Aaon Inc (AAON) 2004 Q3 法說會逐字稿

Thank you for holding ladies and gentlemen, and welcome to the AAON, Inc. third quarter conference call discussion of revenue and earnings conference call. At this time, all lines are in a listen-only mode. There will be an opportunity to ask questions at the end of today's conference, and instructions for asking questions will be given at that time. Thank you for the attention, and I'll turn it over to the host, Mr. Norm Asbjornson. Go ahead, please.

Good afternoon. Norman Asbjornson here. I'd like to introduce Kathy Sheffield, our CFO.

Good afternoon. Welcome to our conference call.

Before going any further, I wish to read the Safe Harbor statement. To the extent any statement presented herein deals with information which is not historical, including the outlook for the remainder of the year, such statement is necessarily forward-looking and made pursuant to the Safe Harbor provisions of the Security Litigation Reform Act of 1995. As such, it is subject to the occurrence of many events outside AAON's control, which could cause AAON's results to differ materially than those anticipated. Please see the risk factors contained in our most recent Securities Exchange Commission filings, including the annual report on Form 10-K and the quarterly report on Form 10-Q. Thank you.

We will proceed into discussion of our income statement and what is contained there in. As most of you are aware, that our income has risen fairly decently this year, pretty much in keeping with what we had anticipated in the beginning of the year. The kicker to the entire thing was that we did not anticipate the inflationary events which have occurred this year. Where in, for instance, steel has virtually doubled in cost to us and is a major component in our cost structure. Likewise, copper has gone up close to that amount. We have been able to -- because we did hedge the copper somewhat -- been able to off set that.

We had tried to make some agreements with steel companies on steel, but we thought we had agreements, which didn't turn out to be agreements after all; they did not hold up their part of the agreement. So the net result of that is that we have had an incredible inflationary environment primarily due to two components, steel and copper, and to a lesser degree, aluminum, all of which are controlled not by very much that goes on in the United States but rather what goes on in the world economy, and the world's economy is driving up the prices of basic commodities rather astronomically.

The net result to us is that it totally destroyed our bottom line from what we had anticipated going into the year. We've had significantly more increase than we had ever dreamt possible. This has been further compounded by the fact that while we have made fairly substantial price increases, the cost increases have actually outrun our price increases. And all of this has been compounded by the fact that the reaction time in our industry by our competitors for whatever reason, seems to be lagging, and competition is not, for whatever reason, raising their prices as we would expect that they would have to.

This, of course, causes a problem, if you raise a price too fast in accordance with what the cost has increased, you stand a very high probability of reducing your volume, and so you're on a precarious position of trading off volume and profitability while the industry recognizes the cost increases which have been occurring to all of us. The -- almost the total change in our direct cost is due to these cost increases and may have been further magnified by the fact that most of our suppliers of motors, compressors, wire, you name it, have been affected by the two, three costs that I mentioned, and those that haven't have been effected by petroleum cost increases.

So across the board, we've been getting price increases from virtually every source of component that we buy for our product. The necessity for further price increases is obvious. We will be increasing our prices again, shortly. We've effectively had two price increases so far this year, which in total for the last month of production looks like we've effectively improved our pricing by about 8% and we've fallen behind.

So that's not a very pleasant-looking picture when you can effectively have 8% price increase and still not effectively get better gross margin. The ratio of what's going to happen in the future, who knows. We've been, very sadly, long so far this year. I don't think that the information we get is very reliable, because too much of what in the past we've gotten in the way of guidance from economists and everything tended to be, sort of, looking at the U.S. economy. And I think most of these costs increases are not so much due to the U.S. economy as due to other economies.

And I can kind of reiterate the fact that in steel last year, we used a little less -- or little bit more than 1/3 as much steel as China did, and , therefore, what's happening in the U.S. is not the big cost-controlling factor. It's what's happening worldwide; both China and Japan use considerably more steel than we did. So they're going to control the future pricing of that, and that's not uncommon to a lot of the commodities now, which are much more controlled by the world market than the U.S. market.

