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Kaydon Corporation (NYSE:KDN)

Q2 2008 Earnings Call

July 29, 2008 11:00 am ET

Executives

James O’Leary – Chairman, President and Chief Executive Officer

Kenneth Crawford – Chief Financial Officer, Senior Vice President, Corporate Controller

Richard Mosteller – Assistant Corporate Controller

Analysts

Holden Lewis - BB&T

Nigel Coe - Deutsche Bank

Michael Corelli - Barry Vogel & Associates

Walter Liptak - Barrington

Michael Hamilton - RBC

Steve Barger - KeyBanc Capital Markets

Peter Lisnic - Robert W. Baird

Ian Fleischer - FBR Capital Markets

Eli Lustgarten - Longbow Research

Richard Marshall - Longbow Research

Peter Thompson - Coho Partners

Richard Mosteller

Welcome to the Kaydon Corporation second quarter 2008 earnings conference call. Before the conference begins, the company would like to make the legal disclaimer that certain information in this formal discussion and that may be included in the question-and-answer session, is forward-looking, within the meaning of the federal securities laws.

These forward-looking statements are only predictions based on the company’s current expectations about future events. While the company believes that any forward-looking statements made are reasonable, actual results could differ materially, since the statements are based on the company’s current expectations and are subject to risks and uncertainties beyond the control of the company.

Listeners are cautioned to refer to the company’s 2007 Form 10-K for a list of factors that could cause its results to differ from those anticipated in any forward-looking statement. The company does not undertake and expressly disclaims any obligation to update or alter its forward-looking statements, whether as a result of new information, future events or otherwise except as required by applicable law.

During this conference call, Kaydon spokespersons will refer to free cash flow, a non-GAAP measure. To assist you in understanding this non-GAAP measure, as well as to comply with SEC requirements, the company has included in its press release, a reconciliation of this non-GAAP measure to the most directly comparable GAAP measure. Today’s conference is being recorded.

Now, I would like to turn the call over to Mr. James O’Leary, President and Chief Executive Officer of Kaydon Corporation.

James O’Leary

Thank you, Rick. Good morning, and thanks for joining us today. We apologize for a slightly later than expected start. We understand there was a call or two before this. I wanted to give people an opportunity to jump off that call and clear the queue here. We’ll extend Q&A a little bit longer so we don’t short change anybody.

I’m joined this morning by Ken Crawford, our CFO, and Rick Mosteller, our Assistant Corporate Controller. Peter DeChants is on assignment today.

I am pleased to be reporting on a second quarter in which we achieved second quarter records for operating income and diluted earnings per share, and the highest quarterly sales performance in Kaydon’s history.

We also had record second quarter orders, setting an all time record for quarter-end backlog. This was all achieved in what I’ve heard described by many of our peers and investors as one of the most challenging and uncertain macro environments they’ve seen in some time.

Also during the quarter, we’ve accelerated and are beginning to realize the benefits from structural changes in our portfolio, undertaking the position for growth, which previously would not have been available to us, namely in the wind energy market and broadening our international profile.

As in prior calls, we’ll provide many of the building blocks as practical, to help you with your analysis of our results, while not departing from our policy of not providing explicit guidance. Through the balance of the year, we’ll continue to address these in sufficient detail so you can keep track of them.

During the quarter, diluted EPS equaled $0.64, a second quarter record as compared with the $0.61 in the prior year second quarter. Sales increased 23.4% for a quarterly record of $139.9 million compared to $113.4 million in the prior year second quarter.

We also had record second quarter orders of $144 million, up 12% year-over-year. This leaves us with quarter-end backlog of $324 million, an increase of $60.8 million, almost 61% as compared to the second quarter of 2007.

Total wind orders booked in the quarter were $24.6 million, which with the $80.9 million of wind orders in the first quarter, brings year-to-date wind orders to a total of $105.5 million.

Our record second quarter sales performance of $139.9 million, was driven by especially strong performance by our two largest segments, Friction Controls and Velocity Controls.

Gross profit for the second quarter was $54.2 million, or 38.7% of sales, as compared to $48 million or 42.3% of sales during last year’s second quarter. Gross margin was affected by changes in the product mix.

The inclusion of Avon, whose margins are negatively impacted in the current period by acquisition accounting integration costs and identifiable costs associated with our wind energy ramp up. By identifiable, we mean easily discreet capturable items, not lost overhead absorption. These totaled about $1.2 million in the quarter.

SG&A was $22 million during the second quarter, as compared to $19.6 million in the second quarter of 2007, which, if you recall, included some duplicative costs associated with our CEO transition, which impacted marginal comparisons somewhat.

Operating income was a second quarter record of $32.1 million, as compared to $28.3 million in the prior year second quarter.

Operating margin was 23% versus 25% last year, and was impacted by product mix shifts, Avon purchase accounting, and costs associated with the wind energy ramp up. In a few minutes, Ken will provide comparable detail on the identifiable acquisition, integration, and ramp up costs for the quarter and the balance of the year to help you in modeling margin performance expected in Q3 and Q4.

We’ll discuss the mix issues in detail momentarily as it relates to our various end markets, but I would like to give you the broader prospective as it really tells the story.

We’re seeing faster growth, including faster than expected growth, in our wind energy business, which has operating margins expected to be in the low 20s, offsetting potentially slower growth in the North American industrial business and in defense, where we’ve seen an order delayed into next year.

Defense includes certain legacy defense programs, which we’ve discussed in prior quarters. These two segments, general industrial, typically at once book and ship orders, and defense have margins well above the company average, which brought the overall company average higher for a period.

What we’re seeing is faster growing, lower, but still high margin business reflecting a potential slowdown in other segments of the company.

Second quarter 2008 interest income of $1.7 million declined 63.4% from the $4.8 million earned during the second quarter of 2007. This decline, which we’ve talked about previously, is due to lower marker interest rates achieved on lower investible balance.

Rates have declined almost 300 basis points year-over-year, due to lower rates and the impact of steps taken by us to reserve capital and liquidity, rather than pursue higher short term market yields in things like auction-rate securities, sub-prime investments, and many of the things that have plagued other companies with high cash balances. We’ve managed to avoid them, but at the expense of lower yields.

More importantly, however, we put cash to work in areas such as the wind energy expansion and the Avon acquisition. As we have successfully done that, we’ve seen the short term impact of turning investment income into operating earnings, which will be meaningfully higher than would otherwise be the case as the capital comes online in the second half of this year and as the Avon acquisition costs come to an end at the end of this year.

The effective tax rate during the quarter was 35.4%, compared with 36.1% in the prior year second quarter, primarily due to an increase in foreign earnings in 2008. We expect the tax rate for 2008 to be 35.4%.

Net income for the second quarter equaled $20.3 million or 14.5% of sales, as compared to $19.6 million or 17.3% last year. Again diluted EPS equaled $0.64, a record as compared to $0.61 in the prior year second quarter.

Now let’s review our operating performance. Sales of Friction Control products increased $21.8 million to $86.8 million with 33.6% higher than last year. This segment benefited from increased demands for specialty bearings utilized in the wind energy market, and inclusion of Avon Bearings.

