Applied Industrial Technologies Inc (AIT) 2005 Q2 法說會逐字稿

Hello and welcome to the Applied Industrial Technologies second-quarter 2005 financial earnings conference call.

All lines will be in a listen-only mode until the formal question-and-answer session. (OPERATOR INSTRUCTIONS) At the request of Applied Industrial Technologies today's conference call is being recorded.

If you should have any objections, you may disconnect at this time.

I would like to introduce Mr. Richard Shaw, Applied's Vice President of Communications.

Mr. Shaw, please go ahead.

Thank you, operator, and thanks to all of you who are listening in for joining us on this Friday morning.

On behalf of Applied Industrial Technologies, welcome to our second-quarter call.

You should have already received our earnings news release that was issued this morning; and if you have not received it, you can retrieve it by visiting our website, www.Applied.com.

A replay of today's broadcast will be available for the next 2 weeks, and archived information is listed in our release.

Before we begin I would like to remind everyone that we will discuss Applied's business outlook during this conference call and make statements that are forward-looking.

Applied intends that all forward-looking statements be subject to the Safe Harbor of the Private Securities Litigation Reform Act of 1995.

All forward-looking statements are based on the current expectations regarding important risk factors, including the trends in the industrial sector of the economy, the success of our various marketing strategies, and other risk factors identified in Applied's most recent periodic report and other filings made with the Securities and Exchange Commission.

Accordingly, actual results may differ materially from those expressed in the forward-looking statements, and the making of such statements should not be regarded as representation by Applied or any other person that the results expressed therein will be achieved.

Applied assumes no obligation to publicly update or revise any forward-looking statements whether due to new information or events or otherwise.

This conference call is the copyrighted property of Applied Industrial Technologies; any copying, rebroadcast, publication, posting, transcription, or distribution of any portion of this call without Applied's express prior written consent is prohibited.

Our speakers today include David Pugh, Chairman and CEO of Applied, who will discuss our overall performance during the quarter.

We will also hear from Mark Eisele, Vice President and Chief Financial Officer, who will discuss our financial performance in detail; and Bill Purser, President and Chief Operating Officer, who will discuss our sales performance and operational activities.

Here to start us off is Dave Pugh.

Thanks, Rick, and thanks for joining us today.

I guess I will start off by saying I'm very pleased to report another strong quarter for the period ended December 31. (indiscernible) the operations, I'd have to say we're hitting on all cylinders.

We have discussed before, there is really nothing extraordinary in our strategy.

Ours is a pretty simple straightforward demand and response business.

Our plans are to do the basics and to do them well with a zero defect mentality.

Fortunately for us today demand is up.

What our results do show is that we have a very spirited and disciplined execution that is allowing us to absorb a fairly good rate of sales increase within existing resources and investment.

Our associates are providing what is being asked of them, and the results show it.

This was our ninth consecutive quarter of year-over-year earnings per share increases of 25 percent or more.

Looking down the road, while the growth rate is going to probably flatten out a bit due to tougher comparisons as we go forward, we're still committed to continued growth in sales and earnings.

We think we still have pretty good room for improvements in the expense and asset management, and we have new initiatives in place to protect and to grow our margins.

Our sales continue to grow at a double-digit rate for the quarter, up 12.4 percent from last year.

The thing that was great is we converted that 12.4 percent sales growth rate into a healthy 94 percent increase in earnings.

We did it by paying attention to details.

The 6-month period was even better.

We delivered 131 percent increase in earnings on a sales growth of 13.4 percent.

That is a pretty solid conversion rate in anybody's book.

These represent record earnings for both the quarter and the first half.

SG&A control was excellent for the quarter.

We absorbed the 12.4 percent increase in sales, plus the normal cost creep; and we held expenses virtually flat to last year.

These were good productivity gains for us.

Our leaders are to be commended for their work in this area.

We did allow inventories to trend up over the period to cover several things.

To cover sales increases for one.

Inventories going up I'm sure catch your attention; they certainly catch mine.

It's something we make sure we are doing properly.

But considering the sales increase, considering some of the projected shortages that we might have been seeing in productlines and we wanted to protect against, and buying ahead of announced price increases for the next quarter, all contributed to the inventories going up.

We have an inventory management process, not an inventory reduction target.

That inventory management process assures that we're going to have the right stuff in place to take care of our customers first and foremost.

The buying that we did with regard to inventory, we consider to be a very judicious use of our cash, and we think it will positively influence our earnings going forward.