SG&A and other costs have been rather pleasant. We have had a relatively substantial decrease on a year-to-year basis of our warranty and some of our other expenses on the SG&A level. That is down from a year ago in a comparable quarter by $456,000. But all that said, the Company is running pretty well. It still doesnt' really have a major impact on giving us back our bottom line. It's nice that we are able to do that and it is helpful, but, still, the base materials are what's killing us.

Looking down at the rest of the year, all I can surmise is what I read and you read also, about where these costs are going. And in general, I would say that we are going to be fortunate if they don't continue any higher than they are at this point in time. That being said, most of our price increase that we have announced, most of it has been flowing through in the third month of our third quarter; in other words, the month that we just finished, September, we got to see most of it in that month. The first two months, we were seeing some of it, but not most of the price increases.

The net result of all that would tell us that if we don't continue to get additional high costs increased in the fourth quarter, we might get a little bit of relief and we might start improving our gross margin marginally, but it's not going to be anything tremendous. Looking down through the balance sheet for the Company, we still have a current ratio of two to one. Looking at our capital expenditures, they have exceeded what we had started out. We thought we were going to be in the $11 to 12 million; thus far, we have spent 13,467,000, not a significant share -- well, a significant share but not a major share, I guess, of that, is the purchase of the[Air Wise] up in Canada, the assets, and the purchase of a facility to move them into since they were previously, and still are, in the leased facility.

So that was one we didn't really anticipate when we set up our capital budget for the year, but it was an opportunity that we felt was well worth doing, and therefore, we did it. On that -- in that regard, for those who may not be totally up to speed on that, the Company Air Wise was an independently owned company, privately owned, and had, last year, in their last fiscal year, which ended in the end of September of last year, done about a little over 21 million in sales. That was part of their problem. They really should not have done that much because they ended up having to run a lot of overtime due to their facilities being inadequate, in order to make that much in sales.

Their reputation in the marketplace was good quality, good engineering, but the negative side of it was that their operational part of their business wasn't run so well. And then due to the exchange rate change last year between U.S. dollar and Canadian dollar, and the fact that 40-something percent of their sales were done in the U.S., they got hammered rather badly when the exchange rate went against them in addition to other operational problems and not having gotten enough money for their product. So they ended up in bankruptcy and that is where we bought them.

At that point in time they had very little backlog, and so we had kind of a start up cost. It has not been huge, but it represents a negative kick to our bottom line of some half million plus dollars, and also it has been an expenditure for capital equipment, mainly the building for their facility that we've hoped to be moving into next month. On the up side of it, it gives us a lot of product in areas which we have not had product in before. It compliments us extraordinarily well. The synergies between manufacturing, what we do and what they do, is very large.

There is a lot that we bring to the table to help them, not only in running the business better, which we have already got them into our computer system and eliminated a lot of their control problems and that portion of it, but also, by buying the facility which we hope to move them into next month, will give us the ability to go up, probably without any more capital investment we probably could get it up into the $40 to $50 million, because the building -- the manufacturing portion of this new building is over twice the size of their previous building.

And so, we believe we have the sales capability within our sales operation to make that happen rather rapidly, about as fast as we can do it with the manpower and the ability to grow the business. So it will start contributing significantly to our top line and bottom line. The bottom line we would expect to start doing a positive contribution sometime early next year, growing fairly well throughout the year and on a long-term basis, we expect to do as well, at least as well as anything else we've got, and theoretically should do a little better than with a we've got now, but time will only tell on that.

The new facility that we purchased is in the town of Burlington, Ontario, which is, oh, 40 to 50 miles from Niagara Falls, just around the lake a little ways. So its proximity to the U.S. market is very good. The product line that they have is very much attuned to industrial type facilities, and both Canada and the U.S. have a lot of facilities in that geographical area. So we expect business to rebound very quickly. It is already up. We're doing as much business, and we've got ass much backlog as we need right now until we get the move completed.