Sales have especially turned tables to the wind energy market, and split roller bearings globally, in particular, enjoyed robust performance. I’ll give a more granular review of end market performance in a couple of minutes.

Second quarter operating income of Friction Control products increased to $21.5 million, 15.7% higher than last year driven largely by higher volume.

Operating margins were effected by product mix shift as growth in wind energy and split roller bearing products both high margin but lower than the company average, lowered the overall blended margin and the inclusion of Avon whose short-term results were impacted by acquisition costs and integration.

As the impact of the cost associated with Avon dissipate at the end of this year as we’ve discussed previously, Avon’s gross margins and contribution margins will approximate those of Kaydon’s existing wind business.

Also worth noting are the specifically identifiable costs associated with the wind energy ramp up and collectively Avon and the ramp up costs equal $1.2 million in this quarter.

Operating margin equaled 24.8% as compared to 28.6% attained in the prior year. Finally, second quarter orders for Friction Controls increased $14.4 million or 18.5% as compared to the $92 million last year.

In Velocity Controls, second quarter sales increased $3.8 million to $20 million or 23.6% over the prior quarter, with particularly strong sales from our European operations, including the benefit of foreign currency translation and a solid performance in North America.

Operating income for Velocity Controls increased to $6.1 million or 43.9% higher than the second quarter of last year, while operating margin rose to 30.4%. Both sales and operating income benefited from healthy market demand for our products, improved pricing year-over-year and the favorable impact of currency translation.

Orders increased 14.1% over prior year, leaving us with record backlog at the end of the second quarter.

Sealing product sales were $11.7 million as compared to $11.5 in the second quarter as higher pricing offset modestly lower volumes. Operating income of Sealing products declined from $2 million to $1.5 million largely due to inefficiencies and redundant costs being incurred during our previously announced facility relocation.

Orders during the second quarter totaled $10.3 million, a decline of 21.7% as compared to the second quarter of last year. Orders in this segment have become increasingly program driven and very significantly on a quarter-to-quarter basis, very similar to the chunky nature of our wind energy business.

When you look at orders on an LTM basis to compensate for this factor, comparisons better reflect the order pattern in a general wind demand. When you look at LTM patterns, they’re roughly about comparable to sales.

In other, sales of other businesses equaled $21.4 million during the second quarter, a year-to-year increase of $600,000 or 3%, principally because of higher demand for air filtration products and higher pricing for metal alloy products. Operating income was $3.2 million in both the second quarters of 2008 and 2007.

Let’s talk a little bit more granularly about orders and backlog and end markets. Order entry was strong during the second quarter as we achieved a second quarter record of $144 million, 12% higher than the second quarter of last year.

The strong order activity resulted in record backlog of $324 million, an increase of almost 61% as compared to the prior year’s second quarter.

Our backlog consists of order shippable over the next six quarters, and as discussed in previous quarters, our large wind energy orders will ship later than non wind orders largely due to capacity.

As a result, these large orders have continued to shift the timing of when our overall backlog is expected to ship. We currently expect to ship about 35% of backlog during the next quarter; approximately 35% over the next two quarters, so Q2 and Q3, and the final 30% over the last three subsequent quarters.

Now I’ll turn it over to Ken to cover some financial items.

Kenneth L. Crawford

Thanks, Jim, and good morning, everyone. During the second quarter of 2008, we earned 2.4% on average investable balances of $282 million. Interest income totaled $1.7 million in this year’s second quarter.

During the second quarter last year, we earned 5.1% on average investable balances of $372.4 million, which generated $4.8 million in interest income.

As Jim noted earlier, the lower average investable balances compared to the prior second quarter resulted from the affect of capital expenditures to support our capacity expansion projects; the Avon acquisition; our third quarter 2007 pension contribution, and our stock repurchase actions.

The lower interest rates were caused by lower rates available in the market and by proactive steps taken by us to protect principle and liquidity.

Sequentially, in the first quarter of 2008, we earned 3.4% on average investable balances of $288.8 million. Just as we had forecasted during our previous conference call, the lower average interest rate and the lower average investable balances reduced second quarter 2008 interest income by $3 million, which is equivalent to $0.06 per share on a diluted basis, compared to the second quarter of 2007.

At the end of this year’s second quarter, our investable balances totaled $280 million, which is $22 million lower than at the beginning of 2008. The lower in interest rates and lower average cash balances will also reduce interest income in our third quarter by at least $3 million compared to the third quarter of last year.

Again that $3 million would be equivalent to $0.06 per share on a diluted EPS basis. We expect interest income for the full year 2008 to be approximately $7 million as compared to $18.1 million in 2007.

That said, we believe our financial resources will provide us the flexibility to take advantage of potentially unique opportunities that may arise during a period when liquidity can be a competitive advantage.

Interest expense during both of the second quarters in 2008 and 2007 equaled $2.4 million. In June of this year, holders of $11.5 million of our contingent convertible notes presented those notes for conversion into 394,375 shares of common stock.

This will result in slightly lower interest expense, but with no impact on fully diluted EPS due to the accounting treatment of the underlying convertible debt instrument.

The effective tax rate during our second quarter this year decreased to 35.4% compared to 36.1% in the prior second quarter, primarily because of an increase in foreign earnings, and we expect the effective tax rate for full year 2008 to be approximately 35.4%.

Net income in the second quarter was $20.3 million equal to $0.64 per share on a diluted basis compared to $19.6 million or $0.61 per share on a diluted basis a year ago.

Free cash flow during the second quarter of 2008 was a negative $1.9 million compared to a positive $6.3 million in the prior second quarter. This swing was due to increased capital expenditures to generate long-term profitable growth and higher cash usage associated with working capital increases to support our significant sales growth.

During the second quarter of 2008, we invested $15.1 million in capital expenditures compared to $12.8 million invested in the second quarter last year.

Capital expenditures will accelerate in the second half of this year and remain at high levels, as we expand to take advantage of the outstanding secular growth opportunity in wind energy.

Again free cash flow should be viewed as supplemental data rather than as a substitute or alternative to the GAAP measure, and we’ve included in our earnings release a reconciliation of this metric to the most comparable GAAP measure for your reference.

Cash and cash equivalents plus short-term investments totaled $268.5 million at the end of the second quarter of 2008, compared to $287 million at the end of 2007. Long-term debt declined to $188.5 million on the conversion of the $11.5 million of notes during the quarter and is now equal to 26.8% of totaled capitalization.

During the second quarter, we paid dividends of $4.2 million, equivalent to $0.15 per share. We repurchased 81,800 shares of common stock for $4.5 million, and we invested $15.1 million in net capital expenditures.

As we’ve talked about during the quarter, we incurred an aggregate $1 million of expenses related to Avon purchase acquisition accounting and integration costs, and wind energy ramp-up cost totaled an additional $200,000.

These are expected to approximate $1.6 million in the aggregate during the third quarter of this year and another $1.1 million in the aggregate during the fourth quarter of this year.

Now I’d like to turn call back over to Jim.

James O’Leary

Thank you. Ken. As I’ve said at the top of the call, we’re pleased with the results achieved this quarter, but more importantly we’re pleased with the significant progress on our long-term growth initiatives; particularly, our accelerated and increased expansion in the large-diameter bearing market. It should continue to yield considerable benefits as we move into the second half of 2008 and into 2009.

