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Hardinge, Inc. (NASDAQ:HDNG)

Q2 2008 Earnings Call Transcript

August 7, 2008 11:00 am ET

Executives

Rick Simons – President, CEO and COO

Ed Gaio – CFO

Doug Tifft – SVP, Administration

Analysts

Bob Schenosky – Jefferies & Co.

Brian Rafn – Morgan Dempsey Capital Management

Sheldon Grodsky – Grodsky & Associates

Gary Linhoff – Iron Works Capital

Robert Kosowsky – Sidoti

Tom Spiro – Spiro Capital

Operator

Good day, everyone. And welcome to the Hardinge conference call second quarter. Please note that this presentation contains forward-looking statements within the provisions of the Private Securities Litigation Reform Act of 1995 that are based on current expectations, estimates and projections about the industry, markets and economic environment in which the company operates.

Such statements involve risks and uncertainties that could cause actual results to differ materially from the results discussed in these statements. These risks are detailed in the Company's annual report and the Form 10-K filed with the Securities and Exchange Commission.

Today's call leaders are Rich Simons, President and Chief Executive Officer, and Edward Gaio, Vice President and Chief Financial Officer. Gentlemen, you may now begin.

Rick Simons

Thank you. Good morning, everyone. We're pleased you can join us today. As Elaine mentioned with me are Ed Gaio, our Vice President and Chief Financial Officer, and Doug Tifft, our Senior Vice President, Administration. Ed is on hand to comment on our results and to answer any of your detailed questions regarding our financial statements. Doug is available to answer any human resource or other operational questions that might come up.

During the call this morning, we will comment on our second quarter results and update you on some key operational programs. We'll then give you an opportunity to ask questions. First I'll comment on our reported second quarter performance compared to the same period of 2007.

Our net income for the second quarter of 2008 was $448,000 or $0.04 a share. Weighted average shares were $11.379 million, up 8% in comparison to 2007, resulting from the company's follow-on stock offering in April of '07.

Included in net income for the quarter was $2.2 million of one-time costs including $1.9 million in severance costs in the U.S. and the UK in addition to $300,000 of legal and consulting costs related to the company's fiscal restructuring of its international operations. Those two items had an unfavorable impact of $0.19 per share.

The company also recorded a provision for uncertain tax positions of $300,000 or $0.03 per share. Without these unusual items, our earnings per share would have been $0.26 a share.

However, on a comparable basis, our results continue to be disappointing and compare unfavorably to last year's strong second quarter which generated net income of $6 million or $0.57 per share. On a year-to-date basis, we have a net loss of $282,000 or $0.02 per share. This compares to net income of $11.3 million or $1.18 per share as reported for the first half of 2007.

The one-time event in this most recent quarter and the unusual charge related to currency exposures, which were discussed in the first quarter's earnings release had an unfavorable impact on year-to-date net income of $3.9 million or a $0.37 per share. While these items are real costs to the company, we offer these numbers only to allow you to consider our performance on a more normalized basis.

Let me discuss in more depth the key drivers of performance on the quarter compared to prior year. I'll comment on orders, sales and operational initiatives and then I'll turn the call over to Ed to comment on gross profit, SG&A expenses and our balance sheet. After our comments, we will open up the call to questions.

Net sales for the quarter were $96.6 million, an increase of 8% versus prior year. However, excluding the impact of translating foreign subsidiary financial statements, sales were virtually flat with the prior year. To explain these numbers on a regional basis, sales in North America were $30.5 million, a decline of 7% versus prior year.

We anticipate the balance of 2008 for the North American region to continue to be difficult as a result of the transition issues related to the development of a direct sales channel and the impact of an overall economy, which seems to be headed towards or is already in a recession.

The transition issues we mentioned have to do with the learning curve required to get our new direct sales force up to speed on the benefits of our broad product line and to learn their territories. Most of this team was hired in the fourth quarter of last year and are still in the learning process.

These new salesmen have replaced salesmen from our past distributors who, although were not performing to our expectations, were established in their markets and had knowledge of our products. Our transition will continue into the second half of the year and unfortunately, it's happening at a time when there appears to be a slowdown in ordering by our traditional customer base.

We are also seeing a slowdown during the past couple months in the activity levels in North America. There remains to be seen if this is economically driven or is the usual pause before the IMTS Show in September.

In Europe, net sales are $44.8 million or 16% above the prior year. This increase in net sales was influenced by good performance in continental Europe, primarily in our grinding product line, stable performance in milling and turning products and the favorable effect of financial statement translation. Convertibly, we continue to see an economic slowdown in the UK which is an important market for us.

Net sales in Asia and other were $21.3 million, an increase of 15% for the quarter when compared to the prior year. This reflects our improved performance in the Chinese market. China net sales were up 22% over the same quarter in a prior year.

Growth prospects in China continue to be good despite a regulatory environment that is restricting import for certain types of machine tools into the country. The majority of the overall market growth in China consumption is now from products made within the country.

We are well-positioned to take advantage of the Chinese market with our grinding products, which are not restricted for import and our manufacturing facility in Shanghai where we can participate in the more rapidly growing internally produced machine tool market.