Now, the record performance that we did have for the quarter was done in the face an a margin squeeze that was driven by a spate of price increases and by a shift in our product mix towards some larger, more heavily negotiated products.

While we did have a deterioration in our first quarter, and that is always disappointing, but it was predictable, given the situation we were facing.

We don't take it lightly, we are going to work on it.

Obviously, this has been and will continue to be a focus for improvement for us.

Bill is going to spend a little bit more time talking about that in detail later.

We had taken this margin risk into consideration when we gave guidance for the quarter.

While the margins are down from our first quarter, I want you do note that we are up significantly year-over-year.

This will be an item of significance in our future planning processes, but I do not by any stretch of the imagination consider it a catastrophic event for this quarter.

Until recently, we have been in an extended economic period where the prices remained relatively flat.

Even the price increases that were announced tended to be negotiated away.

But today, we are faced with rising prices that are nonnegotiable due to real cost increases experienced by our suppliers.

This new environment requires a change in our thought process and a change in our actions, and certainly it requires a change in customer expectations.

For instance, the practice of firm price contracts for extended periods, which became a common practice in national accounts during this period of stable supplier pricing, needs to be reconsidered as we seek to prevent future price erosion or margin erosion.

There are more price increases coming in the third quarter.

We again have taken this into consideration in our guidance.

While I don't mean to dwell on this one challenging issue; but I would have been remiss if I had not commented on it.

On a very positive side, I would like to call your attention to the January 10 issue of Forbes Magazine where we once again were named to their Platinum 400 list of the best-managed public companies in America.

The second year in a row we have been named.

I have been advised that this year we are the only distributor of industrial products to be so honored.

Now when Forbes makes the selection, and in this case for us they noted that our 5-year annualized return of 23.2 percent to our shareholders ranks us 133rd out of the 1,000 largest publicly traded companies they reviewed.

This year's score was up 32 slots from our last year's ranking of 165, so I feel pretty good about this.

I feel good about it because this is not a beauty contest.

It is not a personality contest.

Forbes uses a pretty good laundry list of valuation metrics.

So this is one that I am proud to be on.

Overall, the quarter and the first half saw some of the most significant achievements in our corporate history.

Sound business practices drove us to new highs.

There was nothing flashy.

There was nothing highly speculative.

We behaved as a small cap value stock should behave, and we did a lot of good things.

Our plans are to continue to push the initiatives and to finish 2005 with record sales and earnings.

With that, I will ask Mark to review the numbers in detail.

Thanks, Dave; good morning, everyone.

Let me provide some additional insight for our second-quarter financial performance.

We're very pleased that we set a new record during the quarter of 33 cents per share, the highest fiscal second-quarter earnings in Company history.

As you may recall, on December 28, we reaffirmed our earnings per share guidance of a range of 28 cents to 35 cents per share and stated that we would probably come in near the midpoint of the range.

Our final results ended up slightly better than the midpoint.

Sales for the second quarter ended up at $404.1 million.

This represents a 12.4 percent improvement over last year's second quarter.

We had 61 selling days this quarter, which was 1 less than the same period last year.

We believe that 5 to 6 percent of this sales increase percentage is due to the impact of supplier price increases.

In addition, we believe our quarter-end sales were helped by the Christmas and New Year's holidays each falling on a Saturday.

This enabled our customers have less disruption to the manufacturing flow and helped offset the traditional slowing of activity we normally see towards the end of December.

On a sales per day basis, the same-store sales increase for our U.S. service centers was 12.3 percent for the quarter.

This was a slight improvement over the 11.3 percent increase we experienced in our first fiscal quarter.

We also saw our Canadian operation sales improve by 25 percent in the quarter, of which 8 percent related to currency translation from the strengthening of the Canadian dollar compared to the prior year.

Our U.S. fluid power operations also saw a sales increase of 13 percent in the quarter.

In addition, we continue to be pleased with Rybalsa, our Mexican acquisition, which we completed a little over a year ago in November of 2003.

While their sales are not significant on an overall basis, they are accretive to earnings and are matching our performance expectations.

During the quarter, our number of operating facilities declined by 1, leaving us with 432 operating locations.

This decline was from a merger of a service center in Wisconsin.

Our gross profit percentage for the quarter was 25.7 percent compared to 26.5 percent for last year's second quarter.

Bill Purser will have more to say about gross profit in his discussion later.

We have previously stated that we expect the gross dollar amount of supplier rebates for all of fiscal 2005 to be slightly higher than fiscal 2004.

We saw increases happen in both the first and second quarters in line with our sales increases.