The record bookings achieved in the second quarter leaves us with the highest backlog in Kaydon’s history, and our continued penetration in the fast growing wind energy infrastructure market halted by the Avon acquisition, positions us well for the balance of 2008, 2009 and beyond.

When we assess end market performance and prospects, I would say our business falls into a few general categories. Number one, the very good if not excellent. The good, the bad, and I’ll point out we only have one market which I’d characterize as relatively bad, and the uncertain.

Let’s go through it and so we can give you a little bit more color as to how we see the end market shaping up now and for the balance of the year. The very good or excellent is clearly the wind energy market, with the strength of that market coupled with our strategic position into recent expansions in the Avon acquisition are resulting a meaningful contributions well ahead of last year and consistent with, if not ahead, of our earlier expectations.

This has led us to commence preparation for what may be a further build out, which I’ll go into a bit more detail on in a minute, in at least one of our North American facilities and accelerating due diligence on possible international expansions.

The good would cover many of our other markets. In medical, we’re performing extremely well as we picked up qualifications in customer market share over the past few quarters despite a soft funding environment to some of our customers.

In heavy equipment, we have very strong markets, putting us in the fortunate position of having the choice as to whether to allocate that available capacity to wind energy or heavy equipment.

Our international business, particularly our split roller bearing business, and our Velocity Control subsidiary, continue to see healthy demand despite concerns about potential slowing in Europe.

The relatively bad, and I use the word relatively, comes in terms of current demand as really unchanged, but the forecast is a bit more murkier, and that’s with respect to semiconductor.

Demand for semiconductor equipment into which our products go continues to suffer. I would not say materially worse in prior years, but certainly not better.

That leaves uncertain, and uncertain would include on North American general industrial markets particularly as it relates to recent patterns on book and ship business, which occurs intra quarter. So outside of backlog booked, orders where we get an order during a quarter and ship it the same quarter, which often goes to or through distribution and a single specific issue related to a military order for the MRAP program.

With that as back drop, we expect 2008 to set records in terms of revenues, net income and EPS. Meaningful gains are expected during the latter half of 2008 as additional capacity comes online in our growing wind energy business.

Our previously announced expansions of our large turntable bearings operations continue to progress as planned as we had sales through the wind energy market of $34.9 million for the first six months of 2008 as compared to $32.8 million for all of 2007. So we’ve already exceeded last years total, and we now expect full year sales to approximate $90 million in 2008.

While we continue to work towards our historical target of 10% to 12% earnings per share growth, attainment in 2008 will be more challenging in light of certain current business conditions.

Attainment in 2008 will be predicated on an improved flow of those immediately shippable book and ship businesses to our general industrial markets in North America and upon the funding and release of certain military orders, specifically MRAP, previously expected in the fourth quarter, which may be impacted by delayed funding and therefore fall into 2009.

Also, thus far, while much of the increase in material and operating costs sustained over the past year have been more than offset through proactive remediation steps on the part of our operating team, this may get increasingly difficult absent relief in some of the upward pressure of these inputs over the rest of the year.

Finally, while interest income continues to trend lower as market rates remain well below level, we expect interest income to be materially lower than last year; particularly, as we turn interest income into operating earnings. We now expect interest income this year to be about $7 million as compared to $18 million last year.

Nonetheless, we expect a record year for revenues, net income and earnings as growth in our wind energy business offsets the potential softening and funding delays in our general industrial North American business and the military market.

Our strategic investments in serving the wind energy market, coupled with strong growth internationally highlight our business’ potential overall. Together with the strength of our balance sheet, we’re positioned to take full advantage of the organic and acquisition opportunities available to further build out the foundation in place.

In addition, we expect to be able a prudently return capital to our shareholders both in the form of share repurchases and periodically increase dividend while driving profitable organic growth. As a testament to our confidence, our Board of Directors declared a more than 13% increase in our quarterly dividend to $0.17 per share for the third quarter. With the indicated annual dividend now being $0.68 per share.

More importantly for long-term profitable growth, and as a result of the continued strength in the demand for specialty bearings utilized by the wind energy industry, our Board authorized us to review options to add capacity to serve this fast growing market.

We intend to solidify our leadership position and are considering options to expand our North American facilities principally our devoted wind energy facility in Monterrey, Mexico, during the next 12 to 16 months.

While any expansion decision and the scale, scope and timing will be dependent on finalizing customer commitments, we believe the long-term strength of this market and our unique position in it will result in further meaningful investments.

With existing infrastructure, namely the personnel and the geographic footprint already in place, we believe we’re extremely well positioned to expand our presence to the benefit of both our customers and our shareholders.

In conclusion, we’re pleased with our record second quarter results. Our backlog positions us well for the balance of 2008 and beyond as we expand our internal capabilities to service segments enjoying strong secular growth.

We believe we’re taking all the appropriate measures to maximize shareholder value well into the future and with our strong balance sheet and financial flexibility you can expect us to continue to drive internal growth while selectively evaluating external opportunities.

Lastly, I’d like to thank each of our employees for their efforts this quarter, and prospectively for the balance of 2008.

Rochelle, that concludes our formal comments, and we would be pleased to take questions.

Question-and-Answer Session

Operator

Our first question comes from Peter Thompson - Coho Partners.

Peter Thompson - Coho Partners

My question is really about your convertible. I understand rates have come down significantly, but just on balance sheet management, why would you not retire that convert and avoid the bondholders essentially from converting over to common stock? Just seems to me you would be picking up earnings doing that.

James O’Leary

No, you wouldn’t. In the fully diluted EPS calculation, the conversion is already fully assumed, so as far as incremental shares on the market, or the negative impact of interest expense, they’re both fully eliminated when you do the as-if calculation to get the diluted EPS.

Peter Thompson - Coho Partners

But your cash is earning 2.4, and your convert is costing you 4.

James O’Leary

Yes, but that would only if you settled for cash, which would essentially be a share repurchase which we have said we are considering and have accelerated. The only way to put the cash to work relative to the shares hitting the market is just to do a straight repurchase, and then you could retire some of the bonds for cash, but I look at that as a Dutch auction.

Peter Thompson - Coho Partners

Okay.

James O’Leary

Since you raised it, I do think it’s worth mentioning. The reason we don’t convert is because there are tax benefits which are considerable, given we have no debt other than the covert.

That’s one of the reasons or the arguments for leaving it outstanding, but as we find either acquisition opportunities, or expand the capital program, I think we would be considering, in the interest of balance sheet clean up, potentially converting.

We’ve had a number of people come and convert, but even the $11 million done this quarter, Peter, it’s neutral to EPS because they’re fully eliminated when you do the as-if calculation.

Peter Thompson - Coho Partners

That helps me a lot. Appreciate it, thanks.

Operator

Our next question comes from Richard Marshall - Longbow Research.

Richard Marshall - Longbow Research

You raised the target for 2008 wind sales to $90 million from $80 million. I’m just wondering if there’s any change to the out years 2009, or even looking beyond that to 2010?

James O’Leary

We could do a little bit better than I think that $175 million we expect it to do in 2009. But remember we’re bounded somewhat by the $200 million rough full run rate capacity, which we expect to have in place.

