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Executives

Tom Paulson – VP and CFO

Chris Killingstad – President and CEO

Analysts

Ted Kundtz – Needham & Company

Seaver Wang – Utendahl Capital Partners

Rob Damron – 21st Century Equities

Robert Schenosky – Jefferies & Company

Beth Lilly – Gabelli

Tennant Company (TNC) Q2 2008 Earnings Call Transcript July 29, 2008 11:00 AM ET

Operator

Good morning and thank you for participating in today's Tennant Company second quarter earnings conference call. This call is being recorded. If you do not wish to participate, you may disconnect at this time. (Operator instructions) Beginning today's meeting is Tom Paulson, Vice President and Chief Financial Officer for Tennant Company. Mr. Paulson, you may begin your conference.

Tom Paulson

Thanks, Sakiya. Good morning, everyone, and welcome to Tennant Company's second quarter 2008 earnings conference call.

I'm Tom Paulson, Vice President and Chief Financial Officer of Tennant Company. With me on the call today are Chris Killingstad, the Tennant's President and CEO, Pat O'Neill, our Treasurer, and Karen Durant, our Corporate Controller.

Our agenda this morning is to review Tennant's performance during the quarter and first six months and discuss our revised outlook for the remainder of 2008. First, I'll review the financials, then Chris will update you on our operations. After that, we will open up the call for your questions.

Before we begin, please be advised that our remarks this morning and our answers to questions may contain forward-looking statements regarding the Company's expectations of future performance. Such statements are subject to risks and uncertainties and our actual results may differ materially from those contained in the statements. These risks and uncertainties are described in today's news release in the documents we file with the Securities and Exchange Commission. We encourage you to review these documents, particularly our Safe Harbor statement, for a description of the risks and uncertainties that may affect our results. Our earnings release was issued this morning via Business Wire and is also posted on the investors section of our website at tennantco.com.

Before I review the financials, let me start by stating that we at Tennant are very disappointed with our second quarter earnings and the need to revise our full-year outlook for 2008. We stated in our first quarter conference call that our 2008 outlook was predicated on a modest US economic recovery in the second half of 2008. At this point, we are less confident that we will see any economic recovery in the US in the second half and we expect slower economic growth in Europe than in the first half of the year.

We also anticipate commodity inflation pressure to intensify, which may increase our cost for oil derivative groups such as tires, plastics, chemicals and resins, as well as steel products. We believe that these combined macroeconomic headwinds will result in Tennant's 2008 financial performance being below the earnings we originally forecasted for the year. And while we cannot control an economic recession or commodity price hikes, we are addressing the factors within our control as Chris will discuss in a moment. In my comments today, all references to earnings per share are on a fully diluted basis.

For the second quarter ended June 30, 2008, Tennant reported that net sales increased 17.2% to $193.6 million versus net sales of $165.2 million in the second quarter of 2007. Contributing to the rise in net sales are recent acquisitions, strong volume gains in emerging markets, sales of new products, as well as selling price increases taken worldwide to mitigate higher material costs. The Applied and Alfa acquisitions added approximately 8% to consolidated net sales for the quarter, and foreign currency exchange added approximately 5%.

Organic net sales growth, which excludes acquisitions and foreign currency benefits, was approximately 4%. We've seen results from our long-term strategy to build our international business with revenue outside of North America rising to 44% of sales in the 2008 second quarter, up from 35% a year ago. Net earnings were $8.3 million, or $0.44 per diluted share in the 2008 second quarter compared to net earnings in the prior year second quarter of $10.5 million, or $0.55 per diluted share.

There were several unusual items that reduced 2008 second quarter earnings by $0.10 per share. These included

legal settlement expenses of $0.06 per share, primarily related to the settlement of a claim filed in the second quarter by a terminated distributor in Brazil; expenses related to curtailed acquisition initiatives of $0.02 per share; a tax reserve of $0.03 per share for a discrete item related to prior period uncertain tax provisions. These are partially offset by a $0.01 per share gain from the divestiture of certain assets. In addition to these unusual items, we incurred dilution of $0.01 per share in the second quarter from the Applied and Alfa acquisitions, although the full-year impact is still expected to only be modestly dilutive.

Let me provides in context around the unusual legal settlement expenses in the quarter. First, we terminated a distributor in Brazil, which was necessary in order to have broader sales coverage in that country. The terminated distributor filed a legal claim in the second quarter, and we made the decision to settle that claim outside of the Brazilian court system in order to swiftly transition business to our new Brazil distributor. Although the action was not directly related to the Alfa acquisition, the timing was important to move forward with a new distributor in order to capture the sales synergies for Alfa and Tennant.

We also accrued for a legal settlement for an employment claim filed in France that was indirectly related to the Applied acquisition. We moved quickly to reorganize and combined the Applied and Tennant French sales forces in order to improve sales efficiency. We also had two other legal settlements, one related to a former board member and one related to a severed employee. In addition to the unusual items in the second quarter, continued economic weakness in North America resulted in a lower equipment sales than anticipated, and commodity inflation pressure became more intense. Our results in the quarter were also somewhat impacted by the softening economy in Europe.