Our expectations for the remaining 2 quarters of our fiscal year our flat compared to prior year.

We also took another physical inventory this quarter and our planning to do so quarterly from now on.

Last fiscal year we performed the physical inventory only 3 times.

Looking at our selling, distribution, and administrative expenses, you'll notice a decrease to 21.5 percent of sales in the quarter, from 23.9 percent in the second quarter of last year.

This rate is consistent with the 21.3 percent we experienced last quarter.

The absolute increase in SD&A dollars was only 0.9 percent compared to a sales increase of 12.4 percent.

We once again exceeded our goal of limiting the SD&A increase to no more than half the rate of sales increase.

In addition, we had gains on sales of property during the second quarter of about $200,000.

Our operating margin increased to 4.3 percent compared to 2.6 percent in the prior year's second quarter.

This achievement continues our upward trend in operating margins.

This trend is driven by the increase in sales while maintaining adequate gross margins and limiting the growth in SD&A expenses.

Our annual expected effective tax rate moved from 36.3 percent last quarter to 36.5 percent as of December 31, 2004.

Therefore, the actual effective tax rate for the second quarter was 36.75 percent.

This is primarily due to rising effective foreign, state, and local income tax rates.

We expect our tax rate for the remainder of the year to be around 36.5 percent also.

Our balance sheet continues to strengthen, with shareholder equity exceeding $366 million and our current ratio at 3.4 to 1.

Overall inventory balances grew during the quarter, as we were buying in advance of another round of supplier price increases.

We expect inventory balances to begin declining in January, and for that to continue through June, so that fiscal year-end inventory balances will be comparable to the prior year.

Accounts receivable and Days Sales Outstanding remain in good shape.

Cash used in operations during the quarter was $3.5 million, as the cash generated from our sales activities was offset by additional investments in inventory.

Our results through December 31 are similar to what we have experienced in the prior year.

Starting in January, we expect cash from operations to post very favorable results through the remainder of our fiscal year.

Our expectation is for positive cash from operations for all of fiscal 2005 to exceed the level we accomplished in fiscal 2004.

From a cash planning perspective, we now expect property additions, which are primarily in the IT area, to be in the $10 million range for the full fiscal year.

While we were not active in purchasing Company treasury stock in the second quarter, we expect to purchase stock for treasury in our third quarter.

Finally, regarding the quarterly dividend, our Board of Directors is scheduled to meet on January 19.

Therefore we have no comment on dividend at this time.

We provided financial guidance for the third quarter of fiscal 2005 in this morning's press release for sales increasing from 10 percent to 12.5 percent, up to between 430 million to $440 million, with projected earnings per share in the range of 37 cents to 41 cents per share.

Last year's earnings per share in the third quarter was 36 cents per share and included approximately 5 cents from a onetime tax benefit.

In addition, we raised our overall earnings guidance for all of fiscal 2005 to a range of $1.55 to $1.62 per share.

Now, Bill Purser will comment on sales and operations.

Thanks, Mark, and good morning, everyone.

As Dave stated in his opening remarks, we had a very good quarter, one that I am very proud of our results.

From a sales standpoint, the U.S. saw strength in virtually all our top 30 industries.

Particularly strong this quarter was the stone, glass and clay, primary metals, metal mining, lumber and wood products, and our largest industry, which is industrial machinery and equipment.

The paper and food industries were somewhat soft for us this quarter.

As Marks mentioned our Canadian, Puerto Rican, and Mexican facilities continued to provide strong results from both the sales line and the operating margin line.

Our fluid power subsidiaries also have been strong contributors to our Company's growth and profitability.

During my travels in recent weeks, I was able to spend time with a diverse group of our customers including those from the utility industry, the cement industry, the beverage industry, the paper industry, and the transportation industry.

All were optimistic.

I did not hear any negatives regarding the next 6 to 12 months.

In fact, all were positive about the opportunities that lie ahead.

As both Dave and Mark mentioned, even though we had a substantial increase in sales, we were able to continue to control our SD&A costs and improve productivity.

Also an important point is that during this increase in sales, our service level to our customers remained high.

Our on-time and error-free performance was around 96 percent in the quarter.

We believe our investments in technology and logistics processes over the last 5 years have enabled us to handle the higher volume without adding significantly to our infrastructure.

As Dave mentioned earlier, we did see some fall off in our gross margin performance during the quarter.

We feel this can be attributed to 3 external factors and 2 internal factors.

First of all, from an external standpoint, we saw an increase in project work.