I think the one meaningful potential driver of increasing that will be future capacity expansions, which as I mentioned during the prepared remarks, we’re looking at. Our Board has approved a number of possible expansions, which we’re evaluating today, relative to customer commitments and logistics.

That would meaningfully change to $200 million. Now, is it possible, we could do better than $175 million next year, which we said we’ve expected to leave 2009 at. Sure, but the maximum we could increase it is about $15 million, which would get us to full capacity both in Mexico and our Sumter facility.

Richard Marshall - Longbow Research

Okay. And how much of the increase for 2008, can you break it down between Mexico capacity and Avon?

James O’Leary

A little bit of it is Avon; most of it’s Mexico.

Richard Marshall - Longbow Research

Okay.

James O’Leary

Remember, Avon was already in the $80 million we talked about, I think in prior presentations and commentary.

Richard Marshall - Longbow Research

Okay. Can you talk a little bit about the geographic breakdown of your wind customers? Has that changed at all, and maybe give us a little more color there?

James O’Leary

We have more than a handful of clients now. We have one cornerstone major client. They have a domestic FOB, but I’d be reticent to say that’s not an international customer.

For the most part, they know the day they ship, when their business is being shipped overseas or elsewhere, and the market is hot enough and dynamic enough where saying that a domestic FOB, meaning our business is domestically bound, is probably a mistake on our part.

But we do have a couple of customers that are overseas FOBs, and it would be a guess, but I’d be surprised if the business wasn’t more than 25%, maybe as much as 55% international. To begin, our customers are shipping all over the world. So they’re not necessarily constrained by what our FOB point is.

Richard Marshall - Longbow Research

Okay. You mentioned that the wind bearings are a little bit lower than company average. I’d assumed they were in line with company average margins. How should we look at that going forward, once supplies cease to be as tight as they are right now; how should we look at those margins for 2009-2010 timeframe?

James O’Leary

I am very glad you asked that question. It’s something that we have said consistently over the last year plus in our prepared remarks, that where we think the margins for Kaydon overall went up, is low 20s to mid-20s, peak to trough.

Knowing what happens in this quarter and I think we’re about 150 to 200, depending on who is looking at the margins, below where expectations were. That’s a mix issue. That’s not a deterioration in our businesses, and it’s not a deterioration in the quote unquote legacy Kaydon businesses or margins.

It’s really a mix issue with faster growth; low 20 type business replaces business that was at least 30%, in some cases better, in general industrial and legacy military.

Now if you look at Kaydon’s history, in 2005 and the 2006 period, the margins were about where they are today. The spike in 2006 and early 2007 was driven by a very heavy mix of military, particularly on a legacy program called (Shurkable?) Races which we talked about.

Where the margins are today and where we expect them to be in the long-term, absent big military orders, which absolutely are possible. But I would almost view them as windfalls.

It’s still in the low 20s, which I’d like to point out is higher than most, if not all, of the industrial comps out there, and is in line with where Kaydon historically has been over the past 10 years, once you exclude about 6 to 7 quarters in the 2006, 2007 range.

We’re happy with where the margins are. We will gladly take any orders for higher margin business from the government when they’re ready to give them, but unfortunately we can’t time that.

Richard Marshall - Longbow Research

Okay. Great, that’s all I have.

Operator

Our next question comes from Holden Lewis - BB&T.

Holden Lewis - BB&T

I’m getting a little bit confused about the capacity versus sales argument. I just wanted to make sure that I understood. If you’re looking at $90 million in revenues this year out of wind, I was under the impression that by the end of the year you’re going to have wind capacity of like $100 million.

So you’re not just exiting at $100 million run rate, you’re actually recognizing $100 million in 2008, or close to it. Does that mean that you’re ahead of pace, in terms of adding the capacity?

Then related to that, the $175 million you’re referring to, again I had that as going out at 2009 and having $175 million in capacity on hand, not a $175 million in revenues. I’m trying to make sure I understand what the capacity versus revenue assumptions are.

James O’Leary

Yes, we said $125 million wind this year; capacity not sales. We’ve said $80 million of sales, which is now a bit better at $90, this year. Next year, the capacity would be about $175 to $200 million, and I think that what we said is, for next year?

Kenneth Crawford

Yes. That capacity comes on line relatively early. Our last phase is currently under development. It comes on line in February, so the capacity and the sales number, the capacity is slightly higher, but we’ve talked about $150 to $175 million sales number in 2009.

James O’Leary

And if you asked, are we doing better than previously expected? The answer is yes.

Holden Lewis - BB&T

Okay. Got it. Just trying to understand the guidance, as you talked about it. The language fully went from exceeding 10% to 12%, to the hurdles are higher to meeting 10% to 12%. But I look at a quarter where orders were strong, the book to bill was still north of 1. It looks like even in the non-wind side, the book to bill was around 1.

I don’t really see in the quarter or in your tone any change that would prompt the language. What am I missing?

James O’Leary

If you look at where we expect the year to come out, the revenue number will not be materially different. And when you look at how various analysts out there have modeled it, I don’t think the revenue number’s materially different.

The margin number, both at the gross and the net operating margin number, it’s probably between 150-ish and 175-ish basis point high, depending on how mix comes out.

What we’re expecting is wind orders to be marginally better, $10 million or so better, shipped this year, relative to what was expected to be book and ship, which is general industrial to North American distribution. Those are typically much higher margin product shipped intra-quarter. So that’s outside of the 35% backlog we’ve talked about.

That pace slowed down a bit at the end of June, and it continued to be a bit slower in July. Defense, in particular MRAP, which falls from fourth quarter into next year, was about $2.5 plus million of shipments, which, could you get that? Absolutely.

The forecasts for MRAP has been all over from despair to euphoria. I would not say they’re despair now, but they’re lower than they were earlier in the year. Those two things combined means the mix, as it impacts profit margin, gross margin, and our operating margin will be a bit lower.

The other thing, and this is purely a cautionary note, but year-to-date, we have more than offset raw material cost increases. Year-to-date, we have more than offset operating cost increases of about $6 million, with more than that in terms of price, but notably cost improvements.

Whether it’s Six Sigma or other programs we have underway. So we have done better in offsetting cost increases thus far to date. That is getting increasingly challenging. Unless we see some relief on some of the inputs of our cost to sales, both on an operating basis and a cost of goods sold basis, I think that’s the risk for the balance of the year.

You’re right; everything is still positive. However, when you look at a huge ramp up in growth, when you look at the growth in operating earnings, when you take out what’s almost, if not a little bit over $11 million in interest income, which does fall directly to the bottom line, we thought it was appropriate to be a bit more cautionary this quarter than, unfortunately, some would like us to be.

Holden Lewis - BB&T

Okay, but are conditions exiting the quarter such that unless you see an improvement in those imminently, you are not going to make the 10% to 12%, right? Are you putting out caution out there or are you saying...

James O’Leary

We specifically said we would need to see an improvement in the book and ship rate, and potentially higher orders on MRAP for the 10% to 12% to be met.

Holden Lewis - BB&T

Okay.

James O’Leary

That’s specifically what we said in the press release.

Holden Lewis - BB&T

Okay. So if book-to-bill is at the same level you saw in June, July, the rest of the year, if MRAP pushes into 2009 instead of 2008, then 10% to 12% is probably not achievable.