The other aspect of what is happening in that is that we have been working down our backlog. Our backlog at the time last quarter, as you may remember, we were up into the 50-some million dollars in backlog. We have now gone down into the high $30 million; $38, $39 million in backlog. Part of that is for two reasons: one because of the capital expenditures we've had, we've been able to produce product more quickly than we had anticipated, and we have eaten up part of it there; and part of it is our price increases, which have not been followed by the industry, have caused us to have a slow down in order input.

One of our major customers who we gave a price increase to, namely, Walmart in the early part of this year, is one of those who has reduced purchases from us. We don't have all the details, but I am sure the fact that we increased our price, and perhaps our competitor did not do as much, might have had some effect on that to us. In all cases, including Walmart, we still need more price increase due to the material cost increases which have occurred throughout the year. So it's a knotted-ended situation by any means.

Thus far, on the number of shares we purchased back, we authorized back in the fall of 202, a share repurchase of up to 10% of our stock, which would have been approximately a million, little over a million, 325,000 shares or there abouts. Thus far, we have bout back 1,014,664 shares. We've spent approximately $18 million doing it. There is still 310,336 shares remaining to be purchased. It is our intent, after the blackout period, which we do prior to and immediately following a quarterly release, to be back in the market and buying more stock.

The incoming order rate, as I've noted, has been adversely effected. We can't say that it's all because of our pricing policy or whether there is a general slowdown in the business or not. I think it's a little bit of both as near as I can tell. I think this cost increases, which have occurred in the construction industry not only in the steel virtually doubling, but my understanding is that several of the other costs such as concrete and lumber have also have a fairly significantly increase and they could be adversely effecting the building industry.

We have a lot of new product. We've spent a lot of time and a lot of effort on new products. And on November 5th, 6th, and 7th, we will be having a national sales meeting. We anticipate some 320 to 350 sales people coming in at their own expense to this sales meeting. Some of the significant things that we have done that we have to tell the story to our customers on, one of the most significant is the fact that energy, while it's been touted for quite some time in our industry, has largely caused manufacturers to improve the efficiency of producing heating or producing cooling.

Nobody has really gone after two other aspects of it. One, the cost of moving the air after you produce the cooling or the heating, and we already embarked on that many years ago and we've realized some benefit from it. But the other side is that -- and it's almost farcical in some respects -- is the cabinet that contains the heating and air conditioned air that sits on top of the roof has been virtually not addressed since the industry was founded back in the 1960s.

And what am I talking about? Well, insulation value in buildings is considered by a term called an "R" value, a resistance to heat flow. R values in your home now probably -- if you've a relatively new home -- probably up in at least, probably, in the low teens on an average, or not too much below that. The rooftop units, by our industry, typically use one inch of insulation inside of a piece of sheet metal. And one inch of insulation gives you a R value of about 3.5. somewhere, plus or minus.

We have embarked upon improving that and we now, on our bigger rooftops, are building units with two pieces of sheet metal. And inner and outer piece filled in between by a percentage of foam, which is a much -- roughly twice as good an insulator as fiberglass. And therefore, we're talking about getting R values well into the teens. So we're competing with people that might have R values down in three to five, and we're talking about having a cabinet that has a R value of 13, 14, 15. So we have a lot of work to do to get the benefit of that, but it is a very significant thing, we think, that is coming, and we are already there. We are producing the foam panels, we are building the foam units, we are converting all of our unit over to that.

And cost, from a cost standpoint, it varies from going to cost a little bit more money, to not going to cost any more money, and then in some cases it's actually going to reduce costs. So we've addressed the places where we get the cost benefit first. And the cost benefit is largely due to the fact that compared to the way a lot of equipment is built -- because of the structural integrity of the foam panels -- we've been able to reduce steel content, which reduces our steel usage in the product; that being a very major cost of our unit gives us a cost benefit.