These tend to be large orders that lower margins.

Second, we also saw a larger sales increase in those industries such as primary metals that traditionally have lower margin due to the product mix than other industries we serve such as the food industry.

Last, however certainly not least, we experienced another round of price increases from our suppliers.

Now from an internal standpoint, there were 2 factors.

We were unable to pass along many of the price increases that occurred during the quarter to our large national accounts because of restrictions in their agreements with us.

We also found that some of our internal processes needed to be changed to ensure that where we could we implemented the price increases in a timely manner.

Corrections to these processes are now being made.

It was this combination of external and internal factors that resulted in the lower than planned gross product margins.

Going forward, our January window of price updates on our contract accounts will positively influence our margins, as will the fact that negotiated project business should not be as large a part of our mix.

However, I must add that a new round of price increases expected in the quarter will present some of the same margin pressures we encountered last quarter.

Our company continues to focus, as Dave stated, on the basic initiatives of margin improvement, asset management, cost control, and profitable growth.

The results of our efforts are evident in the performance we have had in the last quarter.

All our associates are dedicated and committed to these 4 initiatives and, as a result, we feel we will have a solid third quarter.

Now I will turn the call back to Dave for some closing comments.

Thanks Bill.

I feel I can comfortably state that our operations are as strong as they have ever been.

We certainly know that there are still things on the drawing board for us to improve upon.

So, good opportunity going forward.

It will come as no surprise to any of you that our number 1 priority for the remainder of fiscal 2005 is to work with both our suppliers and our customers to get our gross margin back on track.

We are continually committed and focused upon profitable growth.

We think that is going to come.

We're focused as an organization on making this happen.

We do expect additional price volatility in the current quarter and the challenges that come with it.

We will be diligent in passing those through.

Any reasonable vendor price increases we have to pass through in a manner that is fair and acceptable to our customers.

This includes the latest round of price increases we saw in December and January.

To do this is going to require better processes, which we are already putting in place, and a very staunch resolve by each of our associates to protect our margins and to continue our cost controls.

Our optimism is high for achieving this objective, and it's reflected in our increased earnings guidance for the remainder of the year.

With that, I am going to close off this formal part of the presentation and open it up for questions.

(OPERATOR INSTRUCTIONS) Holden Lewis of BB&T.

You guys alluded to or mentioned sort of new initiatives in place to support further margin expansion, in your opening dialogue.

Could you give a little bit more detail as to what those new initiatives are?

I'm imagining they're above and beyond sort of the pricing stuff that you have done in the transportation side (ph).

This is Bill.

There are 5 initiatives that we have begun working on.

I'm hesitant to get into too much detail in an open forum of the things that we're doing.

But let's just say that some (indiscernible) that internal processes that we feel like will help us gain from a margin standpoint.

Again, due to the nature of an open forum like this, I really don't want to get into too much detail.

Can you give a sense of what the magnitude of potential impact or the timing of the impact of these 5 new initiatives are likely to be, without talking about the specific initiatives themselves?

(inaudible) You're going to take the impact of the initiatives, and they are going to be offset by a new round of price increases, so it is tough to put an exact number on that.

I guess overall if I were to look at this thing from a 40,000-foot level, I'd say we're going to stress timeliness of putting price increases into play.

That involves improved processes from this end.

And the other thing is, we have probably put in a higher level of oversight with regard to price overrides, to make sure that coming out a period of stable pricing culture that we are helping our associates to trend into this new era that we feel like we are in today.

Okay.

Can you comment also, not listed I guess in those 5 topics for gross margin was the notion that maybe there are some smaller or more localized competitors that are sort of eating the price increases, and therefore essentially bringing the market down to a price issue.

Are you seeing much of that in local markets?

Or is that really not a factor in the gross margins?

Bill again.

It is spotty.

There are from time to time some competitors that make a decision maybe more on an order-by-order basis than on a regular basis -- ongoing basis I should say -- to maybe take a piece of business at margins that we choose not -- that we walk away from.

But I cannot say that it is totally across the board and it is running rampant.

I would not say that at all.

It is just is spotty, and I noticed that if we see any large orders coming up, that is when it usually raises its ugly head.

Okay.

Lastly and I will jump into queue, with regards to the project work, why are you confident that that is going to diminish beyond Q2?

It kind of seems like as this cycle has lengthened perhaps we're getting more capital-type larger project works, just inherent to the cycle.

And perhaps those may not be as predictable in terms of when the order comes as sort of the day-to-day business.

Can you just comment why you're confident that is going to diminish in the mix?