Orders in the second quarter of 2008 were a record $109 million, an increase of $23 million or 27%. Excluding foreign currency effect of translation of approximately $8 million, orders of $101 million are still a record quarter and indicate an 18% increase over last year.

Orders in North America were $31.8 million, an increase of 27% over last year. This may sound contrary to my explanation above, but you need to understand that the increase is primarily attributable to one single, large order for a turnkey project for the auto industry.

Now, in the U.S. market, we have not had many individual orders of this magnitude in recent years. Without this order, the balance of activity was flat for the second quarter of last year, which is more indicative of the general business environment.

European orders were $56.1 million, an increase of 39% compared to the second quarter of 2007. This performance is driven by continued strong grinding demand, stable milling and turning demand and a favorable effect of foreign income statement translation.

Asia and other orders increased by $900,000 to $21.4 million, an increase of 5%. Orders in China increased by $3 million or 33% partially offset by declines in other parts of this region. As I mentioned above, business activity in China continues to be very strong.

We are fortunate to have a great geographical balance in our sales around the world which is unique in our industry with most companies relying primarily on one market, usually their home market. In the first half of this year, 49% of our orders were in Europe, 28% in North America and 23% in Asia. This diversification allows us to endure short-term economic problems in one region.

Now before I turn the call over to Ed, let me comment on our inventory management efforts that I addressed in last quarter's conference call. We are actively addressing higher than normal inventory levels through adjustments to machine build schedules in our factories and supply sources, as well as discounting programs to move product in the market.

We've been able to reduce inventory by $8 million during the quarter and are now flat with year-end 2007 on a constant currency basis. Although this is progress and has changed the tide of inventory growth we experienced over the past few years, I'm still not satisfied we've done enough to make meaningful improvements.

We will concentrate on cash flow for the remainder of the year and will continue to take steps to reduce our inventory. Beginning with the first of this month, we have implemented even more aggressive sales promotions and incentives throughout the world to give our customers the opportunity to take advantage of our over-inventory situation we find ourselves in. This will apply some downward pressure on margins, but it's the right thing to do to improve our balance sheet and to make room for new products.

Now I'll turn the call over to Ed to comment further on our financial performance of the first quarter.

Ed Gaio

Thank you, Rick. Good morning, everyone. Since Rick commented on orders and sales for the second quarter compared to last year, I'd like to make some comments about the other drivers of operating performance.

Gross profit for the second quarter of 2008 was $30.3 million, an increase of $1 million or 3.5% compared to the same period in 2007. The primary driver was increased sales levels and the favorable effects of financial statement translation. Gross profit on the year-to-date basis was $55.4 million, down 3% from 2007.

Gross margin for the quarter was 31.4% compared to 32.6% for the same quarter last year, or a 120 basis point reduction. This reduction to prior year is impacted by lower utilization of the company's U.S. and Taiwanese production facilities and material cost inflation.

We have taken some cost reduction actions in re-deployment of resources in our U.S. facility. On a sequential quarter basis, gross margin increased by 200 basis points. This sequential improvement was favorably influenced by increased prices in some markets that offset the unfavorable effects of the material cost increases and the currency impact in Taiwan produced products. On a year-to-date basis, gross margin is 30.4%, down 200 basis points versus 2007.

Selling, general and administrative expenses were $28 million for the second quarter 2008, an increase of $6.6 million or 31% compared to $21.4 million for the same period of 2007. SG&A expense as a percent of sales was 29% for the second quarter of 2008, up from 23.8% in the same quarter of 2007.

The primary drivers for the $6.6 million SG&A increase were $1.9 million in cost-related severance costs in the U.S. and the UK, $300,000 related to our legal entity restructuring in support of our new credit facility, $2 million due to the unfavorable effects of financial statement translation and the balance primarily a result of investments in sales and marketing expenses for direct sales channels and tradeshow expenses incurred during the quarter. The company's current run rate of normal operating expenses is in the $25 million to $26 million range per quarter.

Other income was $0.1 million in the second quarter of 2008 compared to $0.7 million in the same quarter last year. The $600,000 changes was primarily a result of differences in realized and unrealized foreign exchange losses.

Net interest expense was $0.3 million for the second quarter of 2008 compared to $0.7 million for the prior year quarter. The decrease was due to the reduction in outstanding debt, as a result of the company's follow-on stock offering.

The provision for income taxes was $1.6 million for the three and six months ended June 30th 2008, compared to $2 million and $4.4 million for the same periods in 2007. The effective tax rate was 78.5% and 122% for the three and six months ended June 30th 2008, compared to 25.2% and 27.8% for the same periods in 2007.

The differences are due to the mix of earnings by country, the non-recognition of tax benefits for certain entities in a loss position where a full valuation allowance has been recorded. The benefit of the completion of the qualifying $0.6 million hedge contract in an increase in the amount of reserves for uncertain tax positions of $0.3 million. The company expects the 2008 effective tax rate to be in the range of 39% to 41%, excluding discreet items, which would have a 1.5 unfavorable impact on the effective tax rate.

