Applied Industrial Technologies Inc (AIT) 2005 Q4 法說會逐字稿

Good day, everyone and welcome to the Applied Industrial Technologies fourth quarter, 2005 financial earnings conference call. [OPERATOR INSTRUCTIONS] And now at this time I would like to introduce Mr. Richard Shaw, Applied Technologies' Vice President of Communications. Mr. Shaw, please go ahead, sir.

Thanks and good afternoon, everyone. On behalf of Applied Industrial Technologies, I would like to thank you for joining our call this afternoon. You should have already received our earnings news release that was issued this morning and if you have not received that release, you can retrieve it by visiting applied.com, our website. A replay of today's broadcast will be available in the next two weeks and archive information is contained in that release.

Before we would 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 Act of 1995. All forward-looking statements are based on current expectations regarding important risk factors, including 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 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 operational activities.

Here to start us off is Dave Pugh.

Thanks Rick, and good afternoon again. I trust you have had a chance to review our release from this morning. Obviously, we are pleased with our results for the fourth quarter and for the full year of 2005. This does represent three successive years of earnings growth in the top tier of publicly-traded companies. We had tail wind from the economy over the last 18 months but in all three years, the rate of our earnings growth has significantly surpassed the rate of our sales growth. So, we continue to strengthen the operating fundamentals of our company.

Our fourth quarter was strong. Our sales increase of 11.9% was above the rank and file of our industry. The rate of growth did slow somewhat, as we had anticipated, from market indices but we leveraged that growth into a strong 46.7% improvement in net income. There was nothing flashy to report from the performance. It was just more of the same blocking and tackling that we have been using to provide solid earnings.

As you know, we have been diligent over the past several years in systemically and structurally building profit leverage into our business. We focussed on operating excellence in all areas and the results continue to show that. We are confident that this higher level of earnings performance is sustainable with upside room still left for improvement. But while there is gold left to be mined, it is at deeper levels and we are going to -- it is going to take an increase investment to extract it.

We exceeded our stated objective of a 5% operating margin, not only in the fourth quarter but for the entire year. Strong fourth quarter performance was a historically robust 5.6% operating margin. And, this performance comes in the face of a year of abnormal price increases from our suppliers driven by extraordinary steel and oil price hikes. Passing these price increases on was not easy but over time we found a way to do it. The price increases, while we consider them positive long-term, generally do have a negative short-term impact on our margins. Our 76% increase in operating margin in fiscal 2005 came on top of a 42% increase last year which was on top of an almost 18% increase the year before that. So, it is strength upon strength.

Cash generation for the year was excellent even though we let inventories edge up a bit to cover spot shortages and the sales increases. The inventories were also impacted by price increases and the acquisition of GLM. And, you probably know me. I am never one to accept a creep in inventory very easily but this one was operationally acceptable on the short-term. Our processes and inventory management are still strong. We brought the total down $10.5 million in the fourth quarter while sales were going up and on-time performance continues to be at historic highs. So, a lot of good things happening in the asset management area.

As I mentioned, we continue to build strength upon strength. Fourth quarter was the 11th consecutive quarter of year-over-year increases in earnings per share of 25% or more. That is what I would call continuous improvement. We take great satisfaction in the returns these earnings are providing to the shareholders. In addition to the price appreciation we have shown in our stock, we increased dividends by 50% during this past year. So there is a lot going on here, as always, and we like to tell you more about it -- the story behind the numbers. Mark is going to run through the financial details. Bill is going to discuss what is going on at operations and then I will come back to wrap it up and take your questions. So, Mark?

Thanks, Dave. Good afternoon, everyone. Let me provide some additional insight for our fourth quarter and year-end financial performance. We are very pleased to achieve fourth quarter earnings of $0.52 per share. This enabled us to close out fiscal 2005 with record earnings of $1.80 per shared. Sales for the fourth quarter ended at $453.3 million. This represents an 11.9% improvement over last year's fourth quarter. We had 64 selling days this quarter which was one half day more than the same period last year. We believe that approximately 5 points of the sales increase percentage is due to the impact of supplier price increases.

Total U.S. service center sales are up 10%. On a sales-per-day basis, the same-store sales increases for our U.S. service centers was 9.1% for the quarter, a reduction from the 12.5% increase we experienced in our third quarter but against a tougher comparison. We also saw our Canadian operations' sales improve by 41% in the quarter, of which 14% related to our February, 2005 acquisition of Groupe GLM, 11% related to currency translation from the strengthening of the Canadian Dollar compared to the prior year, and 16% increase is due to additional volume, mix and pricing.