For the six months ended June 30, 2008, Tennant net sales grew 13.1% to $362.2 million, with acquisitions and favorable foreign currency exchange effects each contributing approximately 5% to first-half net sales. Year-to-date net earnings totaled $13.5 million or $0.72 per diluted share. The first-half results in 2008 include $0.10 per share for unusual items in the second quarter and $0.06 per share dilution from the two acquisitions. In the comparable 2007 period, we reported net earnings of 16.3 million, or $0.85 per diluted share on net sales of $320.3 million.

In North America, 2008 second quarter net sales totaled $108.6 million, up 0.7% versus the prior year quarter, primarily due to the benefit from selling price actions taken to mitigate the impact of inflationary cost increases. We continue to see a longer sales cycle during the second quarter. We also had a large non-recurring shipment to a national account customer in the second quarter of 2007 that did not repeat in the 2008 second quarter. For the first six months of 2008, net sales in North America rose 1.2% to $206.8 million versus the prior year period. Foreign currency exchange effects on North America sales added less than 1% for the second quarter and first-half of 2008. Continued soft sales of industrial equipment were somewhat offset by increased sales of service and parts and consumables.

In our EMEA markets, which encompasses Europe, the Middle East and Africa, second quarter net sales grew to $63.7 million, up 50.2% compared with the 2007 second quarter. The Applied acquisition contributed approximately 24% to second quarter sales growth in this region. Favorable foreign currency exchange effects added approximately 16% to sales for the quarter. For the year-to-date, net sales in the EMEA region increased 35% to $116.4 million. The Applied acquisition was responsible for approximately 15% of the first-half EMEA sales gain, and favorable foreign currency exchange effects added approximately 15% to sales for the first-half of 2008.

In Tennant's other international markets, which is comprised of China and other Asian markets, Japan, Australia and Latin America, 2008 second quarter net sales rose 42% to $21.3 million versus the comparable 2007 quarter. The Alfa acquisition contributed approximately 13% to the sales increase while favorable foreign currency exchange effects benefited sales by approximately 11% in the 2008 second quarter. Volume gains in the Latin America and Asia Pacific regions reflect the investments we've made in these emerging markets. Year-to-date, other international grew 31.3% to $39 million versus the first-half of 2007 with Alfa acquisition responsible for approximately 7% of the growth and favorable foreign currency exchange effects adding approximately 7% to sales in other international markets in the first-half of 2008.

Tennant's gross margin was 42.5% for the 2008 second quarter compared with 42.9% in the 2007 second quarter. Given the current environment, we're pleased with this performance. Earlier selling price increases and continued cost reduction initiatives more than offset rising raw material and purchase component costs. A favorable impact from foreign currency fluctuations also benefited gross margins in the quarter. The slight decrease in the gross margin was due to approximately $900,000 of expense or 40 basis points from the flow-through of a portion of the fair market value step up of inventory related to the Applied and Alfa acquisitions. Year-to-date, Tennant's gross margin was 41.9% compared with 42% in the comparable prior year period. The 1.3 million of expense from the flow-through of fair market value inventory step up reduced gross margin by 40 basis points, which was nearly offset by selling price increases and savings initiatives.

For a number of quarters we discussed our programs to reduce operational costs. We generated approximately 6.4 million of gross savings from global low-cost sourcing and lean manufacturing combined in the first-half of 2008. And we remain on track to generate savings in our stated range of between $9 million and $12 million in 2008 from these initiatives.

Research and development expenses in the second quarter were $5.7 million compared with $6 million in the 2007 second quarter. R&D expense as a percent of sales was 2.9% in the second quarter of 2008 compared with 3.6% in the comparable quarter last year. Year-to-date research and development expense was $11.7 million compared with $11.8 million in the first-half of 2007. R&D expense as a percent of sales was 3.2% in the first-half of 2008 compared to 3.7% in the comparable period last year. We plan to stay within our target of annually investing 3% to 4% of net sales in R&D.

For the quarter, selling and administrative expenses were $60.7 million, or 31.4% of sales versus $49.7 million or 30.1% of sales in the 2007 second quarter. Included in the 2008 expense was 3.4 million of selling and administrative expenses from the Applied and Alfa acquisitions, and approximately $3 million of unfavorable foreign currency exchange. Also included was $1.7 million or 90 basis points of unusual legal settlement expenses. The increase in S&A expense in the second quarter outpaced sales growth due in part to investments in infrastructure made earlier in the year to expand market coverage as well as new product launch expenses.

We began implementing our contingency plans in early April 2008 to better align expenses with sales. These actions helped control growth and expenses in the second quarter; however, the benefits of those actions are skewed more towards the back half of the year. To further control expenses, we have both tightened and extended our policies to prevent non-essential hiring and reduce discretionary spending on a global basis. Year-to-date, selling and administrative expenses was $115.8 million or 32% of sales compared to $98.6 million or 30.8% of sales in the prior year period.

Our second quarter operating profit was up approximately 6% to $16 million compared to the 2007 second quarter. On a percentage basis, our operating profit margin was 8.3%, including the net unfavorable 120 basis point impact from the legal settlement expenses, the gain from the divestiture of assets and the flow-through of inventory step up from the recent acquisitions. Operating profit margin was 9.1% in the 2007 second quarter.