James O’Leary

Our book-to-bill is out of the equation. We’re talking about orders that come in and out, typically to distribution, typically to smaller customers in North America, and typically higher margin. It’s the margin and the mix that are the principal drivers.

Holden Lewis - BB&T

Got it. Okay.

Operator

Our next question is from Eli Lustgarten - Longbow Research.

Eli Lustgarten - Longbow Research

Couple of clarifications; one, can you talk about how much pricing is up, and for example, looks like you made into $90 million in wind. Is that units, or is that pricing, because fuel is up that much, it would drive it by itself?

James O’Leary

It’s both. It’s partially pricing, where we’ve got raw material price insets, but we are doing a bit better on units. We found some additional capacity coming on line. While it’s not Avon, we do expect for the balance of year to be able to ring a bit more out of Avon than we originally anticipated.

As far as pricing, it’s 3% to 5%. We’re doing a bit a better than certain of our inputs. If you remember steel as it relates to our highest raw material intensive product, which is the slewing ring for wind energy, we get price pass throughs on that, but they come about a quarter later. There is a lag on when we present invoices.

The balance of our businesses, where the cost of sales, raw material intensity is a bit a less, say it’s 50% in the slewing ring, and it’s 30% everywhere else. But we’ve had success in passing that through. We’re offsetting with cost increase.

But I am cautious that that can continue with the success we’ve had to date. That doesn’t mean we’re not trying. And that doesn’t mean we don’t expect to have some success, but we thought it was appropriate to put some caution over it.

Eli Lustgarten - Longbow Research

And do you have any clarification of how much currency benefits you had both on the top-line and bottom-line in the quarter?

James O’Leary

We do; about $2 million on the top-line, and call it $1 million on the EBIT line.

Eli Lustgarten - Longbow Research

Okay. As we look out into 2009, we’re going to add more wind, but in economic conditions could remain reasonably difficult and currencies are going to go away at this point, unless the dollar radically weakens.

Do you become as cautious for 2009 in business mix as you are today, and is there any reason why business mix could change radically if we look at it? It looks like we’re looking at the same thing for at least two full quarters at this point, going into 2009?

James O’Leary

Probably a bit early to comment on that, Eli, and as the recent slow down on the book and ship orders was a very recent. I’d almost say it was like hitting a light switch. The thing you’ve got to remember about that, and there are some good information in the public domain.

Some of our distributors are public on the AIT; there are some relatively large distributors. I think SKF has some pretty good commentary on what’s going on in North America, which they predicted to be flat next quarter. What we saw, and what we believe is happening, this is anecdotal, is some of our distributors are cutting back a bit on inventory…

Eli Lustgarten - Longbow Research

It’s an inventory reduction more than anything else.

James O’Leary

Absolutely, and lot of this is anecdotal, but I think anecdotal drives animal spirit sometimes, and whether it becomes a reality or not, depends on the environment you’re in.

What we think has happened recently is purchasing managers have pulled in their horns a bit. You’ve seen distributors get a bit more cautious about inventory build. That has an immediate impact on us as far as book and ship business.

If you got a bunch of good numbers, if people feel better about the world that could change quickly, so I think it’s probably premature to talk about 2009. The reason we thought it was important to put some cautionary wording on 2008 is we’re in the middle of the year, it’s a very aggressive ramp-up, and we didn’t think you would be done a service if we didn’t.

Eli Lustgarten - Longbow Research

Absolutely; one final question. Can you talk about whether you’ve seen any changes in Europe yet, and that’s probably the rhetoric that we’re hearing more from other companies than anything else. U.S. is sloppy, but the Europe is beginning to slow down.

James O’Leary

Surprisingly, no. But I would not say that we’re representative of some of our peers in some of the much bigger companies that have broader European exposure. In our Velocity Control segment, that’s a German value added distributor. We believe we’re out-executing the competition. We’ve picked up a fair number of relatively big orders.

They probably skew it towards company-specific performance, rather than overall Europe, both eastern and western. Our split roller bearing business is doing very well, but that’s largely in developing nations, and that’s a heavy industrial product as well, so I don’t know if we’re broad enough to be a good data point, given that I know part of that is company-specific execution. We’re just doing very well in that market against a couple of specific customers.

Eli Lustgarten - Longbow Research

We don’t have the general industrial worry in Europe as we do have in the U.S. at this time?

James O’Leary

We have not yet seen it, but I’ve seen and read and heard a lot of the same conference calls you do, and some pretty smart guys are talking about that being a possibility. So we check every week. We talk to our guys regularly, and we’re cautionary about it, but we’ve yet to see it.

Eli Lustgarten - Longbow Research

Right. Thank you very much.

Operator

Our next question comes from Ian Fleischer - FBR Capital Markets.

Ian Fleischer - FBR Capital Markets

On that note, can you touch on some of your organic efforts to grow out some of your product lines in international markets?

James O’Leary

The question Eli just asked about how we’re doing internationally, our Western European business in Velocity Controls is in the process of expanding. We’re moving into a bigger facility to accommodate growth there, and that market services much of the rest of Europe, including Eastern Europe and a number of international locales, pretty wide spread.

The guy who manages that facility for us is taking responsibility for an Indian distributorship, which we will be setting up. In terms of Velocity Control, of expansion in Western Europe, and more than contemplated, we’ve got the paper work filed. We’re in the process of going through all the legal traps and the like to get fully established and certified in India.

We’ve recently, and it’s earlier this year, set up a Chinese distributorship, wholly owned by ourselves, within our liquid filtration company. And that’s started to do well, but that’s going to take a couple of quarters, I think, to fully come on and pay back. But thus far, we’re very happy with it.

We mentioned in the prepared remarks that we’re accelerating due diligence on potential manufacturing elsewhere in the world for the bearings division. But given that our opportunities to expand around an existing footprint and existing management team in North America, I wouldn’t say low hanging fruit, but they’re easier and faster to come to market.

I’d say that is not as fast as we’d like, but will be faster, potentially, than I would have said a few quarters ago because the Chinese and Indian market are very robust, very strong. With North America, they’re mentioned as the three developing nations for alternative energy, notably wind.

We’ve accelerated our due diligence a bit on overseas expansions and some of the things that could potentially lead to – I wouldn’t suggest JV, but we’d consider that. We’re looking at opening our own facility. We’d hoped to do it on the backs of some customers, which already do business there.

I think that’s one to stay tuned on, but that would be the biggest and the most capital intensive, and probably the highest impact expansion we could do. I don’t consider Mexican expansion as part your question, but obviously, that’s the one that could happen fastest.

Ian Fleischer - FBR Capital Markets

Okay. To circle back on wind, can you remind us of the time line of your capacity expansion plans? You brought up the first phase, you have two additional phases, when do those come on line?

James O’Leary

They’re blended together now.

Kenneth Crawford

The one will be online in the third quarter of this year, and the other one is expected to be online in February of 2009.

Ian Fleischer - FBR Capital Markets

Okay. And then you have almost all of 2009 to continue to invest in that business. Are you going to do it incrementally, like you’ve done in the past, see where the market is and do $20-$25 million in increments, or would you do a much bigger expansion plan?