The other things that are occurring right now is that we are probably producing somewhere around 20% of our product with the new refrigerant, the new green refrigerant, which is R-410. Compared to the competition in the marketplace, the bulk of the marketplace has not yet begun to produce equipment with a green refrigerant like 410, because by mandate, it's not required until the year 2010 by Montreal protocol and our governmental rules and regulations. However, the R-22, which is presently being used in product, began being phased out by 35%, less by a chemical companies, at the beginning of this year compared to the base year of 1999.

So anybody buying equipment is kind of foolish buying something where the refrigerant will be phased out entirely by the year 2020, which is before the life expectancy of the product you're buying today. So we're kind of in the forefront of technological advances, and we've done that over the past three years while we've been kind of languishing in volume increases. And so we expect that to benefit us as we manage to take it into the market place and promote it properly. So we believe innovationally, we are a leader, if not the leader, in our industry.

The other change which is occuring is that this growth that you're seeing is coming from our rep force, not from our national account business. So we are getting more and more customers and we are spreading our base of operations fairly significantly as we speak, and we are less and less tied to any particular segment and any particular customer. That's not to say we don't value each customer and try and retain them as much as we possibly can, but it is beneficial, in our estimation, to have a broader customer base.

By business segment, we would say that as it affects us, our retail market has been a little on the weak side. The medical market, which is not a big market for us but it's on the plus side. The educational market has become our leading market. It is definitely a strong market and one that we participate in very nicely. The other two major portions of the market identifiable are industrial construction, which still is languishing, and office buildings, likewise, aren't doing too well. Then the conglomerate is things called "other" in our industry and they throw everything in that, and that part of the market is pretty decent. So basically, out of the six segments, two of them are pretty sick and the others are kind of mediocre, some of them are mediocre, and two of them are fairly strong; namely, educational and other and medical.

Capital expenditures remaining for the year 2004. We basically have on the plant here in Tulsa, we still have approximately $200,000 worth of of work on the building addition, and we're putting a new roof on a major portion of the facility and we still have about $440,000 to go on that. On our [Salvanini,] our most two recent ones, we haven't paid them and haven't yet received portions of those machine, and we will owe them about another 2,100,000 on that. We have $100,000 on some new vendors we've got that we have yet to pay.

In our Longview facility we have an automatic brazing system that we still owe money on, and a few other items down there, which, collectively a couple hundred thousand dollars. And on the Canadian facility, we are doing a lot of work on getting that prepared for our building, for our new move into it, and we probably have about $300,000 worth of work of various kinds going on there. So collectively, we've got about three and a half million or thereabouts, of additional things that will happen this year.

Looking forward to next year, we've done most of the capital investment things which we think that we need to do, and so there would be a very significant drop-off of capital expenditures next year. We haven't yet done our planning in total detail so I am not going to give awe number, but it's going to be significantly less than this year. The new product lines that we are embarking on, basically, we've gotten into a very minimal amount of production on our residential air conditioning.

We have built some equipment. We haven't really put anything of significance in the volume or profitability due to it, but we are off and running. We still have some work to do to get it totally up to speed. As we have long told you, this was the year of getting it launched; next year is the year that , hopefully, it starts becoming significant. We still believe that to be so. We have also designed a new, smaller rooftop product, a more cost-competitive rooftop product in the small sizes, which is a huge market. It almost equals the bigger size all by itself, and we will be introducing that product this fall into that market, so it will expand our potential market rather considerably when we go in there.

How effective we will be at getting into it remains to be seen, but we've run some numbers to give you an idea of what is possible. We could do $3 or $4 million more per month and only have to have approximately 5% out of the marketplace in which we are designing that product. So it -- just like the residential, is a very high-volume type of marketplace that we are entering and time will tell how successfully we are able to participate, but we don't need a very large percentage to make it a significant number to us. With that, I am going to open it to question-and-answer. [Rona,] will you open it?

Thank you, sir. [Operator Instructions.] Our first question comes from Mr. James Gentile.

Hello. I was just wondering if you could give us the order of magnitude, the Walmart decline, in business?

It's a fairly significant percentage. I am going to say it's gone down by roughly one-half. So it's quite significant. As I said, there is always a lot of factors and you're never sure of what all is motivating any of these, but we do know that price is a very important thing to them and we do know that we raised our price early this year to them when we changed to R-410 refrigerant, and about that time we noticed a fall-off of business from them.