Year-to-date our operating margin was 6.8%, including the net unfavorable 70 basis points impact from those same items I just mentioned. Operating profit margin totaled 7.6% in the first-half of 2007. Although operating margins have been constrained in the first-half of this year, we still expect to reach an operating margin of 9.5% in the fourth quarter of 2008.

The effective tax rate in the second quarter and first-half of 2008 was 43.7% and 41.2% respectively. In the 2008 second quarter, the base tax rate increased to 38.5% from 36% due to lower overall level and geographic mix of earnings in the current outlook. We also established an additional tax reserve of approximately $500,000 or $0.03 per share for a discrete item related to prior period uncertain tax positions. The base tax rate for 2008 is still expected to be in the range of 36.5% to 38.5% and discrete tax items are anticipated to be insignificant for the full year. Our estimate of the full year tax rate does include the recent acquisitions. We hired a new tax director and an international tax manager in the first quarter of 2008. One of our top priorities this year is to develop a more comprehensive long-term tax strategy to achieve a lower tax rate in the future. That process is well underway and we do already anticipate some favorable tax benefits will occur in the second half of this year.

Now turning to the balance sheet. Net receivables at quarter end totaled $149.9 million compared with $116.3 million a year earlier, a $33.6 million increase. Of this, $10.3 million is related to our 2008 first quarter acquisitions and the remaining $23.3 million is due to foreign currency translations and growth in net sales over the 2007 second quarter. Accounts receivable days outstanding was 66 at quarter end versus 61 in the prior year period. The increase was primarily due to a higher mix of sales in Europe, which carry longer payment terms than in North America.

Our inventories at quarter end totaled $78.1 million, up from $61 million at the end of the 2007 second quarter. The $17.1 million increase included $5.5 million of foreign currency translation and $5.4 million of inventory from our 2000 [ph] first quarter acquisitions with the remaining $6.2 million from increased demo inventory related to the transition to new products and higher inventory levels due to low-cost country sourcing and new product introductions.

FIFO days inventory on hand was 90 days at the end of the quarter versus 86 days in the comparable period last year. Capital expenditures totaled $10.9 million in the first-half of 2008, $6.6 million lower than the $17.5 million in the first-half of 2007. We expect full year capital spending in 2008 to be approximately $26 million to $30 million, including spending related to our recent acquisitions. This also includes our SAP upgrade and related infrastructure enhancements, which we accelerated by one year to improve the ability of our systems infrastructure to expand globally.

In addition, we're investing and our Minnesota facilities, creating a global R&D center of excellence. These investments were initiated last year and we need to follow through and complete them in order to improve our business processes and continue our new product innovation.

During the second quarter, we repurchased approximately 129,300 shares of common stock under the board authorized one million share buyback programs. Total cost of the shares repurchased was $4.7 million. At quarter end, approximately 512,000 shares remained under Tennant's shares repurchase program. We're willing to use our current authorization to buyback the shares remaining and we will continue to consider the repurchase of shares whenever we feel our stock is undervalued. We will likely recommend another repurchase authorization through our Board of Directors in the near future.

Tennant's cash and cash equivalents totaled $18.5 million at the end of the 2008 second quarter compared to $32.9 million in the prior year quarter. We had a debt to capital ratio of 28% at end of the second quarter compared to 1.8% at December 31st, 2007. The increased debt to capital ratio primarily reflects the drawdown of $95.5 million from our credit facility during the first-half to fund our two acquisitions.

At this time, I'll turn the call over to Chris.

Chris Killingstad

Thanks, Tom, and thank you all for joining us this morning.

Let me begin by saying that the lower second quarter earnings and the lower 2008 guidance obviously is not the news we wanted to share with you today. We are disappointed with this short-term setback, but not in Tennant's strategic direction or long-term future. Know that we are intensely focused on addressing the factors within our control.

Clearly the second quarter sales and profit margins did not meet our expectations, and the economic climate, especially in North America and in Europe, is very challenging. We originally forecasted a modest economic recovery in North America in the back half of this year, and planned that Europe would not be impacted by economic weakness. At present, the most significant risks to our performance this year are rising commodity costs and continued economic uncertainty, both in North America and the potential for the downturn in the US economy to adversely impact other regions. We continue to execute against our contingency plans.

Our approach during this period of uncertainty is one of making selective and highly disciplined investments in the business that are balanced against our current rate of growth, and protect our overall profitability. There were, however, a number of bright spots in the second quarter. These included

second quarter revenue growth despite a difficult macroeconomic environment; Tennant's ability to maintain gross margins through selling price increases and our lean and low-cost sourcing efforts in the face of inflationary commodity pressures and lower volume; on track execution of our integration plans for Applied and Alfa acquisitions; volume gains in emerging markets, and the successful introduction of several important new products.

I'll touch on these highlights in more detail as I review results from our three business regions. I'll also discuss our cost control actions and progress in leveraging operational efficiencies. After that I will outline our efforts to continue growing the business.

It was another tough quarter for our North American business, which grew less than 1% during the second quarter. A decline in unit volume was caused by lower sales of our industrial and outdoor equipment as we experienced late in the first quarter. As Tom mentioned, we continue to see a longer sales cycle with customers potentially delaying their purchases due to broader economic factors. We're focusing on the growing segments of the market such as building service contractors, as well as offering targeted incentives in order to stimulate demand and close active deals.