James O’Leary

It would be done in increments, but it would be done probably faster and with more of a holistic approach to where this business is going to be in 5 or 10 years than I think the earlier ones have been done. The early ones were pretty opportunistic. This one is with a couple of things in mind. We would want to add in a fashion to get the product to market for our customers as fast as possible.

While Mexico is the lowest cost alternative, still we have a great facility in Sumter, South Carolina. We bought a great facility in Avon Lake, Cleveland. The possibility of expanding either of those is not off the table. It’s just a question of cost effectiveness relative to price our customers are willing to pay, but those could come to market much faster than a complete Greenfield in Mexico.

That said, the Greenfield in Mexico and Greenfield would be a bit of a misnomer. What we would end up doing in an existing facility in the industrial park we’re in in Mexico, that would be relatively quick but it wouldn’t be as quick as the other. It probably couldn’t add to 2009, but that’s something we’re looking at as well.

The key to that is not just customer commitments, but the mix of customers. We’d like to avail ourselves of broad customer base, but also some different technologies. Whether it’s a geared or non-geared facility, the size of the turbine, the composition of where we ship to. All those things go into the mix, and again that I don’t think could be done fast enough to impact 2009.

But probably could be done faster than most of the people in the industry or most of our peers, potential competitors in the industry because we’ve already got the footprint and we’ve already got the experience in the management team that have been through the ramp over the past year. That’s a valuable intangible asset that we’d like to leverage.

Ian Fleischer - FBR Capital Markets

It looks like you’ve done the heavily lifting there with respect to bringing on the capacity and it probably would go more smoothly going forward. Is that a fair assumption?

James O’Leary

Absolutely, but I would say it’s gone pretty smooth relative to a capacity expansion that is more than all the capital this company has done added up in a decade. I think you have to give fine marks to the company on that, and obviously there is a bit more water between here and the shore, but we can’t be unhappy with how that’s gone. But we do have a valuable asset there in terms of the experience to leverage.

Ian Fleischer - FBR Capital Markets

Right. And just one final point. You’re saying right now that given your current capacity expansion plans, you can do $175 to $200 million in annual sales, is that the number?

James O’Leary

Yes, by the time we leave 2009.

Ian Fleischer - FBR Capital Markets

Okay. Thank you.

Operator

Our next question is from Peter Lisnic - Robert W. Baird.

Peter Lisnic - Robert W. Baird

Sorry if I missed this, but we had a fire drill in the building. I wanted to ask again on the book and ship business. It sounded like that business tailed off at the end of the quarter than into July. I know July is not done, but what does it look like for July’s numbers?

James O’Leary

Pete, down, but I don’t have those at my fingertip, Pete. I probably would be remiss in giving them out, but down relative to our expectations and down relative to the ramp that we would have expected in the back half of the year.

Again you may have been out when one of the gentlemen before asked the question. A lot of this business goes to distribution or the smaller industrial customers in North America, and if you look at some of the publicly held distributors, if you look at some of the comments by our peers, North America, in particular distribution, has seen a bit of an inventory leveling off.

I think some of the purchasing managers and certainly AIT would be a good example because their numbers are public. I’ve talked about keeping an eye on inventories, being cautious, and I think calling in the horns is a good way to describe it.

That’s what we think has happened, and it’s too early to say whether or not that continues and how severe. But that is the biggest driver of margin as it relates to mix, and the incremental profit it would have gotten us to the target, based on where we where the last time we talked.

Peter Lisnic - Robert W. Baird

Okay, all right. Good on that one. And then if I look at the non-book and ship and non-wind, that order book in the first quarter may have been mid single digit organic order growth, and then that slows to looks like maybe flat, maybe down a little, maybe up a little. I don’t have the exact number.

But can you give us a sense as to what the puts and takes were on the order front for the non-book and ship business and non-wind?

James O’Leary

The book and ship or the book and bill?

Peter Lisnic - Robert W. Baird

I’m sorry, the book and bill.

James O’Leary

Okay. The book and bill was right around 1 on non-wind, at roughly a $120 million in sales and $120 million in orders.

Peter Lisnic - Robert W. Baird

Okay. Were there any incremental negatives relative to your expectations?

James O’Leary

I say no. We’ve got record backlog, record orders, but the mix of the components with defense and the book and ship part being down, that’s one of the biggest drivers of the difference between the 23%, 23.5%, 24% margin and 25%, 25.5%, 26% margin. It’s the mix and the contribution of those two product lines, which would be general industrial, machinery, principally in North American, and military.

The mix within the rest of the business is wind, but not just wind, medical, heavy equipment. There were no obvious negatives, but those are longer dated and modestly lower margin, but modestly is low 20s, so that’s a bit lower than what we’ve done over the past year and half. But the business is still strong.

If you look at the order book and when it unfolds, unfortunately not enough of it comes next quarter. With our customers we’re now talking about orders for 2010 and 2011 and beyond. The way our backlog ships now however, it’s 35%, 35% over the next two and 30% over the balance.

We’ve seen a shifting of our book and bill business to the back half of the 18 month period, which puts you a little bit more dependent, in fact I’d say a fair bit more dependent on book and ship business this intra quarter.

Does that make sense?

Peter Lisnic - Robert W. Baird

Yes. It absolutely does. Thank you for your help.

Operator

Our next question comes from Steve Barger - KeyBanc Capital Markets.

Steve Barger - KeyBanc Capital Markets

We talked a little bit about the potential capacity expansions right now, but based on your preliminary customer conversations or commitments and where you think the end market could go, as you look out over two or three years, is that business 50% or 100% or what magnitude bigger than your implied installed base for 2009?

James O’Leary

Between $50 and a $100 million bigger. And that would depend on the mix of right now we’re looking at it as a couple of potential phases. By the way, $50 to $100 million revenues not percent but actually on $200 million, it’s about the same.

Steve Barger - KeyBanc Capital Markets

Right.

James O’Leary

So anywhere between 25% and 30% and 50% bigger than the capacity installed by the end of 2009.

Steve Barger - KeyBanc Capital Markets

Given that the additional fabrication machines are probably one of the big bottlenecks there, how are you dealing with getting in queue relative to your expectations for being able to put out additional capacity on?

James O’Leary

We have a very specific strategy for doing so, and I think it would be not doing ourselves a favor to talk about it.

Steve Barger - KeyBanc Capital Markets

Okay.

James O’Leary

That is the biggest bottleneck, and the relationship with the machine fabricators; the relationship with our customers who have the wrong relationships with some of these guys, and how you’re strategically approaching queuing up deposits and the like have a lot to do with it. We’ve been forward thinking about it.

Steve Barger - KeyBanc Capital Markets

Okay. And when you talk about $50 to $100 million, is that excluding the due diligence process that you’re going through for potential international opportunities right now?

James O’Leary

Yes.

Steve Barger - KeyBanc Capital Markets

That would be on top of that, and any idea of timing and potential size, if you were to pursue something like that? If you were to be able to piggy back that on to an existing customer?

James O’Leary

Probably, a late this year/early next year conversation at the earliest, Steve. Again, we’re finalizing this one. We’re accelerating potential expansions around that foot print, and one of the challenges is we have more opportunities than good guys, and we’ve got a lot of good guys.