I agree that it will continue, that we're definitely seeing an uptake in the projects overall.

But what we find is that most of our customers, their fiscal year is calendar.

They have funds that if you don't use it you lose it.

We almost always see -- well, we did particularly this year -- an increase toward the end of the year on those type expenditures.

It will be part of our mix, but we don't think it will be as big a part of the mix in this quarter.

I got it.

All right, thank you.

Jeff Hammond of KeyBanc Capital Markets.

I guess first question, you provided guidance the end of December, kind of affirmed your fiscal '05 guidance.

What has changed in 3 weeks to prompt you to raise your guidance here?

This is Mark.

I think as we close out the quarter ended December 31, I think one of the big drivers is the sales.

Looking at our sales numbers, and going forward with the sales, and the strength of the economy is helping us, looking at the numbers and looking at the conversion rate for sales down to the bottom line.

When we came out and did our projections, and we have been tweaking those projections every day as we go forward, as we close the second quarter, we feel very good about where the economy is looking right now.

So it is primarily the new sales?

Has anything changed in the last 3 weeks, whether it be Bill talking to customers, that increases your confidence in the sales outlook?

Or just kind of tweaking things and looking through the forecast?

As I said in my remarks, the last couple of weeks I had visits with a pretty diverse group of industries.

I'm hearing nothing but positive.

Now there's some industries that are running 100 percent of capacity; mainly the aggregate group.

But it was all positive from the customers.

I have to tell you, this is probably -- in the last couple of years, I cannot say that I had a total group of customers that diverse and all were positive.

One of the other interesting things, Jeff, is today the government published the manufacturers capacity utilization chart; and that went way up.

Actually it was up to 77.31, so it was an increase of I believe 0.41, which was probably the biggest spike upward in many many months.

So that bodes well for us as well.

I guess on the price increases, and as it relates to the margin compression, I guess I just want to understand better how much of issue this quarter was timing related to your national accounts contracts, versus some change that you are seeing in your non national account business, in terms of people's attitude toward taking on the third and fourth price increase, whatever it may be?

Bill again.

No question there is resistance in the marketplace.

But I think it was more of a timing issue, based on that window of opportunity to increase prices based on the agreement.

Okay.

As you look at this January window to update pricing with national accounts, if you know that there is a follow-on price increase coming in March for a certain product, can you get that into your January price change?

Or is that not allowed under the contract?

It's not allowed under the agreement.

(OPERATOR INSTRUCTIONS) Mark Koznarek of FTN Midwest.

How much is the average price increase targeted to be for January?

Wow, I am running that through my mind right now.

The impact was maybe in the 4 to 5 percent range.

I am giving you approximations, Mark.

But that is the range.

Bill, is that your raw material, your component purchase cost inflation?

Or is that the price increase to your customers?

That is the price increase to ourselves.

I was thinking that was what you were asking.

I was actually asking the expected increase of your product price to customers.

It will be that pass-through increase.

Again it depends on the mix of products.

What I am giving you is an average, realizing that you make an assumption as far as an impact that you're going to buy everything that you did last year.

And you project that against the current price increase.

That may or may not be the case, so it depends on by the line item.

But what I am giving you is an average range of in the 4 to 5 percent range is what the impact of the price increases would be.

It will depend on customers, it will depend on product mix.

So just to make I sure understand correctly, Bill, your component cost increase for calendar '05 is expected up 5 percent; and you expect your average price push-through to your customer also up, you just said 4 to 6 percent.

That is a fair -- realize I am dealing in approximations here; but that that is a fair assessment.

Mark, we will be able to give a better quantification obviously as we get through the quarter as to what the total impact of the price increases are, once they actually happen and we can actually run some reports on that.

Okay.

What would be your budget for SD&A for the full year?

Typically as I look back at prior performance, the second half of your fiscal year is usually up on a run-rate basis anywhere from like 2 to $4 million per quarter on a quarterly run-rate basis.

Is that what we should expect this year?

Do you have a particular percent of sales target for SD&A?

Obviously we always have the target of limiting the SD&A growth to no more than one-half the rate of sales growth.

We have been very successful at exceeding that target the last several quarters.

We expect to exceed that target again for the remainder of this fiscal year as well.

Whether or not we can hit 0.9 percent increase, that we did the quarter just ending remains to be seen.

But we believe we will far exceed our goal and do much better on SD&A.

But we do have situations in the third and fourth quarters with SD&A where just the dollar amounts are sometimes larger than the first quarters.