In our EMEA market, which encompasses Europe, the Middle East and Africa, we were pleased that net sales grew 50% compared to the prior year second quarter. The Applied acquisition contributed approximately 24% of the increase, but we also had approximately 10% organic sales growth in EMEA. This organic growth was in line with our expectations and came from new product volume and sales gains in Central and Eastern Europe due to our continued market expansion initiatives.

Results from our other international markets, which include China and other Asian countries, Japan, Australia, and Latin America, were again very positive, with sales up 42% in the second quarter. As Tom noted, the Alfa acquisition added approximately 13% to the sales gains in this region. Our volume gains in Latin America and Asia Pacific reflect the investments we have made in these emerging markets. We're pleased with the solid revenue growth here and we expect continued market penetration and expansion in these geographies throughout 2008 and beyond.

As I mentioned last quarter, due to the uncertain economic environment, we have already implemented strict policies to control expenses. Our contingency plans are in place and are anticipated to continue to reduce costs globally throughout the second half of 2008. We're developing a stronger cost control culture with the goal of significantly lowering our operating expenses as a percent of sales over the next few years. Some of the cost cutting actions that we have already taken include delays in non-revenue generating new hires, reduced hours in the plants and a combination of deferrals and permanent cuts in discretionary spending.

Additionally, we remain committed to leveraging our operational efficiency. Tennant's global sourcing and cost reduction initiatives contributed to the solid gross margins we were able to maintain in the first half of 2008, especially in this tough commodity market. We're gaining further traction from the manufacturing footprint consolidation we completed last year. As Tom noted, we have generated approximately $6.4 million in gross savings year-to-date from our global sourcing and lean manufacturing initiatives combined, and expect to meet our savings goal of between $9 million and $12 million this year from these initiatives.

Now turning to our growth priorities, I'll update you on our progress in building Tennant's sales through market expansion, including acquisitions and through new products. The integrations of both our Applied and Alfa acquisitions are on plan and proceeding smoothly. We're very pleased with the significant sales generated by both Applied and Alfa. Of note, we completed the merger of Alfa with Tennant do Brasil on May 31st, which cements the overall tax and legal structure surrounding this acquisition. We will continue to update you on the contributions from these new acquisitions going forward.

We're also excited about this year's new products. New products are a key driver of our revenue growth. We target 30% of Tennant's annual sales to come from new products. In the first six months of 2008, we have exceeded this goal, as 41% of our year-to-date equipment revenues came from new products launched over the past three years. We have been successful in introducing new products that carry the same or higher gross margins than the ones they replace.

Following its launch in the 2008 first quarter, we continued the global rollout of our electrically converted water technology, which represents an entirely new and environmentally friendly method of cleaning. We have rebranded this technology from echo to ech2o in order to strengthen and protect the trademark globally. Despite the tough economy, ech2o continues to meet our expectations. We are very pleased with the customer adoption of this game changing technology that reinforces Tennant's leadership position in the cleaning industry.

In fact, we have recently been notified that ech2o is a 2008 R&D 100 award winner. ech2o was selected by R&D magazine as one of the 100 most technologically significant products introduced into the marketplace over the past year. We recently won our first major deal with a large retailer, who is mandating that ech2o be the exclusive cleaning method used in all of their stores. This is a big win for our North America business and hopefully the first of many national account conversions. In the first quarter, we also introduced two new products.

Then in the 2008 second quarter, Tennant launched a family of three new products, a carpet cleaner, cylindrical floor scrubber, and carpet extractor. These compact, maneuverable, cord-electric floor care machines were specifically designed to quickly and effectively clean small, congested spaces in the education, health care, retail, government and commercial office markets. The products are marketed globally under the Tennant brand as the R3 Carpet Cleaner, the T1 Cylindrical Scrubber, and E5 Carpet Extractor. They're also marketed in North America under the Nobles brand as the Strive Compact Carpet Cleaner, the Speed Scrub Cylindrical Scrubber, and the Speed Ex Carpet Extractor. We're excited about the global appeal of this new product family, which will enable us to reach market segments where we have been traditionally under-represented. These three new products, which were built on a common platform, demonstrate our emphasis on lean manufacturing.

We plan to introduce a couple of additional new products in the second half to further enhance our product portfolio and growth opportunities. Because new products will continue to fuel a significant portion of our growth, we remain committed to investing 3% to 4% of annual sales in product development. Going forward, we will continue to focus on leveraging our global cost structure, investing in international expansion, and developing and launching innovative new products. Despite the current macroeconomic conditions, we remain confident in the long-term strength and value creation potential of our business.

Now, I'll turn the call over to Tom for a review of our outlook for the remainder of 2008.

Tom Paulson

Thanks, Chris.

As we noted in the release, we're lowering our 2008 full-year outlook due to a combination of factors that impacted our second quarter results and our expectations for the last six months of the year. Tennant's current outlook assumes no second half economic recovery in North America, as well as slower growth in the European economy during the last six months of the year than in the first six months of 2008. As a result, we now expect full-year 2008 organic net sales growth to be at the low end of or slightly below our targeted range of 5% to 9%. Our revised 2008 expectations are based on achieving sales gains in the second half in North America and in EMEA similar to what we experienced in the first half. In our other international markets, we anticipate double-digit sales gains for all of 2008.