Our U.S. fluid power operations saw a sales increase of 7.4% in the quarter. Finally, our Mexican and Puerto Rican operations had a combined sales increase of 7%. All in all, continued growth across the board. Also, during the quarter, our number of operating facilities remained stable at 440 locations. Our gross profit percentage for the quarter is 26.9%, the same as last year's fourth quarter and 21 basis points better than the third quarter. A major reason for this improvement relates to the traction gained from our gross margin initiatives discussed during our last two conference calls. We had previously stated that we expected the gross dollar amount of supplier rebates for all of fiscal 2005 to be slightly higher than fiscal 2004, although lower as a percent of sales. We were pleased to see increases in supplier rebates in the fourth quarter which helped offset the impact of end user price resistance so the effect on gross profit percentage for the quarter and year-to-date was comparable to the prior year.

While we actively support our suppliers in the quest to recover cost increases, we hardly ever extract the full measure of announced price increases from the marketplace. Looking at our selling, distribution, and administrative expenses you will notice a decrease to 21.4% of sales in the quarter from 22.4% in the fourth quarter of last year. This rate is also consistent with our rates of the last three quarters. The absolute increase in SD&A dollars was only 6.8& compared to a sales increase of 11.9%. The SD&A increase primarily relates to additional compensation, incentives, and benefits which are a direct result of our improved financial performance and, to a lesser extent, due to the GLM acquisition.

If you exclude the impact of the GLM acquisition, 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 fourth quarter of about $300,000. Our fourth quarter operating margin increased to 5.6% compared to 4.5% in the prior year's fourth quarter. This achievement continues our upward trend in operating margins. This trend is driven by the increase in sales, by preventing any erosion of gross margins, and by limiting the growth of SD&A expenses.

Our annual effective tax rate for the year of 35.9% was slightly lower than we originally expected due to recording of some state and local benefits from true-ups of our prior year's provisions upon filing of the returns in the fourth quarter. Our balance sheet continues to strengthen with shareholder's equity exceeding $393 million. Our current ratio is 2.9 to 1. Our pre-tax return on assets rose from 13.7% for all of fiscal 2005, compared to 8.3% for 2004. Overall, inventory balances decreased $10.5 million for the quarter. While we did experience an overall decline for the quarter, several small buying opportunities arose which offset further reduction in inventory.

Accounts receivable and day sales outstanding, at 42 days, remained competitive but with room for improvement. Cash provided from operations during the quarter was a solid $48.2 million, which resulted in our full-year amount nearly doubling to $81 million. We provided financial guidance for the first quarter of fiscal 2006, in this morning's press release for sales increasing 7% to 10% to between $442 million to $454 million, with earnings per share in the range of $0.48 to $0.54 per share. Last year's earnings per share in the first quarter was $0.43. Therefore, our guidance is for an EPS increase of up to 26% on a sales increase of up to 10%.

Our annual guidance for fiscal 2006 is for sales to total anywhere from $1.84 billion to $1.87 billion with earnings per share in the $2.00 to $2.10 range. This would represent operating income improvements of 16% to 22%, EPS improvements of 11% to 17% on a sales increase in the 7 to 9% range. In addition, we are not forecasting any gains on sales of property or benefits from payouts under any corporate-owned life insurance policies as was experienced in fiscal 2005. Taking this into account, the percentage increase in earnings per share looks even better.

We expect fiscal 2006 gross profit levels to be relatively consistent to slightly better with our annual rate of 26.5% in fiscal 2005. As we have discussed in the past, rebates from suppliers continue to be a challenge for us as we move forward into fiscal 2006. While fiscal 2005's impact on gross profit percentage remained similar to 2004's, we believe that 2006 may be slightly down on a percentage basis for supplier rebates. While these rebates are generally paid to compensate us for various sales, marketing, and logistic services, when the rebates flow into our income statement they are accounted for as a reduction of cost of sales as required by accounting rules.

We will seek to offset any gross margin erosion with a blend of purchasing and pricing efforts. We will continue to work our initiatives to improve pricing and freight recovery throughout 2006. Our aim is to keep tight control of our selling, distribution, and administrative growth in fiscal 2006. Our overall growth in SD&A expenses most likely will exceed our goal of one-half the rate of sales growth due to investments and initiatives which we believe will assist us in achieving more profitable growth in the future. For fiscal 2006 interest expense, net of interest income, should be lower due to higher cash balances and rates.

Depreciation, once again, should be slightly down and amortization should be comparable to 2005 amounts. In addition, we expect the ongoing effective tax rate for 2006 to be in the 37.5% range. This rate is higher than the fiscal 2005 rate as the 2005 rate was lowered due to the tax-free benefits from proceeds under life insurance policies as well as some state and local tax true-up benefits not expected to continue into 2006.

