe continued infrastructure development throughout the world will drive capital expenditures and our sales in the general industrial market. General industrial sales were 48% of our sales in the second quarter and were 42% of our orders. On an organic basis, sales increased 26% for the quarter and 19% year-to-date while orders increased about 20% and 15% for the same period. The growth and sales in this market for the quarter was broad based across several sub markets with the chemical market being particularly strong.

Turning to a more detailed review of our financial results, sales for the second quarter were particularly robust to our alien customers in Europe driving an organic sales increase of 22% in that region. Sales also remained strong in the US with an organic increase of 9%. Power generation and general industrial sales were also very strong. For the first six months, consolidated organic growth was 10% which met our expectations. Gross profit margins for the quarter were flat when compared to prior year but are up a 140 basis points year-to-date. The year-to-date margin improvement was driven by increased profitability in our commercial marine business by driving price and lowering cost due to improvement in manufacturing productivity in our European operations and incremental production from our Wuxi, China facility.

For the quarter, a heaver mix of system shipments offset continued margin improvement in our European operations resulting in a flat gross profit margin. Selling, general and administrative expenses increased to $10.4 million during the quarter including a $4.1 million charge related to a non asbestos product liability case that is further detailed in our 10-K and $2.6 million due to the impact of foreign exchange rates. Excluding the effect of the $4.1 million legal charge, SG&A decreased as a percentage of sales by 120 basis points to 19.6% for the quarter even though the current quarter contains $700,000 of public company operating cost. Without these costs, the decline was down a 170 basis points.

To the first months excluding the impact of the $4.1 million charge, SG&A expense were flat as the percentage of sales. However in 2007 these expenses had a one time benefit of a million dollar gain related to the sales securities but the Company received an insurance deneutralization. We are moving this gain as well at the 2008 public company cost results in a decline as the percentage of sales of 50 basis points in SG&A expense.

On status expense, the extents and indemnity expense related to our asbestos claims was $1.2 million for the quarter. Year-to-date effective tax rate on a pro forma basis excluding nonrecurring certain asbestos, certain legal understated interest cost will be approximately 34%. Based on current operations, subject to 1048 [ph] and excluding the aforementioned items, the approximate effective tax rate is expected to be 34% or less for the remainder of 2008.

Inventory increased in additional $4.1 million during the quarter which result in a total increase of the first six months of $22.3 million. While on the normalized basis, we will be very uncomfortable with such a large increase in inventory, we believe that it is appropriate given the anticipated large project growth for the balance of the year. Net cash flow from operations was a use of $57 million for the first six months. One time cash outflows related to the IPO were $42.4 million while asbestos related cash outflows were $16.3 million.

If matters proceed as we expect, we will enter into a settlement with one of our large insurers and its affiliate shortly which will provide for a significant reimbursement of past cost during this third and fourth quarters of 2008. We believe these insurers will also begin to pay a significant portion of our current cost as well. The Company's proceeds from the IPO in May 8 were approximately a $193 million which we will use primarily to repay debt, pay dividends to our existing preferred shareholders and further corporate purposes. We have a $115 million of availability on our credit facility and our net debt to adjusted EBITDA ratio is just over 0.75 times at the quarter end. We believe that we are well positioned financially to continue to execute our growth strategies.

In summary, we had a strong second quarter from booking sales and profit perspective but sales and profitability have exceeded our expectations to the first half of the year. We continue to see strong order growth across our end strategic market and across each of our geographic regions while it is possible that there maybe some shifting sales from the third quarter to the fourth quarter due to the timing of project shipments and European summer holiday period with our existing backlog and robust order rates, we believe we are on track to deliver low double digit organic sales growth for the balance of the year.

With that, I will open up the floor for Q&A.

Question-and-Answer Session

Operator

(Operator's instruction) Our first question comes from John Inch with Merrill Lynch.

, John.

John Inch - Merrill Lynch

I guess the obvious question of oil and gas, if I remember I thought from the first quarter, you thought that was going to rebound a little bit in the second quarter and it really did not but you think it is going to improve in the second half. A little bit of color there perhaps, Scott and John, in terms of what happened and sort of why you think it is going to come back in the second half.

John Young

Yes, sure. I think the comment was related to orders, John. We anticipated a large influx of oil and gas orders in the second quarter which we did receive. Orders were up 61% in that end market. We tend to be somewhat backend loaded in the third and fourth quarters on oil and gas shipment this year related to some of the project business that we had. So we feel pretty comfortable with our oil and gas revenue in the back half of the year.