As we’ve said, the company expects to realize savings of between $9 million and $12 million in 2008 from global low cost sourcing and lean manufacturing initiatives. We continue to target an operating profit margin of 9.5% in the fourth quarter 2008, also as noted earlier. This outlook assumes the Applied and Alfa acquisitions will be modestly dilutive for the year. The base tax rate for 2008 is still expected to be in the range of 36.5% to 38.5% and discrete tax items are anticipated to be insignificant for the full-year.

Given these assumptions, we now anticipate 2008 full-year dilutive earnings per share to be in the range of $1.85 to $2.10 versus the 2007 reported earnings per share of $2.08. This does represent an increase of 3% and 17% compared to 2007 adjusted earnings per diluted share of $1.79. This includes the onetime tax benefit of $0.19 recorded in the third quarter of 2007, the gain from the Maple Grove facility sale of $0.19 recorded in the fourth quarter of 2007, and the restructuring charge of $0.09, of which $0.06 and $0.03 were recorded in the third and fourth quarters of 2007 respectively. Previously the company's 2008 forecast called for full-year diluted earnings per share of $2.25 to $2.40, and organic sales growth at the high-end of the targeted range of 5% to 9%.

As you are aware, we do not provide quarterly guidance; however, we would like to remind you of two additional items that affect the results in the second half of 2007. First, we had a higher effective tax rate in the fourth quarter 2007 than in the third quarter 2007, even excluding the impact of the net one-time tax benefit recognized in the third quarter of 2007. Second, our ESOP plan generated fairly significant income in the 2007 third quarter when Tennant's stock price was at record levels. This income is recorded below operating profit as other income. We expect these items will affect our comparisons in the third and fourth quarters of 2008 to some extent.

With that, we would like to open up the call to any questions. Sakiya?

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from Ted Kundtz.

Ted Kundtz – Needham & Company

Hello, everyone.

Tom Paulson

Hi, Ted.

Chris Killingstad

Hi, Ted.

Ted Kundtz – Needham & Company

Could you guys talk a little bit about the – given this environment, a little weaker environment, could you talk about the competitive situations, and any kind of price pressure you're seeing from your competition, or from your customers as the case may be that are putting pressure on you to lower prices?

Chris Killingstad

I think we're probably seeing a little more price pressure than we would normally do. I don't think that our competitors are acting any differently than they have historically. Most of us, we basically have list prices and offer our salespeople the opportunity to discount within a limited range. And they have probably taken that opportunity a little bit more then they normally do and we see that probably in the case of our competition as well. But the price gap between us – we're the price leaders, especially in North America. The price gap between us and the competition has not changed.

Ted Kundtz – Needham & Company

Okay, and nor do you think the market shares have changed any – in any significant way?

Chris Killingstad

I mean I can't tell you definitively. We know that our market share has changed because of the two acquisitions that we just made.

Ted Kundtz – Needham & Company

Right, ex-that.

Chris Killingstad

But organically, we don't have good enough information in real time to be able to measure that. I think we once a year can step back and figure out what progress we've made from a market share standpoint. But what I will tell you is that most of the deals that we're involved in are being postponed. We're not losing deals. We said this in the first quarter, and that's the same thing that we experienced in the second quarter.

Ted Kundtz – Needham & Company

Okay.

Chris Killingstad

As a matter of fact I think that with our ech2o technology, we're probably winning more than our fair share of deals, as we did with the one major retailer, which I can't name, but it's a significant one. And the fact that they mandated the exclusive use of ech2o to clean all of their stores is a huge win for us, something we can use to market ech2o with other national accounts, both in North America and around the world.

Tom Paulson

I'd add one thing, Ted. I mean we did pricing that we took in the first quarter was an important part of holding onto margins. That was even more successful in Q2. And really based on all the data we have, we just don’t – we believe our pricing can hold up for the rest of the year. So, we aren't seeing that we're losing deals due to price.

Ted Kundtz – Needham & Company

Okay. Are there any more price increases scheduled for the balance of the year to reflect the inflationary environment?

Tom Paulson

We will continue to evaluate that. The one thing we're doing is in selected areas within Europe, we are in the process of implementing a price increase due to some of the pricing pressures we’ve have seen there, but – and we will evaluate pricing in other geographies as we continue to go forward.

Ted Kundtz – Needham & Company

Okay. Chris, just going back to the ech2o outlook, do you expect to see – maybe you could talk a little bit more about the reception to that product line. You mentioned that one large retailer coming on with the– kind of exclusively with this technology. Are you seeing other people thinking that way, or do you think this would be kind of a slower take-up given the environment, what is kind of your outlook for that?

Chris Killingstad

I’d say even though we're in a tough environment, it's meeting our expectations. We haven't divulged what the sales are yet for competitive reasons, but it is meeting our expectations. And we are in discussions with many national accounts around the world regarding ech2o. And our hope is and our anticipation is that we will win some of that business. I mean it is being received extremely favorably across the board. We have not gotten a negative reaction from any customer that we're talking to that's important to our business, important to our future.