This projected range is significantly different than our original guidance from last quarter. The driver for the change is the projected earnings by country. This can be primarily attributed to the U.S. entity where $1.9 million of one-time charges and lower projected income from operations generated no projected tax benefit. Said another way, projected pre-tax income is being reduced with no material change in projected taxes.

I would now like to comment on liquidity and capital resources. Cash provided by operating activities in the quarter was $5.5 million in the second quarter of 2008 compared to cash used of $0.8 million in 2007. On a year-to-date basis, cash generated was $3.4 million compared to $2.2 million in 2007. The drivers to cash increased during the quarter were reductions in accounts annual receivable as well as the reductions in inventory.

Cash used in investing activities was $1.2 million in the current quarter compared to $1.3 million in the same quarter prior year. Cash used from financing activities was $3.8 million for the second quarter 2008 compared to cash provided at $3.4 million in 2007.

Debt outstanding as of June 30, 2008 was $26 million. Our debt, net of cash, is $12 million. The company has additional borrowing availability of $105 million at June 30, 2008. The company believes that currently available funds and credit facilities along with internally generated funds provide sufficient financial resources to fund ongoing business operations.

As a result of the company securing its new $100 million multi-currency credit facility, along with our new legal entity structure, we anticipate that we will use any idle cash to reduce our outstanding debt. This will occur in the third and fourth quarter as we complete our final legal entity restructuring.

And now I'll turn the call back to Rick for his closing comments before we open it up for questions.

Rick Simons

Thanks, Ed. Before we turn it over to our moderator for questions, I would like to address other issues we mentioned in the press release.

First, we are very excited to have Mike Hillock join our company. Mike spent the majority of his career with Diebold, a world-wide manufacture of ATM machines and security equipment for the banking industry. He does not have a machine tool background. However, he, along with Ed Gaio who you just heard from, and Jim Langa, our Vice President of North America Operation, who brings a strong engineering background to our company from another industry, provide a good ability to look at our company and industry from a totally different point of view and challenge our traditional thinking. Mike was responsible for setting up Diebold's international sales and distribution network in Europe and Asia and is focusing his attention there in his early days here at Hardinge. He'll be joining us on future conference calls, but in fact, he is overseas right now, just where we need him.

I've outlined in the press release some of our action plans for our company. During my short time away from Hardinge, I had the privilege of working with a successful management team and two CEO's at a very-well run company. I saw the benefits of simplification, focus and discipline processes firsthand and learned a great deal from them. I believe we can improve Hardinge's performance by simplifying our operations. A prior executive from our company referred to it as paying attention to our blocking and tackling.

Now, I realize our employees in Asia and Europe may not understand the football analogy, but they do all understand that getting back to the basics and doing everything, no matter how small in a straightforward way will contribute to a winning formula. And we have success to build on. But we, like any company, have limited resources and the necessary measures companies have to take during slower economic times strain those resources even further.

So we have to pick our priorities and focus ourselves on those areas with the most significant probability of success. We can be more efficient, productive and focused if we clearly state our priorities to our employees and customers and they understand who we are and where we are headed. Next we have to be more disciplined in our processes throughout the company.

Improvements in areas like new product design through introduction, inventory planning and control, employee development, clear path of authority and responsibility; these are all areas we will be working on, which we feel will pay dividends in terms of improved long-term financial performance.

One of my early mantras to our employees is to have us become a truly global company instead of a company that has operations around the globe. We are fortunate, and almost unique in our industry to have engineering, manufacturing and distribution operations on the ground in the United States, Europe and Asia. However, I don't consider us to be a global company. The difference is that a truly global company has people around the world that are effectively and efficiently working together, helping each other, teaching each other, designing and building products together and satisfying the needs of our customers together.

One of the joys I personally have is to visit our factories in the U.S., Switzerland, Taiwan, China and the UK As I visit people on a shop floor, it occurs to me that even though there are different languages spoken at these plants, the common language is the knowledge, pride and even love of machine tools.

We need to get those people around the world working together so that we are making world machine tools that have used the best of the knowledge, skills and resources of the people in each of our countries to make the best machine tool for our customers and to build them in a place that best addresses our customers' needs in each of our markets for delivery, option configuration and value without doing it through massive investments in inventory.

Lastly, we need to focus our attention on the needs of the growing machine tool markets of the world with the number one opportunity being the China market. China is not only the biggest market but continues to be the fastest growing market for machine tool consumption. As we develop products and solutions, we have to make sure they are fulfilling the requirements of our customers in this area. And those customers are not only Chinese manufacturers, but in many cases, they are our traditional customers from the U.S., Europe and Taiwan who have established operations there. We have been in China longer and more successfully than most of our competitors. We have to continue to build on that success.

Although these are ideas that I personally have discussed here, they are not my ideas alone. They are the result of my discussions with the great people of Hardinge throughout the world. These are action plans that we are just beginning to develop, but I encourage you to ask questions in the future about our success stories. I'm confident we'll have plenty to talk about. Now, Ed, Doug and I will entertain any questions you might have.