John Inch - Merrill Lynch

Is it, John, sort of a large project that you are looking at in terms of oil and gas or are they just broader based activity that is going to weigh itself to the back half?

John Young

No, it would be broader based activity. Last year, we had one extremely large project that they created some lumpiness in our comparison that is why the revenue on the quarter to quarter basis was down this year but this year it is a series of projects but tend to be for shipment dates in the third and fourth quarters.

John Inch - Merrill Lynch

Then the order trends for the quarter sort of progress on a linear basis or do they tend to pick up as the quarter progress or actually drop off? I mean a little bit more color as the quarter progress would actually be helpful.

John Young

Sure. It was fairly linear. I mean we came out of the blocks, very strong in April and May. June continued to be at a pretty high pace so it was reasonably linear.

John Inch - Merrill Lynch

And then I guess just lastly, US versus sort of rest of world in perhaps even emerging markets, there is a little of bit of consternation around sort of the trend line of emerging markets. What do you guys seeing there? I know that a lot of you say your European business ultimately ends up there but do you have any kind of a read-through in terms of just end market demand?

John Young

Sure. I think our emerging market business continues to be very strong. I mean as you had mentioned, a large percentage of our alien business in Europe ultimately ends up in the Middle East and Asia. We also have reasonable percentage of our sales direct into the Asian region and that business continues to be pretty strong. So, we have not seen any, I would say, sort of any material changed in velocity in that particular market.

Operator

Next is Jeff Hammond of Keybanc Capital Market.

Jeff Hammond - Keybanc Capital Market

Good. So, you are in pretty good momentum in your businesses. I just wanted to see if you are seeing any capacity constraints in any of your plans where you need to bring on more capacity on a near-term basis?

John Young

Yes, we are running in a pretty good cliff right now. In fact, we have invested a larger percentage of capital in the first half of the year as a result of that to increase our capacity. I would say we are still in a position to meet our customer needs from a capacity perspective. I think our bigger issues surround the availability and supply of raw materials and lead times, associated with some of the…, for example, drives in caps and etc. I think that probably more than anything is putting pressure on our delivery schedules.

Jeff Hammond - Keybanc Capital Market

Okay and then just a follow on to the order trend, I think you said on the call last quarter that through I guess April and May, an organic order growth of 28 that is versus I guess 19 for the whole quarter. So, it seems obviously I cannot see the monthly numbers but it seems like you had a fairly sizable downtick and the growth rate is, could you just speak to that?

John Young

Sure. Yes, I mean our orders are pretty lumpy month to month and the month of June in particular in '07 was particularly strong so was a tougher comparison I think if you look at the gross amount of bookings month to month, June in comparison to April and May was a very strong month as well. So, I would say no change in the velocity of order intake at this point.

Operator

Next is Mike Schneider with Robert W. Baird.

Michael Schneider - Robert W. Baird & Co., Inc.

Great. Maybe firstly, just talk about your comment about growth in the second half. You had expressed that you would expect a low double digit growth organically that continue in the second half. I am curious just why you would expect a deceleration from the Q2 rate of 18% because orders at least year-to-date are up 21% organically and I believe that comparison was the second half of last year get easier from here, what is it that you see in any particular market or geography that would cost the deceleration?

John Young

Sure, yes. I think we need to look at the first half in total. If you remember the first quarter was relatively low on organic growth basis. So there were some timing differences between the first quarter and second quarter so I think we are a little over 2% in the first quarter and then 18% in the second quarter. If you look at the back half of the year from a revenue perspective, we actually had pretty strong third and fourth quarter last year. So, the comparisons clearly are higher in the second half of the year versus the first half of the year so I do not really view the deceleration of business sometimes is a little bit lumpy quarter to quarter. I think it will be really a continuation of what we have seen for the first half of the year.

Michael Schneider - Robert W. Baird & Co., Inc.

Okay and then just maybe some color on the general industrial center, you call that chemical was particularly strong. Can you maybe dive into additional end markets and trends there, up or down and then also geographies because at least investor seem to have the most concerns around that sub segment of your business based on what we read in the headlines?

John Young

Sure. [distorted part] so it is a little bit of misnomer that ends up getting classified in general industrial but that is how our systems pick it up when it goes to distribution. So, I think if you look really in each of the sub segment in general industrial which we have about eight different sub segments, the growth was very broad based in all of the sub segments. Building products, diesel engine, waste water, really across the board it was very strong and that was on a global basis, not just in emerging markets but our European business and our US business as well. We had a good quarter in general industrial.