Ted Kundtz – Needham & Company

Okay. Now it is currently on six machines, is that correct?

Chris Killingstad

It's currently on six machines, yes.

Ted Kundtz – Needham & Company

And you plan to expand that?

Chris Killingstad

We'll expand that to some of our ride-on equipment as we go into 2009, a strong [ph] walk-behind scrubbers now.

Ted Kundtz – Needham & Company

Okay. And then just one final question and I'll get back in queue there. The gross margin outlook going forward, given the environment, do you expect to be able to see any increase in gross margin from the current levels?

Tom Paulson

I think that probably the safer way to characterize the back half of the year is we believe we will continue to see flat gross margin relative to the prior year.

Ted Kundtz – Needham & Company

Okay.

Tom Paulson

And that's really all about – we believe we can hold onto pricing. The offset to that is we're going to – our forecast would say that we're going to see higher inflationary costs from commodities, and we believe that we can offset that through our cost savings initiatives and our pricing. But I think it would be overly aggressive for us to assume we can expand margins of any significance in the back half. I would say flat margins would be a better way to think.

Ted Kundtz – Needham & Company

Which would be down from where you currently are? The gross margins in the second half of last year were 41.4 and 42.4, so you expect them to be down?

Tom Paulson

We would expect them to be –

Ted Kundtz – Needham & Company

Be down from – I'm sorry, down from the current quarter.

Tom Paulson

Right. Down, but flat to modestly above prior year. I would say flat relative to prior year is a better way to think about it.

Ted Kundtz – Needham & Company

Okay, thank you.

Operator

Your next question is Seaver Wang.

Seaver Wang – Utendahl Capital Partners

I have a question on the product mix in different geographies, in terms of profitability. You had a pretty good – you had some favorable currency, the international volumes seem to be pretty good too. What's the difference between the profit margins there? And also I had a question on your Chinese plant. Is that profitable at this point?

Chris Killingstad

Let me take the China piece first. We would say that if you just looked at China as an entity by itself, it’s still going to be modestly unprofitable. We don't think we're that far away from turning the corner to profits. So, in the grand scheme of things, it's not material. When you consider the level of sourcing savings that that factory is helping generate as a base, it's clearly profitable overall. But as an entity basis, it is slightly unprofitable.

And I will comment partially on your other question, Seaver. I mean North America is a far more mature market than any of our other markets. It's got a significantly higher revenue base. We don't give out profitability numbers by geography, but it is somewhat more profitable than other areas, and clearly that's one of the things we're working against. As we have done acquisitions and expanded internationally, we want to create further leverage, and we're working toward enhancing the profitability in all of our geographies. But it is one of those things that has had somewhat of a negative impact on us this year as we haven't grown North America as highly as we have. We haven't generated some of the profits this year to fund some of our other markets. So, it is one of the things that is negatively affecting profitability right now.

Seaver Wang – Utendahl Capital Partners

Can you – one last question, can you quantify the amount of discretionary expenses, kind of ballpark that you think you can kind of cut for the year?

Tom Paulson

Here's how I would think about it. I mean if you look at our operating expenses in the back half of the year, I would say that we should be able to be a percentage point to 1.5% lower than our operating expenses as a percent of revenue in the back half of the year. I think that's just for the back half of this year versus the back half of the prior year. I believe we can be about 1% to 1.5% lower.

Seaver Wang – Utendahl Capital Partners

Okay. And R&D will stay at least above 3% –

Tom Paulson

Yes. The full-year R&D numbers will be – will certainly be within the 3% to 4% range.

Seaver Wang – Utendahl Capital Partners

Right. Has– all these new product introductions, has that significantly increased the SG&A too?

Tom Paulson

It certainly did in the front part of the year. It was – one of the – the couple of things that we have not done is any of our longer-term strategic initiatives and all of our new product launches, we have not compromised any of our spending against those. And as you guys know, in the first quarter and in the second quarter, we didn't get the revenue growth we expected. Therefore, our expenses from – as we added people in marketing and sales and as we supported some launches, our spending was higher than we would like it to be with the revenue. We firmly believe we have corrected that in the back half of the year and it will be completely back in line with spending being at an appropriate level for the revenue expectation.

Seaver Wang – Utendahl Capital Partners

Okay, thank you.

Operator

Your next question is from Rob Damron.

Rob Damron – 21st Century Equities

Let’s see, I wanted to talk about the building service contractors here in the US. One assumption that has been discussed in the past was – as the building service contractors grow in importance or as a percentage of your sales, that would help mitigate any slowing in the overall economy. So I guess would you say that is playing out kind of as expected? Is it helping to mitigate the softness in the economy? And maybe you could give us a percent of the sales in North America now that goes through building service contractors.

Chris Killingstad

We predicted that the next recession hit that the fact that building service contractors represent – it's our estimate, about 40% of all facilities cleaned in North America would help smooth out our sales. I think that has come to be true. We said in our statements that the one growing part of our business in North America is building service contractors. And where we're seeing the weakness is more direct sales of our bigger indoor and outdoor equipment. So I think that as building service contractors continue to grow, we said they represent 40% in North America, they represent about 70% in Europe, that's a good thing for us. And we're beginning to win more than our fair share of business against them and technologies like ech2o are spot on.