From a cash planning perspective, we expect property additions to be primarily in the computer and information technology area, and will be in the 12 million to $13 million range. We also expect to continue to purchase stock for treasury periodically throughout the year, depending on market conditions.

That gives you some perspective on our outlook for 2000. Now Bill Purser will comment on sales and operations.

Thanks Mark, and good afternoon, everyone. Let me begin my remarks by saying how pleased I am with the efforts of all our associates. Their dedication and commitment has resulted in the record performance our company realized this past business year. Without everyone pulling together, these accomplishments would not have been possible. A big thanks to all of them. As Dave mentioned, we certainly benefited from a strong economic tail wind this past business year, yet current economic trends are really sending mixed signals in the marketplace. Many of the industries that produced double-digit growth last year are still strong. However, we are seeing some moderation. I would like to take a look at those that carried the day last business year.

Industrial machinery, which is our largest SIC, was up over 15% compared to FY 2004. Much of this increase was driven by projects that had been delayed. Other industries that contributed to our 13% growth were primary metals, which was driven by steel, increased 12.8%. Lumber and wood, driven by home building, was up 14%. Transportation equipment, which was driven as much by truck building and aircraft as by automotive, was up over 17%. Aggregate and cement increased over 28%. Utilities increased 17%. There was also strong growth in all types of mining which showed double-digit increases.

As I said in the beginning, we are still seeing growth in our markets, but more moderate as we move into the next business year. We believe the housing market, which is driven lumber and wood, will soften over the wild ride we experienced last business year. Primary metals has already begun to show signs of softening, with raw material prices declining as well as a decrease in the exports to China. And, we don't see many large projects for the industrial machinery SIC, not as many as we saw last year, and therefore we are forecasting a slow down in purchasing in this SIC.

We believe that metal mining will follow primary metals and, while showing double digit growth, we don't think it will be as great as the 36% increase we saw last year. We see pulp and paper slightly down due to what we think is overcapacity, and the food processing SIC is showing slightly-up to flat. We do feel that transportation equipment SIC will show approximately an 8% growth this next business year, and we are basing that on continued demand for trucks as well as the strong demand for aircraft.

There are quite a few unknowns, however, that could have a major impact on our market performance -- the demand from China for steel, the price of scrap steel, the cost of oil at an all-time high, the current drop in cement exports to China. Now, this could be offset by some new North American activity resulting from the recent renewal of the Transportation Act, but you have to remember that in order to tap the Fed's coffers, states must match the funds. The ability for the states to match the funds will determine how much activity we see in this SIC.

Interest rates which would impact many things is a concern going forward. The automotive incentives, will they continue? The geopolitical events and, last but not least, terrorism. Even with these unknowns, we are confident that we will continue to see growth in the 7 to 9% range in our next fiscal year. We have several marketing programs under our in-sync umbrella we feel will reach our sales goals. I really feel these are worth mentioning.

We have a new HVAC program with products aimed at this largest potential SIC we have. Now for those of you that are not familiar with HVAC, that is heating, ventilation, and air conditioning and that market is estimated to be over $100 billion. Our new program is aimed at a small segment of that market that we feel offers opportunity. We also have a new power generation marketing program aimed at this lucrative SIC. We will be launching this program later this year. We will be introducing mid-year a new petro-chemical marketing program focusing on an industry where, with the exception of Canada, we are not very strong.

And last but not least, is our marketing program aimed at government sales. We made you aware at our last teleconference that we were awarded our GSA number. Just to make sure everyone understands, this is like a fishing license. It doesn't guarantee the fish, it just guarantees the opportunity. We have begun ramping up to serve this large potential which we estimate at over $400 billion. We are anticipating 12 to $15 million in sales this business year moving toward a $50 million annual run rate sometime around the end of calendar 2006.

We are adding system programs as well as government sales specialists to ensure our program is successful. We are also making additional investments in our Maintenance America and Fluid Power Connection catalogs as well as eCommerce to expand their capabilities and make them easier for our customers to utilize. We feel the time is right to move to the next sales plateau with these programs. We continue to invest in our IT systems to offer ease of use and state of the art enhancements to allow our associates to better serve their customers in a more efficient and effective way. We will continue to focus on the four initiatives that we feel have served us well over the last three years -- profitable sales growth, cost control, asset management, and margin enhancement.

A particularly strong emphasis on margin enhancement will be our focus for the coming business year. New operating strategies we have put in place have been well-communicated throughout our organization. The field group, in particular, has risen to the challenge and executed those strategies with enthusiasm, and the results have been outstanding. The nature of our business isn't getting any easier. Competition is ferocious as ever. Challenges like passing through vendor price increases and migrating customers to fee-for-service keep us on our toes.