Say for example the FICA tax and unemployment taxes that we pay; those things start fresh in January, so they trend up a little bit and then trend down.

Sure.

That is basically what I was asking, if that normal seasonal increase in (multiple speakers) --

I think it will be seasonal; and the way we look at things is we will be looking at the quarter ended March 31 SD&A compared to that same quarter from the prior year.

So we will see the same relationships.

Similar relationships.

Finally, can you talk about what the monthly sales trends were on a same-store basis?

And any kind of commentary at all for January?

Let me talk in generalities for that.

It is a little bit unusual in November and December with all the holidays to get good same-store comparables for other months.

But I will say from a general perspective we saw increases throughout the quarter.

So that our quarterly same-store rate this quarter was better than the prior quarter.

And we are starting out January, our run rates still look favorable for us.

So we continue to see positive improvements.

Then we are projecting sales growth for the third quarter of anywhere from 10 to 12.5 percent.

So we expect that to continue throughout this quarter too.

Okay, great; thanks very much.

Brent Rakers of Morgan Keegan.

I guess a couple questions.

Not to harp a little bit more on the pricing and the margins.

I guess first just a point of clarification.

The price increases year-over-year were 5 to 6 percent of sales.

Would you say though that the pricing in the second quarter was pretty much the same type of pricing that existed in the first quarter?

Yes, if I understand your question, yes because --.

So the only component to the margin then that changed with regard to pricing sequentially was that the cost of those sales increased a bit?

Yes, our gross profit percentage was lower this quarter than last quarter.

Second, in the past when you have provided guidance, you have -- despite maybe knowing that there was price increases coming -- you have not accounted for that in your guidance.

With talk now about where we have seen kind of the impact of the short-term maybe negative impact of price increases in the past, are you accounting for this future price increase that you're seeing in your guidance?

And what impact positive or negative would that have on a very short-term time horizon?

The price increases that we're talking about are the increases that are sorted bracketed right around calendar year-end, right around December 31.

Obviously, each of our suppliers has different dates for their price increases.

Some of them started in early December, mid-December, some right at December 31, and some are going throughout January.

So we characterize those as sort of the calendar year-end price increase wave that is happening.

We do have notice of those specific items, of what the price increase amounts are, like Bill mentioned, of around 4 to 5 percent potentially.

So we take those specific amounts for those specific suppliers and we estimate what the impact of that would be on our sales for the quarter ended March.

I think what you might be referring to is like at June 30 of '04, at that point in time our suppliers had told us they were going to have price increases around calendar year-end '04, but they did not tell us at what levels.

So at those point in times we did not incorporate anything for what those potential price increases might be into our sales guidance.

Because we did not know at what levels and what percentages those things were.

Still at September 30 we still had not had notification of what the specific increases were at that time also.

So we were able to do an estimation now because we basically have the notices and announcements for all the increases around calendar year-end.

So we have built that into -- an estimate of those into our sales projections.

Just somewhat related to that then, that you were not beyond what you have officially received formal price increases on?

You have not received any notifications of potential future ones that you have not been able to quantify yet?

Not at this point.

No, we have not.

No.

Last question and I will get back in the queue.

Have you run some sort of estimate as to if the -- given the revenue environment that we talked about and your guidance for the third quarter, and with a successful, if you will, passing through of these higher pricings with national accounts and other customers, as to what adjustments that that would make in terms of your guidance for the third quarter?

We have put estimates in there in our third quarter as to what we expect our margins to be.

We have incorporated that into our guidance.

So I guess I am not sure I'm following the question.

It seems to me that there is some timing impact involved here in terms of national accounts and other customers, and getting the pricing that you're feeling from the vendors to be actually passed through to your customers.

There seems to be a little bit of a lag typically there.

I was wondering I guess, first, if that is the case.

Then secondly negating that lag, if you will, go forward 3-months, and if you were to capture that, what kind of numbers would we be looking at?

Sometimes there is a lag, but there is a large number of our contract customers that the price update time is January, so we are able to incorporate these increases into the new pricing for those contracts at this -- right now.

So it is a mixed bag.

There's always timing issues as we move forward.

This is Dave.

I don't mean to be evasive on this, but let me just kind of give you a couple of statistics that will help you understand the magnitude of what we are looking at.

This last calendar year, we had about 1.5 million SKUs receive price increases that is in our inventory.

That is opposed to in the prior year it was about 650,000.

As we look out into the first quarter of this coming year, we already know there's over 800,000 receiving price increases, and they vary across the map with regard to which national account uses which one.