Question-and-Answer Session

Operator

Thank you, gentlemen. (Operator instructions) Our first question comes from Bob Schenosky.

Bob Schenosky – Jefferies & Co.

Good morning, thank you.

Rick Simons

Good morning, Bob.

Bob Schenosky – Jefferies & Co.

The first question I had is when do you expect the large auto order to hit the P&L?

Rick Simons

That is not going to happen – I don't believe until the first part of 2009. And actually, Bob, I should know the exact time, but I think it's out into the first quarter.

Bob Schenosky – Jefferies & Co.

Okay. And any sense of the negative impact of the tradeshow in terms of any potential delays of orders from the quarter?

Rick Simons

Bob, as long as I have been in this industry we have always seen that in the July, August time frame, there is a slowdown in orders. I tell the story and as we can as well as things you've heard forever; okay, why is there a slowdown? Are there really that many deals offered at the show? And, yes, there always are some deals, but the bigger answer that someone told me which hit home with me was the fact that if the guy says I'm going to buy the machine in June or July, he has no reason to go to Chicago and see IMTS if he holds off until then he's got a reason to go. I think there usually is a lull, I don't know of any reason why we wouldn't see the same sort of thing.

Bob Schenosky – Jefferies & Co.

Okay, have you seen any cancellations in your order book this year?

Rick Simons

No, we haven't had cancellations.

Bob Schenosky – Jefferies & Co.

Okay, and then finally if you could offer a sense of the profit progression out of the Chinese operations?

Rick Simons

Well, the Chinese operations are profitable. We've got two separate operations we look at; so one is the sales and service operation which we actually have been running since 1992, before that we were handled by a distributor over there. But the sales and service operation is running very profitable, growing sales terrifically. The manufacturing side, we are right now manufacturing three different lines of machines there, we're going to continue to grow how many lines we're doing, but that side as well is making money at this point and is a ramp up over the last three or four years, but this year it's turned the corner to make money.

Bob Schenosky – Jefferies & Co.

Great, thank you for your time.

Rick Simons

Sure, Bob.

Operator

Thank you, sir. The next question comes from Brian – is it Rafn?

Brian Rafn – Morgan Dempsey Capital Management

Yes.

Operator

Thank you.

Brian Rafn – Morgan Dempsey Capital Management

Good morning, guys.

Rick Simons

Hey, Brian.

Brian Rafn – Morgan Dempsey Capital Management

A question for you, Rick, give me a sense that you talked about, I got on the call a little late. Your focus on simplicity over complexity; is that, in your process you've spent, certainly in your past career at Hardinge doing a lot with the factory floor up at Elmira, is it layout? Is the complexity cellular designs? Is it too much work and process inventory on the floor? Give us a sense as to what that simplification means?

Rick Simons

Actually, it's easy for me to say it's all of the things you mentioned before, Brian. And I hesitate in speech or in talking about a LEAN [ph] because I think LEAN in itself can be interpreted by many people and so I was really, through the things I've listed here, picking out the part to LEAN that I think are the most important for us to work on. I think in terms of simplicity, a lot of it has to do with even administrative efficiency of how we process orders, how we process orders through the shop, how we handle material through the shop and so on. And I will say, this isn't a matter of the U.S. facility, this is a matter of all of our factories and our sales and organization people around the world. I really, truly believe that there's lots of opportunity for us to become more efficient, which is going to improve our customer service which is number one in my mind, but also allow us to really improve our cost structure.

Brian Rafn – Morgan Dempsey Capital Management

Okay. Can you give us a sense of what is – of all of your plants, New York, up in Elmira, you've got certainly Switzerland, China, Taiwan; are the cycle times in the efficiencies model against any one of those areas? In other words, is your cycle time in processing orders and production better in Switzerland and Switzerland's the model, or is it Elmira, or is it just all across the board?

Rick Simons

That's a good one. I guess, and I'm shooting from the hip here, which is sometimes dangerous, Brian, but I would say as I look around the world, probably our most efficient order processing and material handling process and so on is in Switzerland. And –

Brian Rafn – Morgan Dempsey Capital Management

In Switzerland.

Rick Simons

I think that it's one of those things that I want to do, and when I talk about becoming a global company, we have to start at each of our factories deciding which one is the best and then having the people at the others go learn from them, and I think that's a good opportunity. Now, there's other places. I would say in Taiwan, they're handling very much their manufacturing processes, the assembly line and so on is something to be admired. Here, in the United States, certainly the way we make machines to order especially and the way we are able to control the quality process through our processes is something that we can teach other people. So my goal is to get each of these factories really sharing best practices because we have some very, very good practices in each of them in sharing best practices in an open and collaborative way.

Brian Rafn – Morgan Dempsey Capital Management

Okay. Does this process involve any headcount reductions, or give us a sense what the payroll side is?