Steve Barger - KeyBanc Capital Markets

Okay. Just talking about the end markets for a second. Couple a weeks ago, or recently the Texas CREZ announcement came out. They increased funding for renewable distribution. Are your customers talking about that and what that means to turbine sales in the U.S. going forward, and what conversations have you had about that?

James O’Leary

Not in the level of granularity where people are saying our forecast is X% or Y% higher specifically, but I would point out the recent forecast EER has now revised up twice in the last six months. They’ve been revised up, and I think the last one was up over 25%. I want to say 29%, but I could be wrong. That’s just in the past couple of months.

I think what you just referred to continued enactment the renewable portfolios standards at the state level. I think the Pickens Plan and were you to translate that into hard orders. All these things anecdotally go into forecasts that continue to be revised up, and when you drill that down at the individual customer forecasting commitments, they continue to be revised up.

I can’t tell you that that specific issue or this specific enactment of a renewable portfolio standard or the T. Boone Pickens order translates into X relative to the macro forecast. But it’s all anecdotally positive, and the last forecast was revised up I think 29%, globally.

Steve Barger - KeyBanc Capital Markets

Right. And one last question then. The stock price was in the low $40 range early in 2Q, and I think if I heard the numbers right your average price for the buyback was about $54. Can you talk about your buyback philosophy here relative to the current share price and potential future dividend considerations, and how you’re thinking about that?

James O’Leary

I think the $54 was just this quarter. Is that right?

Kenneth Crawford

Yes.

James O’Leary

And the average over the program is materially lower than that.

Steve Barger - KeyBanc Capital Markets

Sure, I’m just talking about the quarter.

James O’Leary

Yes, and the quarters doesn’t contemplate what we had as far as 10b5 in a period when we were a little bit under $50 and under $55. Our plans are we are going to continue to be opportunistic about it. When we’re down in the low 40s, we’re more likely to be buyers than when we’re in the high 50s.

But we think it’s an attractive use of proceeds. I think that someone pointed out before the first question was ‘hey, a year and a half, two years ago you could earn 8% on cash. Who’d know you’d be taking a risk on not being able to use it,’ right?

Steve Barger - KeyBanc Capital Markets

Right. Right.

James O’Leary

Now we’re getting to the 300 basis points on cash. We recognize that that is not a great use of funds to be sitting on cash balances at that level. But we’ve accelerated capital a number of times. We’re looking at additional acceleration of capital.

We did a $65 million acquisition; we funded our pension plans; we’ve upped the dividend twice; and to simply answer your question, I think we’ll continue to be opportunistic repurchasers. If we wake up and the stock’s materially lower as it was earlier this morning, if it stays down there, we’re going to be buyers for our shares.

Steve Barger - KeyBanc Capital Markets

Very good. Thanks for your time.

Operator

Our next question is from Michael Hamilton - RBC.

Michael Hamilton - RBC

Could you repeat where your wind backlog was at second quarter end?

Kenneth Crawford

$151 million wind backlog.

Michael Hamilton - RBC

Thanks. Was wondering if you could give some general perspective on whether the momentum that we’re seeing driving wind in European Velocity right now has the potential to offset normal second to third quarter seasonality at the top line? Is there a potential there, or do you think that’s unlikely just in normal seasonality?

James O’Leary

I think it will be a bit tougher largely because of the issue we’ve talked about a couple times on this call, which is the more tenuous certainly relative to the last two years nature of the book and ship business.

But I think the momentum in the wind business certainly at the top-line may offset that. Whether or not it’s going to offset both factors, I think it would be tough for me to say.

Michael Hamilton - RBC

Yes, fair enough. Could you give some perspective on your views on economic dynamics in wind at this stage? In other words, we’ve seen wind require tax credits domestically to get to where we need to be, and we’re looking at continued cost pressures. How do you think about all of that as you lay in your forecast?

James O’Leary

When you look at wind relative to carbon based alternatives, as far as grid parity it is awful close without tax benefit. Obviously the tax benefit helps considerably. When you look at relative to other renewables, which I think one part of the competition within the energy space is with carbon based alternatives, so wind is closer to grid parity than all the other renewables.

I think nuclear you’ve got to put on the side because that’s a completely different conversation in terms of policy and people’s feelings about nuclear. But when you look at wind compared to solar, the disparity between wind and solar as far as grid parity is pretty considerable. Wind needs less tax, but tax would still be helpful.

When you listen to people discuss, and this is people on both sides of the aisle, the likelihood and the feel goodness is the only way I can describe it, but the comfort level that there should be a renewable portfolio; not just renewable portfolio standards but a PTC and PTC enacted this year, you almost can’t find a person who doesn’t think there should be one.

But it’s just amazing that it hasn’t been passed yet, and it’s been tied up obviously with other legislature. It’s been billed with other things that were less favorably inclined to get to passed in the PTC. Bu we are respectful of the fact that the PTC has not yet been renewed. Everyone we talked to says it will be, and no one I’ve heard says it shouldn’t be, but it hasn’t.

Now, what our customers tell us and what their customers tell them is they’ve got a high comfort level in the wind back drop relative to other periods when the PTC didn’t get renewed, because of number one, the prevalence of renewable portfolio standards. I think it’s somewhere around 30 states now where there are expectations and hard expectations by 2020 or 2030 as to the percentage of electrical generation from renewables.

A number of companies now are talking specifically about carbon audits and good citizen policies on the part of their supply base, and while there is lot of discussion, the PTC does have to get renewed.

There’s a lot of discussion about a national renewable standard at some point, and it’s not tree huggers or people who are all green, green, green who are saying that 20% renewable by 2030 is something that in terms of good corporate citizenship and good global citizenship, we should be thinking about as a country.

There’s nothing anecdotally that doesn’t tell me this momentum doesn’t stay there. All that said we really would love to see the portfolio passed, and hopefully it will be some time in the next few months.

Michael Hamilton - RBC

Thanks for insights. Last one, you ran below my expectation on second quarter CapEx. Could you lay in your outlook on the ramp through of CapEx as you roll in Phase II and III here?

James O’Leary

That’s just timing but let me see if Ken can’t get those numbers for you.

Kenneth Crawford

We’ll see probably in a $30 to $35 million CapEx total for next quarter, and in total we’re looking at $75 to $80 million in 20’08, and again that is absent any additional movement we might make to add to our capacity expansion that we talked a lot about this morning.

Michael Hamilton - RBC

All right. Thanks gentlemen.

Operator

Our next question comes from Walter Liptak - Barrington.

Walter Liptak - Barrington

I don’t want to beat a dead horse on the book and ship, but when you went through on your outlook and you talked about the excellent, good, relative and relatively bad, and uncertain. As a percentage of revenue how much is the uncertain portion?

Or maybe another way to say it, as a percentage of revenue, how big is distribution? For those AITs of the world?

James O’Leary

I’d say it’s between 10% to 20% is the uncertain part but it’s the highest margin. We’re still talking about our record year and our record year at the EPS line, we have turned a huge amount of interest income into operating earnings. But we’re talking about on the margin and on the margin that’s our most profitable business.

Walter Liptak - Barrington

Yes.