So you get into putting a weighted average into play.

So this becomes much more of an art than a science in being able to nail down the impact of what this is going to be.

The volatility is still there.

The range of price increases has mitigated somewhat, versus the range of price increases in this past year.

This past year, because of the shortage of scrap steel and the oil prices and a multitude of things, it was a very volatile year.

Certainly reasonable price increases that our vendors were asking for.

I think we are seeing that mitigate somewhat as we head into this next year, and hopefully once we get through this first quarter we are going to get back to a much more stable pricing environment.

Thanks.

That helps a lot.

Thank you.

Dick Henderson of Pershing LLC.

I had a question on inventories.

You mentioned that your inventories had increased; and also, Bill, you had mentioned that you were visiting your customers.

Could you tell us what your customers are doing in terms of their inventories in view of all this commodity inflation?

I think, Dick, what we have seen in the past is inventories were very low.

At the beginning of 2004, we saw somewhat of a jumpstart in building inventories, I think people anticipating improvement in the economy.

Then when we had a little bit of moderation in the economy we started seeing inventory building slowing down again.

Now we are seeing it starting to build back to some degree, but still very much in moderation.

I don't think any of our customers are interested, unless they have completely sold out capacity, of getting into a too much inventory position, as many were entering into this downturn.

Second question, in terms of the gross margin and passing on price increases, since you deal with a variety of industries, do you know the difference between someone whose pricing power has improved significantly, such as the metals people, their willingness to accept price increases more so than someone who has less buying power?

No, definitely, not at all.

The fact that someone is getting and giving increases, even to the part of ramping up their increases more so, does not mean that they are receptive to increases from ourselves.

I think most of the customers have fought very hard for productivity gains, and are really pushing back in every chance when you come in with price increases.

Last question in terms of your ability to expand the gross margin by adding value towards maybe processes or higher product mix.

Could you talk a little bit about the opportunities that you have there?

Well, we think there are opportunities on several fronts. 1, our catalog sales is a good opportunity for us.

That runs at higher margins.

We feel that we have only scratched the proverbial surface there.

We think the services side of our industry, for instance the training programs that we are offering under maintenance pro, (ph) we feel like those are opportunities.

We find customers very receptive to those types of services and willing to pay for them, because they feel like there is, as you said, a value there.

So there are some good opportunities for us along those lines, that we continue to work and spend money to increase the opportunities and improve those products that we have.

Last, on the product mix, I know you guys over the years have migrated from the lower secular (ph) growth prospects of the bearings stuff to fluid power and so forth.

How is that going?

Do you foresee opportunities to continue that?

Well the 2 major platforms that we have, the bearing and power transmission platform and the fluid power platforms, I'm going to say about 2.5 to 3 years ago fluid power was about 7 percent of our business; it is 15 percent today.

We definitely see an opportunity there.

We continue to invest in that business platform.

Thank you.

Jeff Hammond, KeyBanc Capital Markets.

This is a question for Bill.

Bill, you mentioned, I guess, with respect to the gross margin and the pressure there, some internal processes in terms of changes you are considering to speed up -- I guess put through price increases on a more timely basis.

I guess I wanted to better understand what's changed.

Has there been any type of deterioration?

Because over the last years we have seen price increases go through.

There has not been any comment in terms of how you guys process; and now there seems to be some deteriorations or issues.

Let me comment, very generic there.

Jeff, here's what we have found.

The rapidity of the price increases, when they are once a year -- we had some annual processes.

When they are once a year you can address those in a timely manner.

When you have 3 price increases a year, that is not the case.

The result of the rapidity of the price increases that we have seen in the last 12 months have really surfaced some of those inefficiencies, where they were manual in nature.

We are moving those to the system to be automated.

What percentage of your pricing adjustments are still manual versus automated?

I don't have that information.

I really don't.

I'd be guessing if I gave you a number.

Okay, thanks, guys.

Holden Lewis, BB&T.

Can you comment a little bit about the SG&A?

You have done a great job in the last 3 years limiting the growth there, even as the revenues have gone up and even accelerated in the past year or so.

Are you just having people do more?

Are there real, like, productivity and systems initiatives?

At what point do you think you are going to have to begin investing in staffing, both behind the scenes and in sales?

When do we sort of hit the crossover point on the revenues that we have to invest in SG&A again?

This is Bill.

I think there are a couple of things that have helped us from the productivity standpoint.

Investment in systems and investment in logistics.

As a result, I think we have of course asked our people to do more with less, like everyone else has.