Rick Simons

My finest desire is that it does not result in reductions, what it results in is better customer satisfaction and better volumes, and so we're doing more volume with the same number of people, but obviously, and I have said in my thing, I worry about the worldwide economic situation. I think when we talk about a recession in United States and the deceleration of business; it's going to affect the entire world. We, I mean – China does supply lots of product, I'm not talking machine tools, I'm talking everything. But if our economy really does go in for recession here and people continue to slow down their purchases that will end up having China slow down on their manufacturing as well.

Brian Rafn – Morgan Dempsey Capital Management

What do you guys – and again I missed your opening comments, what are you guys seeing on the U.S. domestic job shop sites as far as order rates? What's your sense of their business trends?

Rick Simons

We're seeing a slowdown. We – between our sales and our own intelligence looking at our competitors that are public, with their information and obviously looking at our own orders, we're seeing a slowdown in North America right now.

Brian Rafn – Morgan Dempsey Capital Management

And then just one other one. Rick, you're talking certainly about focusing on China. China being the best. Are you still building your lower-end technology standardized machines for China and is the thought to add higher level technology content complexity machines to China or does that stay in Taiwan? Give us a sense from the standpoint of growing the business in China?

Rick Simons

That's a good question because I just actually, I have a weekly phone call with our people in Taiwan and within China and in Switzerland, let's see yesterday morning I talked with our general manager in China. And I think we have to recognize there is a lot of baseline machines sold in China, and that's where a lot of the growth is, but China is going to become no different than any other market we have competed with in the world. And our mid-range machines, which I would consider to be the machines coming out of our Hardinge Taiwan factory and our higher-end machines coming out of here, are machines that China needs and wants and will have to become an important part of it. Right now, our operation in China is manufacturing machines that were designed both in Taiwan as well as the United States. Obviously there are restrictions, our Super-Precision machines that we produce here are not allowed to be done there, nor have we ever considered having those done there because it's basically – it's illegal under U.S. law, but the other machines we – they are producing machines from each of our plants. I got to back up. Switzerland they are not, but it is something we are looking into, eventually making grinding machines from Switzerland could well be a part of that factory.

Brian Rafn – Morgan Dempsey Capital Management

Okay, thanks. I'll get back in queue. Thanks.

Rick Simons

Okay, thanks, Brian.

Operator

Thank you. The next guest today is Sheldon Grodsky, your line is open.

Sheldon Grodsky – Grodsky & Associates

I have a few fairly brief questions. A, is there any dollar amount of inventory that you think has to be reduced?

Rick Simons

Well, we did reduce $8 million this past quarter and as I said, I'm not satisfied with that. I mean we're at what, $165 million now and assuming constant currency; I mean I really have a goal of myself to get another $15 million out of that. I'm pushing our organization very hard to do that. I can't say for certain it will happen between now and the end of the year, but that's where my goal is, it may slip over in part of it into the next year.

Sheldon Grodsky – Grodsky & Associates

Moving back to China for a second. For the last year or two there have been various issues about setting up facilities there and maybe some start-up problems and so on, are all those behind you? Is your China business going through, especially made in China business about to accelerate very rapidly?

Rick Simons

Yes. I guess right now my only concern about China is figuring out where we're going to build the next factory. We are – we have a factory there that start-up problems with that factory behind us, we are making machines, shipping them out of there on a monthly basis, but we're close to where we think that's pretty much the capacity of that building and so, we will be looking at further investments in China to continue to take advantage of that.

Sheldon Grodsky – Grodsky & Associates

One more quickly. In the move to direct sales, the transition has been going on for some months, is there any chance that that was the wrong move and you might go back to distribution or does the firm have a firm commitment to go to the direct sales route?

Rick Simons

Personally, and of course I'm just taking over, but I believe that the decision that Pat [ph] made was the right decision. I think selling our machines requires, especially our mid-range and high machines, requires people that are very knowledgeable on machines, typically it's a longer sales cycle than you might have on a baseline machine made from a typical factory in China or the typical factory that specializes in baseline machines here in the states. When you buy a Hardinge's machine, you're buying it for a special process for a special part or a complex part or a complex material, and so that sales cycle takes a while. I truly believe that Pat is on the right path that we need direct sales in our key markets where we have the best opportunity to walk in and convince the customer, I should say prove to the customer that our machine is the best machine to make those parts.

Sheldon Grodsky – Grodsky & Associates

Thank you.

Rick Simons

You're welcome.

Operator

Thank you. The next guest today is Gary Linhoff. Your line is open.

Gary Linhoff – Iron Works Capital

Thank you. Ed, you made a comment about, I believe about your SG&A run rate, which I missed. Could you repeat that for me?

Ed Gaio

Yes, the current run rate, setting aside these one-time expenses in the $25 million to $26 million range per quarter.

Gary Linhoff – Iron Works Capital

Okay, that's helpful. And in your proxy, you guys have outlined operating cash flow objectives or goals that management's bonuses are predicated upon. As you find yourself more than halfway through the year, can you handicap for us how – has anything changed? Do you feel comfortable that you'll achieve those objectives?

Rick Simons

Gary, that's good question and it obviously ties into my commitment earlier that I'm aggressively going after inventory and so on. Yes, I mean where are we, is it year-to-date? Ed, do you have it there? Is it $3 million-something from operations? I –

Ed Gaio

$3.4 million.