Thank you. Our next question is from Mr. Chris Kodawitz.

Hi folks.

Hi Chris.

You guys did a real nice job of answering a lot of the questions I have. I did have a few additional ones. Can you guys give us an indication on how much your sales increase in the quarter was volume versus price driven? You guys bumped prices so that should have helped you a little bit.

As I mentioned earlier, in the September time, all of our -- or a lot of our price increase had come into being and it amounted to about 8%. The two quarters preceding that, or two months preceding that, were probably down in the 4 and 5% area, so the blend of the whole quarter is probably, maybe, 5 or 6% of the quarter was price increase and the rest of it was we had volume increase.

Okay. Can you guys quantify raw material costs any fuller -- more fully?

Yeah, we can. Let's see. Where shall we get started here? In the third quarter, purchasing variants amounted to approximately more than we thought it would by about $2.7 million.

Okay.

So all I can say is that we missed it really badly on what was going to happen to steel, copper, aluminum; we didn't see it, I don't think anybody else did too well.

Sure. You're right. You're not unique in that. Now, when you say "purchasing variance," I guess I assume that's net, after taking some price that you'd announced early in the year?

Well, the way our financials work -- so you understand it -- when we talk about variance, that means that we set a standard when we go into the year. And we -- what we believe and what that is usually based upon is our most recent purchasing of it, so we almost always run negative on variances, because almost always there is an inflationary time.

Now, that hasn't been totally true because for awhile here, we had steel prices going down, copper prices going down, and others holding stable, so we, for awhile, ran almost positive variances there for a few years here in the recent past. But almost as a general rule, you can assume that when you set a standard based upon your price as of January 1, that you're probably going to run a negative variance.

Sure.

So it's -- and we never change that standard. And then in our first part of our gross margin analysis, the way we put our financials together, the only thing that we get affected on on standard gross profit -- and you don't see this number -- it's affected by the volume and the -- but primarily the price increases we give to the marketplace because we're still benchmarking it against the standard price.

And then the bottom part of our thing, down to the gross margin that you see is called variances. And that's all the changes in material purchase cost, our labor costs or our labor efficiency, and a few other relatively minor things that effect the standards. In other words, we don't do as well as we were doing on January 1, as what we anticipated on January 1. And we normally expect that, as I say, to run negative. Presumably, we are going to give out salary increases.

Presumably, however, that our labor efficiency should stay where it is so it shouldn't be negative to us, and presumably we are going to get material cost increases. So in some, we expect a negative variance. This year it's just gone out of sight as far as what we would expect. What we projected in our variance columns, we got blown away.

Okay. Well, like I said, you're not unique in that. It's been a tough year for a lot of people in your industry there. I guess one final question and I'll get back in the queue, did you guys see any impact do you think, due to weather being maybe a little cooler in a lot of parts of the country than typical in the summer?

Yeah, there's been a modest amount of that. In our business, there is a little debate because there is no firm number, but over the half of the business done in the products that we build is done on a replacement basis. And so to the extent it didn't need to be replaced because it didn't fail or something, that part of the business didn't show up this year. In the replacement portion of it, there is what we call two categories: the planned replacement, somebody last year decided they were going to replace it just because they had so many problems that they bought it without it falling apart, necessarily; they just bought it because they knew they should. And then you have the unexpected replacement, where something falls apart and the the service person tells them, "Buy a new one, you're just wasting your money fixing this thing," and that part of the business was definitely affected by the cool summer.

Okay. All right. Fair enough. Well, I'll let someone else take a shot at asking a question. Thanks guys.

Thank you.

Our next question is from Mr. Frank Magdalin.

Good afternoon, Norm.

Hi Frank.

Hey. Your tax rate was up a little bit. What should we expect for the balance of the year?

I'll let Kathy answer that one.

It should be about the same as what you're seeing right now.