But I think those, the investments that we made over the last 5 years in those 2 areas, I think we are seeing the fruits of our labor now.

And that has been a big help.

To your question is the crossroads, to Mark's point, we have set the goals that we are going to allow that SD&A to increase based on sales.

That is a disciplined approach that we are using as a Company, and we intend to stay at that level or below it.

Sure.

You have been well below it, and I guess that suggests that you're not investing just at a lesser rate than sales.

It suggests you're not investing at all.

As long as you can get away with that, great.

But at what point do we need to begin investing to support those sales, I guess, is my question?

A couple comments too, to make sure you understand the impact of a couple things.

One is in this last quarter, we did have, because of the shift in mix, while the sales went up the number of tickets did not go up proportionally.

The size of the tickets went up.

So handling a ticket at a higher volume doesn't require a whole lot of extra effort.

So we don't feel like we pushed there.

Over time, as we changed our approach to a return on asset approach to running this Company, we have eliminated a lot of nonperformers.

Places where we were spending money and not getting any return for it.

So that impacted positively on the SD&A.

We do not feel like we have reached a point of stretching the rubber band till it's broken.

There is a certain critical mass that you need, and we have spoken to this before.

When the sales volume went down, we were not able to take SD&A out at a faster rate as sales went down.

That left us some energy out there from a critical mass standpoint.

So we watch that closely.

I don't feel like any of our people today -- (inaudible) I should not say any -- but we don't hear a human cry that we are running sweat boxes out there and beating people to death.

I think we have honest expectations of our people, and they're giving it to us.

One of the keys that we watch is our performance to our customer.

The on-time and the errors are critical.

Our customers identify those as the 2 most critical things.

If we see we are falling off there, that is a very good indicator.

We have not seen that.

In fact, it has gone up.

Okay.

That is a great point, Bill.

Holden, the crossover point is when quality starts to deteriorate.

And we have not seen quality deteriorate.

Okay.

Great, thank you.

Mark Koznarek of FTN Midwest.

I just want to explore this price versus costing again, just to make sure I understand it.

In this quarter just reported, your gross margin was down 80 basis points.

Now moving into your third quarter, you expect your costs to go up 5 percent; and you expect to raise price about 5 percent.

So all things being equal, it sounds like we should expect gross margin again in the third quarter to be below the second quarter.

Is that a fair assessment?

Below the second quarter?

I mean --

Year-over-year below -- I misstated myself, yes.

Third quarter below the third quarter year-ago.

We're looking at the sequentially quarter run rates for the gross profit percentage.

So, yes, we're working on the December -- going forward from the December quarter, going from that point.

That is what we're looking at.

So I would think -- I would agree that the question and the challenge for us in the gross profit initiatives is to try to move where we are currently at, and to move those forward.

Whether or not we will be able to move them all the way towards the margins that we accomplished at the third quarter last year remains to be seen.

Okay, so that year-ago level is a target, but it sounds like it is a challenging target because of the cost increase headwind.

It is a couple of things.

We have to put some new initiatives into place.

At this point in time, we can not tell you how successful they're going to be.

We have good feeling about them, but we're not going to sit here and put that on the table today.

Again to the extent to which that is going to be offset by the next round of price increases, you know we're playing a little bit of a volatility game here over this next quarter, that we will feel a whole lot better about going into the fourth quarter.

Okay.

You mentioned that quality issue; and I think the statistic was 96 percent on0time error-free.

What was that a year ago?

Don't have the book right here, but we have shown a 36-month trend of going upward.

I don't have the (multiple speakers) --

Don't have it, but that is something that we -- in fact it is interesting because we just gave it to the audit committee.

It is a metric that we track very closely.

Bill is trying to pull it up here right now, but I don't have that exact number.

Year-ago it would have been just slightly below that.

If we look at December.

In fact, it had been significantly below.

December last year it would probably have been about up to 95 percent late.

Okay, December of '03? 95 percent.

That is a delivery metric?

Delivery to the customer on-time and then the right amount of stuff in the order?

Yes, and we measure that by order. (multiple speakers) Sorry, by line item.

Okay.

Sounds good.

Thank you.

That concludes the question-and-answer session today.

At this time, Mr. Shaw, I will turn the conference back over to you for any additional or closing remarks.

Thank you, operator, and thanks to everybody for joining us today.

We hope you found the call informative.

We look forward to talking with you again in April as we present our third-quarter results.

Thank you very much.

Have a good day.

Thank you for your participation.

That does conclude today's conference call.