Michael Schneider - Robert W. Baird & Co., Inc.

And then were there any particular deceleration or was there a particular deceleration that has occurred in the US general industrial portion?

John Young

No, not that we saw.

Michael Schneider - Robert W. Baird & Co., Inc.

Okay and then just final question on commercial marine, there is a lot of press about slower shipping trends globally. Do you have or have you seen any cancellations in the order book related to commercial marine or any more cautious commentary from the ship builders themselves?

John Young

No, we have not had any cancellations either in new ship construction or any after market activity. It is certainly we read the same press that do you do related to the commercial marine and we do a fairly aggressive betting out in that particular market on the look out for any type of change in activity level or cancellations. But so far, we have not seen any. Our customers tend to be large European ship owners and we are selling through very large, well capitalized shipyards so as of yet, we certainly have not seen any change in the order rate or any cancellations.

Operator

We will go next to Shannon O'Callaghan with Lehman Brothers.

Shannon O'Callaghan - Lehman Brothers

Good. Maybe just help us out with a little bit of the lumpiness as we think about it for the rest of the year. Organic growth first quarter 2% now 18% and you mentioned some projects maybe shifting from 3Q to 4Q so I mean could we be seeing that kind of variability in the organic growth pattern in the second half too or what kind of variance might we see?

John Young

Yes, I think from a second half perspective in total, we feel very comfortable with the guidance overall. The question is whether hit from the third quarter or the fourth quarter and that is just a factor of our project-related business that tends to move around a little bit on delivery dates. I think at this point we feel pretty comfortable about the overall growth level in the second half of the year.

Shannon O'Callaghan - Lehman Brothers

Okay but it feels like fourth quarter is going to be the strongest productivity base on what you are saying.

John Young

Yes and that is our normal seasonal pattern. Fourth quarter is definitely the largest overall quarter of the year for us, year in year out.

Shannon O'Callaghan - Lehman Brothers

But even on the growth year-over-year perspective, it sounds like more maybe comes in the fourth based on the project push-outs you mentioned?

John Young

Yes, potentially.

Shannon O'Callaghan - Lehman Brothers

Okay.

John Young

Yes, that is the way we could see that.

Shannon O'Callaghan - Lehman Brothers

And then on the gross margins, you mentioned the system's impact, I mean can you either size that for us or give us a sense I mean get a really strong gross margin in the first quarter or the last quarter, can you talk through the fact that it is there and how are you thinking about that for the second half?

John Young

Sure, yes. I mean that is related to very large systems business which again tends to be a little bit lumpy business and there is a higher buy out content on those very large systems so the gross margins tend to be a little bit lower than our average gross margin and the fact that they are very large sort of excuse the mix number a little bit. I think for the balance of the year, from various margin perspective we should see some moderate increase in our gross profit in the back half of the year.

Scott Faison

I think the situation somewhere at the sale, we had very good mix and positive impact in the first quarter and I think the blending of the two quarters was more indicative of that are underlying rates.

Shannon O'Callaghan - Lehman Brothers

How is the acquisition environment out there and how are you guys thinking about progressing towards that goal?

John Young

Sure. Certainly, acquisition is a big part of our growth strategy in building the business and we are actively looking at transactions right now, the pipeline seems to be pretty good. So, I think well certainly I will not comment specifically on any transactions. At this point, we continue to see pretty good activity in the M&A market in our sector.

Operator

And we have a follow up question from Jeff Hammond, Keybanc Capital Market.

Jeff Hammond - Keybanc Capital Market

Can you just speak to how you are seeing price in the quarter on a go forward basis and how are you thinking about working capital source use for a full year basis?

John Young

I think, on the price question Jeff, I think we continue to be pretty successful at passing along raw material price increases in the marketplace given the engineer to order type of business that we have. We continue to be pretty effective in passing price along. On the working capital, I think we certainly have a pretty big buildup in the first half of the year particularly on the inventory side. We will certainly convert a fair amount of the inventory receivables in back half of the year. We tend to be more working capital positive in the first quarter of the year is all that as the receivables are collected but we will see certainly a reduction in the inventory in the back half of the year.

Operator

And it does appear there are no further questions at this time.

John Young

Thank you for joining us this morning. I guess that ends the second quarter call. We will speak to you again at the end of the third quarter. Thanks very much.

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