All right. And then, Norm, getting back to Canada, the half a million, or 500,000 you spent up there, what quarters was that really spent in?

Well, we bought the thing the first part of May and thus far, through the end of the third quarter, we've lost about that much money. So I am very pleased with that because we didn't give very much money for this company at all. In fact, we got a real good buy on the company, so you could call this a part of our purchase price, if you will. That's the way I looked at it. I knew we were going to invest some money getting it straightened out and getting it up and running. We knew that going in the door, obviously. And it looks like we are going to get by on the lower end of what I thought it might cost us to get it up and moving.

So if you put the half a million in there with what you actually paid for it with maybe what you spent for the rest of the year, what's that purchase price work out to?

Kathy, you've got a better feel for that than I do.

Probably about 2.3 million.

2.3 million, doing about 20 million in revenue. And Norm, a little bit more about the smaller rooftop units that you were talking about and maybe a comment on where you think you are market share-wise. In the past you've thought you've been able to maintain or grow your market share. Where do you think that stands as when you're trying to be a price leader in an industry that's been reluctant to raise price?

Okay. We are going to enter this 2 to 5 ton portion of the market on the high side of the market, but not as high as we are. We had been in the 2 to 5 market, but more as a custom manufacturer, because that is, generally, a pretty commodity type of a market. And the 2 to 5 ton that we've had from day one is more of a custom-type approach, and it has -- we've gotten a pretty good amount of business for us out that that part of the market.

The new product that we're bringing out is not to replace the existing product we have but to compliment it by being a little lower cost and a little less capable product. It won't have all the customization capabilities that the present product does. But the market is so huge, we don't think that we necessarily have to give up one segment of the market in order to enter the other segment, and that's what we are endeavoring to do. We think that this new product , and like I say, we're going to enter it with two things. We are going to enter it with some capabilities that are not present in that lower side. There are not very many of them because for most part, you add capabilities, you had base cost to your product, and so we only added those complimentary capabilities that weren't going to affect the base cost of the product, with one exception.

The one exception is that it is going to be foam construction. So it's going to have a much better cabinet than what's out there today. We think that there is a big enough part in the market, because we are talking a huge market, that will welcome a better-built cabinet around their unit that we'll be able to get what we're looking for in market penetration.

All right. Thank you very much.

Our next question is from Mr. Brian Bears.

Hey Norm.

Hi.

How much of the growth, sequentially, from quarter-to-quarter here was attributed to the Canadian operation? Was there anything related to that? approximately a million and a half in sales.

Canadian operation gave us approximately 1.5 million in sales. So you can take a million and a half of that increase and attribute that to Canada.

And can you just talk a little bit about what sort of product differences there are between what they are making up in Canada and what you've historically made it in Tulsa?

Surely. Basically, they have been in the manufacturing of what we would call custom rooftop equipment, as opposed to our semi-custom product. Semi custom has a definite limitation; in other words, we won't do a lot of things that a custom manufacturer would do. Custom manufacturing will adjust the physical size of a product sometimes to meet a particular need, and we don't do that. We have some thick sizes and then we semi customize all the insides to the product.

A custom manufacturer will do very physical sizes. The material that we make our product out of is galvanized steel. A custom manufacturer will give you a unit built out of stainless steel or aluminum. So material, they'll change. Those are some of the big differences in the custom versus the semi custom. They will do a one-off; in other words, you would come up with some really odd requirement. We won't probably get involved in that because of the engineering cost and the disruption to our way of manufacturing would be too significant for us to do it.

That is the part of the ball game that those people play in. They are usually pretty skilled engineering groups, and they have methodology that doesn't require that they put everything down in black and white on papers and everything. A lot of it is verbal to the people, a lot of it is what you might call "tradesman" type people in the manufacturing department; people who can think and do for things on their own without being given specific instructions by your engineering department, for instance. So there is a different culture that exists in those kinds of organizations. Typically higher level people in the manufacturing area, because they have to be able to think and do things more on their own.

Will your current sales force be marketing this product?