Rob Damron – 21st Century Equities

Okay, that's helpful. And then –

Chris Killingstad

So, we are not going to tell you what the split is internally within Tennant, but I did give you the split kind of externally within the market.

Rob Damron – 21st Century Equities

Okay. And then just another unrelated question, just in terms of the acquisitions, the two acquisitions made recently this year. Maybe you would just give us how the integration of those acquisitions are going, and as they get more fully integrated into the business, would you anticipate better margins out of those businesses?

Tom Paulson

Yes, I'll comment on that, Rob. I mean, as we said in our prepared remarks, things are going very much according to plan from an integration standpoint. They're both very big and important deals to us. They actually each of them have a very senior level person, that's 100% of their job is to lead the overall integration of the businesses into the world of Tennant, and we also recognize what things we shouldn't change too but – and we are at the upfront stage. The biggest benefit we're seeing is we've fully deployed our sourcing team against sourcing where we can save money in both those acquisitions. That's going quite well, particularly on the Applied side. And we will see further integration as we go forward, and that will drive margin improvement from where we stand today.

Chris Killingstad

And I think we are on track to start producing the Applied machines out of Scotland and our Minneapolis facility early in 2009 for the North America market.

Rob Damron – 21st Century Equities

Okay, that helpful. That's all I have. Thanks.

Chris Killingstad

Thanks.

Operator

Your next question is from Robert Schenosky.

Robert Schenosky – Jefferies & Company

Good morning.

Chris Killingstad

Good morning.

Tom Paulson

Good morning, Robert.

Robert Schenosky – Jefferies & Company

I have a couple questions here. First, you mentioned the FX benefit to top line and gross margin. Do you know with the net benefit is, if there is any, to operating income?

Tom Paulson

We haven't commented on that historically. I would – it’s – call it – it would be better to say we haven't commented on it historically. It's a tricky number, and that's – Tennant historically had commented on that, and when you start to get into that, it's a hard number to get at and show. So we've chosen to walk away from that.

Robert Schenosky – Jefferies & Company

But is it fair to say that it wasn't meaningful?

Tom Paulson

Yes, I wouldn't say it's not a big – it’s not a big benefit overall.

Robert Schenosky – Jefferies & Company

Okay. And given the new range that you – the new range that have given for the full-year, what macro assumptions do you have in place in terms of the low-end of your range versus the high-end, and do you have any FX delta assumptions in there as well?

Tom Paulson

We have not assumed any significant change in FX, so that would be one piece overall. We're not even close to good enough to forecast what's going on in foreign currency. And it would be hard for me to comment on the other broader macroeconomic trends, given the significant number of moving parts with North America, Europe, other international markets, commodities. So, I think we would stick with what we've talked about is basically North America is kind of more of the same from a growth perspective in the back half. In Europe, we expect to grow slightly lower in continuation of the trends in our other international markets, but we really don't want to get any more specific than that at this time.

Robert Schenosky – Jefferies & Company

Okay. And then related to that, can you give us any additional color or any numbers related to the increase of raw material costs in the second half? You talked about that as a concern, and is it a function of increasingly difficult to pass through in the second half versus the first half? Is it changes in supply contracts? Or is it a function of the acquisition of the two companies and reworking contracts there, if you can give us a little bit more detail?

Tom Paulson

Nothing related to the acquisitions. In fact, that's probably an opportunity for us in the back half. But the biggest thing we're seeing is, one is, there's just more pressure, and it's constant and – we’d certainly hope it would start to lessen but it hasn't. The one area that's favorable for us is lead, but in all other fronts the pressure remains really tough. We managed to really push out the increases in many instances from our suppliers, and so we haven't seen the full effect coming through in the front part of the year. And therefore, we're going to see more of that come through in the back half as some of our contracts do run out, and we see the full impact of those price increases. But like I said, we still do believe that we can hold our gross margins flat to last year in the back part, which would be similar to what our gross margins were for the first full six months.

Chris Killingstad

We even have suppliers telling us, yes, we know you have a valid contract, we don't care. We're going to take the price FX.

Robert Schenosky – Jefferies & Company

No, I understand a lot of companies are in the same boat.

Chris Killingstad

So it's either – it’s contracts expiring or suppliers basically saying we don't care what the contract says, we’ve got to take the prices up.

Robert Schenosky – Jefferies & Company

Right, okay. Thanks for your time.

Chris Killingstad

Welcome.

Operator

Your next question is from Beth Lilly.

Beth Lilly – Gabelli

Good morning.

Chris Killingstad

Hi, Beth.

Beth Lilly – Gabelli

I wanted to just better understand these unusual items that you talked about, Tom, in terms of the Brazilian distributor, the legal settlements, there are legal issues, and then you said there were also some expenses related to a former board member and a terminated employee. Can you walk through those items again?

Tom Paulson

Sure. Do you want to ask specific questions, or you’d like me to walk through them, Beth?

Beth Lilly – Gabelli

Why don't you walk through them? And then – I just want to better understand them. Can you go into a little bit more description of each issue?