Rick Simons

Yes, I clearly believe that we will improve on that significantly in the second half of this year.

Gary Linhoff – Iron Works Capital

Okay, and last question. Your Asian orders last quarter were pretty strong and I guess I had expected to see a little bit better sales results in the quarter in Asia, although I guess some of those might be longer lead times. Is that the case? Or can you comment on some of the conversion of orders in Asia to revenues over the following several quarters?

Rick Simons

Yes, there are two things that I will say about Asia, is typically the China orders, many of our China orders, do take a longer time from order to shipment because we do end up having to get licenses. Typically the customer, we're at the mercy of the customer on their end because they have to apply for import certificates, and so on and so that takes longer. And then secondly, our grinding product side, those are always build-to-order machines, and so the delivery cycle on a grinding machine can be as much as six months. And so, that does happen to us.

Gary Linhoff – Iron Works Capital

That's helpful. And related to that, I guess your orders, strong orders in Europe this quarter, we should expect given the strength in grinding that those are likely to be over the next six months as well?

Rick Simons

That's correct.

Gary Linhoff – Iron Works Capital

Great. Thanks very much, guys.

Operator

Thank you. The next question comes from Robert Kosowsky.

Robert Kosowsky – Sidoti

Yes, hello, good morning.

Rick Simons

Good morning.

Robert Kosowsky – Sidoti

I was wondering if you can give us an idea of how to gauge your, I guess, exposure to material inflation, given the inventory draw down and some of your pricing initiatives over the next I guess a few quarters or so?

Rick Simons

Yes, that's one that obviously is affecting everybody. The – we are seeing price increases, especially in castings and parts of the machines that are heavily metal. Those price increases in some areas are the vendors are starting out with double-digit numbers, we're fighting back and working with them and trying to come up with ways to reduce those price increases. I will say, for instance, in one case and this is against our goal of working capital improvement and so on; we will take advantage of an opportunity to buy inventory ahead if we're able to lock into a specific price, and we have done that with some casting suppliers. But we are seeing those increases. We are passing them on in terms of price increases where we can. There is always – they're not always, but there is somewhat of a lag there. We do, especially with our distributors, have a lag so that they have time to adjust their quotes and so on, and so there is a bit of lag, but we do pass them on through price increases. The advantage I think we have is this is not a Hardinge problem, it's not even specific to U.S. or Taiwan; all across the world, material prices are going up and I just came back to Hardinge after leaving a specialty metals company and I lived through that for the last three years and the metal prices are going up, but everyone's going to have to pass them on.

Robert Kosowsky – Sidoti

So do you feel pretty comfortable to be able to, I guess preserve the margins over the next few quarters at least, you said?

Rick Simons

Yes.

Robert Kosowsky – Sidoti

And then on the direct sales force, how is the level of staffing, I guess maybe turnover of the new sales people you hired and also are they geographically focused? Or are there any particular verticals that they concentrate on?

Doug Tifft

The geographic distribution is very, I mean we've added direct sales reps in China, we've added some in the U.S., North America and also a few in Europe. There has been some turnover, you do the best you can, of course, for screening and that sort of thing, but it's a demanding position, and in those instances where someone didn't work out, then we've gone ahead and tried to regroup there and cover it with another person.

Robert Kosowsky – Sidoti

Okay, but you feel staffing right now is kind of where you want to be for – is growing this distribution channel?

Doug Tifft

Yes, we've reached those targets at this point, so we're just trying to get the current incumbents up to speed.

Robert Kosowsky – Sidoti

And then more broadly, do you see any trend of manufacturing moving back the U.S. or North America?

Rick Simons

Yes, I'm excited about that, but I guess I have to temper my excitement with we've got to see lots of results. But I think the weaker dollar, certainly we have heard from some of our customers, and you do read it, that there is work coming back to United States, especially from Europe. And I will say in Europe one of the key drivers of their economy is Airbus, and I think that Airbus is out there now looking for parts manufacturing in the United States because of the strong Euro and the benefit of the weak dollar. And also, I think that's happening, I don't know how fast it's going to happen, but I do truly believe it's happening and that should be a benefit for us in our market here.

The second thing that I do believe is that we will continue to be able to – well, excuse me, the other issue I was going to go into is I have heard stories of people actually bringing work back from China as well. When you get into small volume, and when I say small volume the tens of thousands of parts that are crucial parts. People are finding out that the logistical problems of bringing parts back from China, the problems you have when you have a quality problem from parts for China, those problems far outweigh the cents per part that you were trying to save by getting it over there. I think, lastly, the cost of transportation now, I'm talking longer-term, but the cost of transportation I think will continue to drive us to, worldwide, the manufacturing or at least final assembling products near the end use market, because the cost of shipping with the cost of oil and so on will continue to go up. So, I think there's opportunities for the U.S. manufacturing environment to come back.

Robert Kosowsky – Sidoti

And just finally, do you feel like you're able to acquire at this point in time or is there still so much going on internal that you'd like to get better first?