James O’Leary

And also unfortunately the hardest to forecast. It’s not just the book and ship; every company in this industry, and every guy who follows companies in this industry recognizes that there are occasionally over-orderings. It’s volatile, it’s based on funding. In our case, in particular, we’re a bit far down the food chain. Our visibility is not as good as some of our customers who are impacted directly by the funding.

What we’re saying is the most profitable portions, smaller percent certainly than wind, the smaller percent than the things I’d say were clearly good, fortunately on the good times and unfortunately when they get uncertain are the highest margin pieces.

Walter Liptak - Barrington

Okay. And then the fourth quarter push out of MRAP, did you say that was $2.5 million?

James O’Leary

Yes. That’s $2.5 million of shipments, which could fall into next year.

Walter Liptak - Barrington

Okay. So that’s not all that meaningful. Did you ship MRAP in the second quarter?

James O’Leary

Yes.

Walter Liptak - Barrington

Could you tell me how much you shipped?

James O’Leary

I don’t have that off the top of my head, but we’ll come back to you on that.

Walter Liptak - Barrington

Okay. Can you tell us who your MRAP customers or you shipping to the government?

James O’Leary

Shipping to BAE and partially them.

Walter Liptak - Barrington

Okay. Yes. Because they had a push out. What’s the funding tied to? The supplemental got passed. Where do you think the funding is tied?

James O’Leary

I think it’s timing of releases within competing vehicle platforms; a lot of people think MRAP is the answer, but there are some who don’t.

Walter Liptak - Barrington

All right.

James O’Leary

Right now I think there’s 15,700 vehicles approved and that number has been materially higher at points, but it’s also a bit lower. Like I said it’s swung from despair to euphoria, and there are competing vehicle platforms which would impact whether that 15,700 becomes more.

What we expect is that that will get funded, but it will get funded over a longer period as we go into the election and figure out what the new administration and what’s going to happen in Iraq and Afghanistan.

Walter Liptak - Barrington

Right. Great, thanks.

Operator

We have Michael Corelli - Barry Vogel & Associates.

Michael Corelli - Barry Vogel & Associates

Is there any new competition that’s been announced as far as new facilities, new production capacity in the wind energy area?

James O’Leary

Not that we’re aware of, and what we’ve talked about is both SKF and FAG have announced expansions, but that’s not new. Another domestic competitor has announced a small capacity but that was quarters ago, so there’s nothing new that we’re aware of.

Michael Corelli - Barry Vogel & Associates

Okay. Great. Thank you.

Operator

Our next question is from Nigel Coe - Deutsche Bank.

Nigel Coe - Deutsche Bank

You’ve obviously covered a lot of ground here, but you haven’t talked about acquisitions. What are you seeing, Jim, in terms of things out there, and how has that changed from maybe last quarter?

James O’Leary

I think there’s a little bit more volume in terms of people trying to get things to market. I would say there is not that different than in the IPO market. More people are filing prospectuses, more people are registering for potential IPOs, but you haven’t gotten into hard price discussions yet, which is kind of where the rubber hits the road.

We’re starting to see more volume on what I call mid size to fairly large sponsors looking at harvesting some things in their portfolio. But I think we’re at the early stages.

I’d say volume has picked up a bit relative to the last quarter, but still you’re not quite at the phase where you see whether or not people are willing to sell at prices different than what they might have entered properties at. It will be interesting to see what happens if there’s not a bank market to support larger deals.

Nigel Coe - Deutsche Bank

Sure, and then I thought the small conversion on the note was interesting. They bumped your dividends quite meaningfully, and usually CD holders hate that sort of thing. So, have you seen any more conversions in July?

James O’Leary

No, but we’ve had some inquiries.

Nigel Coe - Deutsche Bank

Okay.

James O’Leary

As we ramp up the capacity expansion, and we think about acquisitions, I think the math answer is you always leave the convert outstanding, but qualitatively as we start to put more capital potentially into wind or the acquisition market heats up a bit, cleaning up the balance sheet may be something we consider because that would give you the ability to go to the agencies and go to the banks with an optically clean balance sheet. But I think that’s all trimming around the edges.

Nigel Coe - Deutsche Bank

Okay. And one final one; thanks for the disclosure on the wind revenues. How does that phase between 1Q and 2Q?

James O’Leary

Did you say between Q3 and 4?

Nigel Coe - Deutsche Bank

No 1Q and 2Q; the $34 million of revenues in the first half of the year.

Kenneth Crawford

$15.5 million in Q1 and $19.3 million in Q2.

Nigel Coe - Deutsche Bank

Great, that’s very helpful. Thanks a lot.

Operator

Our final question comes from Holden Lewis - BB&T.

Holden Lewis - BB&T

What was the acquired revenue from Avon in the quarter?

Kenneth Crawford

Little north of $7 million.

Holden Lewis - BB&T

And you also had a divestiture...

James O’Leary

Less than a million

Holden Lewis - BB&T

And on the working capital I know you said that you’re seeing increases in terms of your receivables inventories due to revenues which is certainly true, but it looks like the rate of growth this quarter and last in both receivables and inventories has been faster than your rate of growth on cogs and sales.

It seems like you’re adding working capital assets at a rate faster than your growth. Can you give some color as to what’s behind that?

Kenneth Crawford

We look at things like DSOs, and on the receivables side we’re not too concerned. We looking at ageings and we always have and this quarter is no exception. 90% of our receivable balances is less than 60 days and 96% is less than 90 days. So the quality of receivables is still good.

On the inventory, you have added Avon since a year ago, and our operation in Mexico is buying a lot of forgings in anticipation of making these wind turbine bearings. It’s obviously something we’d like to turn into cash as soon as possible, but we’re not concerned with the quality of our inventory and our receivables.

James O’Leary

But Holden, qualitatively if you think about the way the material pass throughs work, you’ll be taking in forgings at today’s cost. You just compared that to last quarter’s cost. And you’re not going to get the reset on what you paid a higher price until next quarter.

I think the rate of your inventories, which you’re taking in at a current cost relative to sales and the DSOs, where you don’t get a reset until you pass that to the next quarter, I think it’s a bit of a mismatch between what we take on our books with inventory and how that relates to the various working capital ratios, but we watch that stuff like hawks.

Holden Lewis - BB&T

When you talk about the reset, for the quarter lag, it’s in the first half you’ve offset raw material costs so far, presumably, you’re behind by a quarter. Why would we be concerned about Q3?

James O’Leary

I said we’ve more than offset based on two components: price pass throughs and efficiencies. Well more than half of that thus far has been efficiencies and quite frankly proactive tests on the part of our management to reduce costs.

We look at in two buckets, cost reductions and price increases, and more than half of it has been cost reductions. It’s not just a pass through, it’s efforts we’re taking and unfortunately, that’s where you have diminishing returns and that’s why we gave you the cautionary note about that.

Holden Lewis - BB&T

Great. Thank you.

Operator

And there are no further questions.

Richard Mosteller

Rochelle, thank you very much, and if there is any one still on the line, thank you for your time this afternoon, and we will talk with you next quarter.

Operator

And that will conclude today’s call. We thank you for your participation.

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Source: Kaydon Corporation Q2 2008 Earnings Call Transcript
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