Tom Paulson

Yes, and I'll let my colleagues here jump in too if I miss anything. But the first one, the Brazilian piece, we had an existing distributor in Brazil prior to the acquisition. Frankly, we felt that we could get better performance from a different distributor. We were in the process of looking at making that change. And as we brought on the Alfa acquisition, it became even more apparent that we just couldn't have the conflict that was impending there, and we just decided to move quickly and settled it outside of the court system, and allowed ourselves to firmly move forward. And we feel – we certainly don't like the expense we saw in the quarter, but we feel very strongly that was the right decision and will optimize what we're going to be able to do in that market with moving onto a far bigger distributor who has a lot more reach than our previous distributor had.

Chris Killingstad

Obviously as you know, the distributor we managed to sign up, they're called Somoff [ph], and they're I think the biggest I think Caterpillar distributor in Brazil. So they have unbelievable reach in the markets that we're trying to penetrate.

Beth Lilly – Gabelli

So the problem was you had a contract with this existing distributor in terms of guaranteed amounts?

Chris Killingstad

I mean the issue is – listen, we're an American company operating in Brazil, right? We decided that if we were to take this to court, the chances that they would side with the local distributor and against us were very high. And the expense related to that and the time and effort we decided wasn't worth it, so we just bit the bullet and settled upfront.

Beth Lilly – Gabelli

Okay, so –

Tom Paulson

One of the things the courts are pretty famous for in that part of the world are just the time that things would take. And we heard numbers in excess of 10 years that a case could take to get resolved, and we just couldn't afford that. And we felt it was and still feel very strongly it was the right decision to move outside the legal system and settle and move forward.

Beth Lilly – Gabelli

So, you paid them over $1 million, right?

Tom Paulson

Less than $1 million.

Beth Lilly – Gabelli

Less than $1 million.

Tom Paulson

That was more in the vicinity of – all parts of the settlement were more in the vicinity of $700,000 or so, roughly.

Beth Lilly – Gabelli

Okay, because I took the $0.06 a share times 18.8 million shares. That's how I got over $1 million.

Tom Paulson

Yes. There's other components to that legal settlement. That's just one piece of it. So the other major piece of that was the settlement we talked about in France, and that was really related to, as we started down our path of integration of our existing organization in France and the Applied organization, we made some changes. It's – France is a tough market when it comes to what you need to pay in severance costs, and we again decided that it was the best thing for us was to settle that and move forward. And it's not completely settled yet, so it's still – we've made an accrual for the expense that we expect for that to cost us in the quarter.

Beth Lilly – Gabelli

Okay.

Tom Paulson

We expect to be able to move forward positively.

Beth Lilly – Gabelli

Okay. And then there were a couple other issues, one was the expenses related to curtailed acquisition initiatives?

Tom Paulson

And that was – we had two different transactions which is the price we're going to – we hope it doesn't happen frequently, but we had some activities on two different transactions that we were very excited about. We went pretty deep into them. We got into due diligence and determined that the things that we found in due diligence were – we needed to walk away from them. So we made – as interested as we were, we found things that dictated that we should walk away and we had to eat that expense.

Beth Lilly – Gabelli

Okay. And two other – then you said something about a former board member and a terminated employee. Can you talk about that?

Tom Paulson

Yes, terminated employee, I would say is immaterial. It's just honestly – it's a normal part of doing business, it just happened to be slightly expensive. But I wouldn't say at the time, we could share any more details on that. On the case of the board member, we had determined that we hadn't done as good of a job as we could have in ensuring that – related to some ensuring the people cashed some stock options. And we had – we decided to settle that disagreement and settle that outside of – going forward with any kind of legal action. And we recognized that in the quarter also and took care of that action

Beth Lilly – Gabelli

Okay, so there was issues with their options?

Tom Paulson

There were issues with whether we had appropriately communicated when those options should have been cashed. And they –

Beth Lilly – Gabelli

Okay.

Chris Killingstad

There were some mistakes made, and they were honest mistakes that had to be dealt with. It is now behind us, it is settled, and it is settled to the satisfaction of both parties involved.

Beth Lilly – Gabelli

Okay. So as you go forward and you look out to let's say a more normal environment, whatever that is, are you comfortable that this business can grow 5% to 9%?

Tom Paulson

Yes.

Chris Killingstad

Absolutely. What I would say and as I said, we remain very bullish about the long-term prospects for this business and for the value creation potential. I mean if you step back and you look at our strategic direction, it remains spot on. And we're making very significant progress against all of our key strategies and all of our key initiatives. We're getting good traction. So we – we anticipate that we will be in very strong shape as we come out of this economic environment, and so the 5% to 9% organically remains our commitment.

Beth Lilly – Gabelli

Okay, great. All right, thanks for that.

Chris Killingstad

Nothing has changed from that perspective.

Beth Lilly – Gabelli

Okay, great.

Operator

There are no further questions at this time.

Chris Killingstad

All right, then. Well, thank you for your time today and for your questions. We continue to make solid progress in all of our key strategies and initiatives, and we remain firmly committed to the long-term strategic direction that we have established. We believe a continued focus on our strategies of international market expansion, new products and operating efficiency gains, coupled with strong cost controls positions us for long-term success. And we look forward to keeping you posted on our progress. Thank you all.

Operator

This concludes today's conference call. You may now disconnect.

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Source: Tennant Company Q2 2008 Earnings Call Transcript
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