Rick Simons

I want to get better first. I don't want to imply to anyone that we aren't interested in acquisitions as well, though. But I do – right now our current focus is on improving our efficiencies in the organization we have now, but I'm not going to say that we wouldn't consider an acquisition if the right thing came along.

Robert Kosowsky – Sidoti

Thank you. Good luck.

Rick Simons

Thank you.

Operator

Thank you. The next question comes from Brian Rafn.

Brian Rafn – Morgan Dempsey Capital Management

Rick, and again I missed your opening line comments, can you talk at all about some of the strengths that you're seeing across the world in your end markets, industrial, aerospace, appliances, maybe agriculture, mining. Is there any way that you can give us a sense of what you're seeing trend wise?

Rick Simons

As you know, Brian, we sell to JobShop [ph] and so we don't always know exactly what markets they are selling into, okay? And the common story that we have always said is that JobShop this year, aerospace may be hot, so we're doing work for them, next year it could even be auto is hot. But, I will say, and actually, we just had a good meeting with the managers from around the world down in Newark, New Jersey, it was just a convenient place to bring everyone in from across the world, and when you really drop down to what our strengths are, our strengths are making smaller complex parts with high accuracy to super accuracy. And the market that really probably uses the most are the aerospace, the medical industry; we get into what's referred to as the three C industry; communications, consumer electronics, and what's the third C? I've lost it now. Anyway. And then, even some auto applications where you get into things like fuel injection parts and so on. I mean these parts where people are looking for accuracies in those types of industries are key to us. Energy is one that is hot right now. And again, I'm just coming from a steel manufacturer, these are the industries their very hot in right now. Energy tends to be bigger parts, and so that we don't participate as much, we don't make the lathes that get into those larger sizes.

Brian Rafn – Morgan Dempsey Capital Management

Okay. In the quarter or year-to-date, however you want to comment, what was parts, collets, tool holding, what was that as a percentage of sales?

Rick Simons

It's still around 30%, isn't it Ed?

Ed Gaio

Yes.

Brian Rafn – Morgan Dempsey Capital Management

Okay and the growth there has continued to be pretty good?

Rick Simons

The growth and profitability obviously are very good there.

Brian Rafn – Morgan Dempsey Capital Management

Okay. Is there any – you talked, you took one of my questions when you talked about the high costs of transportation and freight and how that's affecting I think some of your final assembly end market closer to your customer I think is a pretty good point. Is the long-standing reduction from the social welfare state in Europe really aggressively lowering their corporate taxes? Is that going to affect you long-term from looking at making maybe accelerated capital expenditures for your plants and capacities in Europe if they have a more favorable corporate tax environment?

Rick Simons

We'll have to look at that. I mean obviously, Switzerland, we just have wonderful operations there. We have two facilities, one in St. Gallen and one in Biel. As I said, they're very efficient. As you know, Switzerland isn't necessarily a low-cost country in the world, but they are so efficient in what they're doing and truthfully people expect grinding equipment to come from Switzerland and so we will continue to look at – as a matter of fact right now I would say any other CapEx we're doing and any major considerations to CapEx over the next three years are dedicated to their market as well as China.

Brian Rafn – Morgan Dempsey Capital Management

Okay. Ed, what's the CapEx budget for the year? Property, plant and equipment?

Ed Gaio

Well, we spent $2.5 million this first half, so I'd guess it's still going to be the same run rate for the rest of the year. It's $5 million for the total.

Brian Rafn – Morgan Dempsey Capital Management

$5 million total. And maintenance would be what component of that?

Ed Gaio

Probably 60% of that is maintenance.

Rick Simons

Yes.

Brian Rafn – Morgan Dempsey Capital Management

60%. All right, guys. Thanks, again.

Rick Simons

Thank you, Brian.

Operator

Thank you. We have another question from Gary Linhoff. Your line is open.

Gary Linhoff – Iron Works Capital

Hi, that was my follow-up question. But can you give us some idea of what you might be thinking in terms of a CapEx budget for 2009? And you alluded to looking for the next location for a plant in China, what kind of spending might we see in China over the next several years?

Rick Simons

Yes. I don't know. I've got – we are working right now on a three-year plan and starting to put our arms around that. It clearly will be much higher than what we're talking about here. And I will say in China you're probably talking $10 million to $15 million, but that's going to be over a three or four year period. But I would – I mean we intend to fund that obviously by getting working capital more in shape as well as getting product to the cash flow going through this company.

Gary Linhoff – Iron Works Capital

Okay, great. Thank you.

Operator

Thank you. The next question comes from Tom Spiro. Your line is open.

Tom Spiro – Spiro Capital

Tom Spiro, Spiro Capital. Good morning.

Rick Simons

Morning, Tom.

Tom Spiro – Spiro Capital

I'm new to the story. Rick, you've outlined an ambitious program of change for the company as it sounded to me, simplification focus, prioritization. A couple of questions. One, do you have the personnel you need to implement that program, particularly at the mid and the senior level? I see you've appointed a Vice President of Sales and Marketing, are there other gaps that need to be filled?