Certainly will. It's just a perfect, natural thing for them. And a lot of the things that, you know, from a manufacturing standpoint, there is a difference like I just discussed with you, but a a whole raft of things are identical, like our putting our software system in place didn't have any difference at all, virtually. We just took and built a new, another company. We carry two different companies in our software now.

We carry our Texas operation as a separate company, from the standpoint of how we do our internal measuring and running of the company, and we have the Tulsa facility. This will be a third, and is right now, a third set of software running in our mainframe computer, so that we can customize the software, slightly, to their peculiarities that might be different than the other two companies. But in reality, there's almost no difference between the three of them; we have minor things, but very small. So the operational part of the company is very compatible.

The sales of the company, the people that we have selling our present product, in most cases already had another product line. And generally, you are dealing in a small part of the market, in a fringe part of the market. So a lot of the companies these people had been representing are very small companies -- as this one was before we bought it -- that don't have a large corporation behind them, and therefore, when AAON -- and AAON has a very high reputation now, we are respected in the industry -- has a company like this. We're somewhat unusual in that not all of our competitors have a company like this.

And so we get credibility from the customers because of the AAON's credibility will now transfer over to this company. Like I said, the company had gone bankrupt. So customers out there are a little leery of these custom people because they are not large corporations, they are subject to possible going out of business, and so there's an advantage for us to be the backing up a company like this.

Thank you.

Our next question is from Mr. Chris Kodawitz. Go ahead, please.

Hi. I had a follow up on two items. On the tax rate, can you guys give us a description or some color on what's driving that? Going on?

Basically, we have different rates at each one of our facilities, so it's a combined rate, Chris.

Okay. I mean, is that partially the Canadian thing?

That's correct.

Okay. Fair enough. And you gave us the third quarter material variance. How about the full year? Do you have that?

Well, it's a guess on our part. We do have a guess on our part. We do actually put together a complete -- at the beginning of the year, we put together a guesstimate of what we are going to do in all categories so that we have a budget to work against. And then, periodically, we do it again. And as a matter of fact, we have done it for the fourth quarter as we sit here. And what aspect of it do you wish to have me give you some information on? And this is, of course, just projection of the best of our ability.

Fair enough. I guess I was thinking in terms of the first three quarters of the year how are you shaking out compared to what you expected? And then if you have something on 4Q on material, that's really what I am focused on.

Well, let's focus on getting down to where it starts counting and look at gross margin. We believe the fourth quarter gross margin will marginally improve from the gross margin we had for the first three months. That's based upon a premise that we have that says most of our cost increases are already in-house or that we know about them already. We can't imagine steel going up -- you know it's up 100% now. Is it going to go up 120%? We don't think so but we could be wrong. So if our assumptions are right, we think you'll see a marginal improvement in gross margin.

We think that going on down through, our warranty costs are going to stay down, our SG&A is going to continue to be quite good. It might have a little marginal increase from where it has been in the first nine months. We believe it's going to increase slightly, SG&A. That's just about it until you get to the bottom line. We think that the net income as a percent of sales is going to be marginally better when you incorporate everything into it, but it's not going to jump back to where it was a year ago.

Okay. I guess what I was kind of getting at is that you had 2.7 million in variance from the third quarter. I assume your second quarter variance was in the same range and your first quarter was probably slightly down.

First quarter we had very little. Second quarter we had a substantial increase in it. The third quarter was worse yet.

Okay. I have a better feel for that. That's kind of what I thought, I just wanted to confirm it.

Yeah. It started out the first quarter, the first month or two, we're pretty much on planned, and then everything started down the tube. So the first quarter, in summary, the first two months weren't too bad; the third month starting getting in and we went out for a price increase. It continued getting worse in the second quarter, it continued getting worse in the third quarter. We think we bottomed out, but we don't know that.

Okay. Well, I think that takes care of me. Thank you.

Thank you. It appears we have no further questions at this time.

Okay. Well, I thank all of you for joining us for our review of the third quarter. Without further adieu, I would say talk to you in three more months. Goodbye.

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