Rick Simons

Well, Tom, first welcome to Hardinge. I will tell you that I think we're in good shape. I mean I'm not going to say we're not going to add some people here or there, but I'm excited. Ed Gaio joined the company, what about two years ago from outside the industry. We have a new corporate controller that has just joined us, so that's the finance side. On the sales and marketing side we've got Mike Hillock and then the engineering and manufacturing side, Jim Langa as I referred to before. So, we've got some – as I say we were down in Newark, we had a group and it ended up being 11 people and because they are from all over the world, I nickname them the Ocean's Eleven. I hope I don't have a trademark infringement there that I have to pay somebody on but, this Ocean's Eleven group had a very good combination of people that have been with Hardinge for a long time. Some people from the machine tool industry that have joined us more recently and then also, some of these people from outside of the machine tool world that really did a great job of, and I use the term slap us in the head, and I'm not supposed to probably use that, but when we got too hung up in this is the way things are done in machine tool industry, some of these people say wait a minute guys, that may be the way this industry does, but there's a lot better ways to do it. And I will say it's been – it was one of the benefits. I certainly missed Hardinge the last three years, but it was one of the benefits of me going to Carpenter Technology and seeing how another company that's very successful does things. So, I'm excited about the team, I'm excited about us getting together and working on these things. It is as I said, this isn't an idea that I just came in with, it was a consensus of the group that these are things that we need to work on and we can make ourselves better, not only from internally operations, but as I said before, most importantly, we can make ourselves better in treating our customers and supplying our customers with the best products and the best services.

Tom Spiro – Spiro Capital

Does the organization have the right incentives of programs to foster these changes at the senior level down throughout the organization?

Rick Simons

I would say, Tom, in the past, no, we have not, but that was a big topic of discussion down there and we – I mentioned briefly there a clear cut lines of responsibility and authority and within that will also be clear cut lines of motivational goals that get people down to understanding what they need to do to contribute to the overall success and what they need to do when I say blocking and tackling, what that blocking and tackling assignment is for individuals all the way out to the shop floors so that they know that it's something they can control and that we as top management know that if they do what we're asking them to do it will contribute to an overall success.

Tom Spiro – Spiro Capital

And lastly, I understand that in certain parts of the world, I think North America being one, your moving from an independent distributor model to a direct sales force?

Rick Simons

Yes.

Tom Spiro – Spiro Capital

I'm kind of curious when an independent distributor sees that he's losing a piece of business, what can he do, what does he do to try to keep that business?

Rick Simons

Well, it is unfortunate. One of the things he will do is go out and try to find another supplier with similar products. I mean typically our distributors were not – I should say typically not ours, with exception of one, none of our distributors are exclusive to Hardinge. So he is selling other people's products as well as ours, and so when we drop a distributor, it's not like he has nothing to sell, he can concentrate on the other products he was selling. But if our – usually our products fit a niche within his overall portfolio and so he will go out and try to find someone else. I would say on the baseline type machines and some of the mid-range there's probably several people for him to go out and find. And our higher mid-range to high range, it will be difficult for him to replace us because that's really what we've been known for.

Tom Spiro – Spiro Capital

If you can generalize, does a customer's loyalty lie principally to the product or to the salesman?

Rick Simons

That's a good one. I would say, and I'm shooting from the hip again here, but I would say that it's primarily with the machine where that will suffer is if you don't support that customer with service and with support, he will change. But I think usually if you've got good machines and you're offering good machines and good support he will stick with you regardless of the salesman.

Tom Spiro – Spiro Capital

Well, thanks much.

Rick Simons

Okay, thank you.

Operator

Thank you. (Operator instructions) Gentlemen, currently I have no more questions in queue.

Rick Simons

Okay, good. I just wanted in conclusion I wanted to say that I am very happy to be back to Hardinge and I'm excited to have the opportunity to help to lead the company going forward. I have to say working with a wonderful Hardinge employees and partners from around the world I have known from the past and with the new faces that joined the company since I left, it is absolutely the most rewarding part of my job. The knowledge, and I say this sincerely, the knowledge, commitment and energy of our people in each of our locations, be it in the U.S. or Europe or Asia is absolutely inspiring to me. It's what makes coming to work fun. We've got hard work to do going forward to improve our performance, especially during a worldwide activity level that seems to be decelerating, but I truly believe we have the people within our organization and can put together the right plans to allow us to be successful.

We look forward to exhibiting our products, including several new exciting products at the IMTS Show in Chicago from September 8th through the 13th. Now I'm going to be at the show the whole week, and I'm looking forward to talking with our customers about their needs. I certainly invite any of you to stop by our booth and talk to me about the company, or probably more importantly, talk to any of the dedicated Hardinge employees who will be available to describe some of the technological advantages of our products to make us one of the most respected names in the industry.

Furthermore, we look forward to updating you on our progress on our next conference call. Thank you for your time and have a great day.

Operator

That concludes today's conference. Thank you for your participation. You may now disconnect.

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Source: Hardinge, Inc. Q2 2008 Earnings Call Transcript
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