But when a company builds a culture of success, everyone has more confidence in their abilities -- more adrenaline. Overcoming obstacles becomes a way of life. That is the point where I believe we are today at Applied. So, that is the operations overview. Everyone here is energized and charging full bore into 2006. I look forward to updating you on our success again next quarter. Now, I will turn the call back over to Dave for some closing comments.

Thanks, Bill. We had three years of pretty solid performance topped off by this last year of good top-line growth. Excellent margin management and even better earnings and asset management. That is the good news. Now the tough question -- what is next? How do we keep this trend going? And you don't need to ask it because we ask ourselves every day.

It probably hasn't escaped your attention that, while we feel we just had an excellent year and while the earnings leverage was significantly above the norm, the leverage wasn't as good as last year. And, that one wasn't as good as the year before. So, as we look at things and we see the low-hanging fruit in cost control that's been collected, and the fact that we have made our major moves in the margin management, we understand we face a challenge or two.

So, we would say -- what are the plans? First of all, we certainly don't plan to back up. We will maintain our discipline. We are going to stay the course where we have been -- eliminating the underperforming operations, moving away from marketing initiatives that have not generated the expected results. And, we are going to be redeploying those to new areas. I believe we have institutionalized this management process to the point that we won't lose any ground. It is too expensive to capture the same turf twice.

And, we still have some areas of cost control where we have not attained our desired objectives. But in addition, beyond that, we are going to have to look to a higher complement of top-line growth to keep the earnings moving in the future years. Recent upticks in a couple of the key indices are positive signs for a possible re-igniting of the economy in the second half of our fiscal year. We are going to invest more in growth opportunities, both in the entry of new markets such as the government sales and also in the acquisition of existing successful entities.

By design, our SD&A is going to rise this coming year as we invest for the future. We certainly aren't going to throw caution to the wind, but it is obvious that the gains we have made in operating excellence is going to only be maximized by applying our skills to a broader sales base. We plan to offset the increase in expense with additional focus on margin management as Bill discussed earlier. So, I would say look for us to have solid earnings this year, to provide the same stability you have come to expect over the past few years. But also, look for us to make some solid investments to ensure that the years beyond provide the opportunity to continue this earnings growth. We need you to look at just a slight mid-course adjustment to our strategic flight path. With that, I am going to turn it back over to Abe and Abe, queue up the questions.

Thank you very much. [OPERATOR INSTRUCTIONS] Our first question today will come from Mark Koznarek at TF - TFN Midwest Securities.

Good afternoon. A couple of clarifications, if you could -- just for the overall year, we did 13% revenue. How much of that was actual price improvement and how much is foreign exchange?

Mark, we believe of the 13% about 5 to 6 percentage points of that was passing along supplier price increases to our customers for the full year -- for the quarter as well as the whole year.

For Canada, I don't have the full-year number with me for the impact on foreign exchange, but I had it for the fourth quarter that we talked about in the call. But, I think that was a similar percentage throughout the entire year. I can get that for you.

Okay. Yes, that was actually the next clarification, Mark. Just in the quarter, I was wondering the dollar amount of the acquired revenue from the Canada acquisition and the dollar amount of foreign exchange if you have that.

I think the GLM acquisition in our press release -- when we announced that we were acquiring them, we were saying their sales run rate was around $20 million a year. So, I don't have specifically what the dollar amount of that was for the quarter, but very similar to one-fourth of that would be what we had for them.

Mark, it wasn't a full one-quarter's worth. I know their major customer was coming off strike so I don't know whether we got the full-quarter's worth or not.

That was sort of a backup to the question I have got which is that if you subtract out the impact of the acquisition and the impact of price, it looks like your core operating volume this past year rose about 7 to 8%. And, if you strip out the benefit of the rest of the acquisition revenues, you are going to get this current year and the acceleration in your government sales initiative which sounds like it is moving pretty well.

You seem to be indicating that the base sales, sort of the core volume, is going to slow down by 2 to 3 percentage points of growth. And, I know that Bill went through an outlook for the 2006 end markets and one thing I wasn't clear was whether that category metals, mining, pulp and paper -- are you expecting that actually to be down or just slower rates of sales growth.

Slower for the ones you have just named, yes.

Slower rates of growth. I think we are continuing to look at growth throughout fiscal '06 and it is just -- as a percentage basis, was we are comparing ourselves to tougher comps -- the percentage increases just look smaller but it still marches forward.

Okay, and I imagine there is some embedded price increase that will occur in '06 is based on initiatives you have already taken, is that right? So, you will get some price benefit in this current year as well?

From suppliers? Or price --

Your own price increases?

We continue to work our initiatives to try to help our margins as we try to improve things.

Mark, one of the things that had us a little cautionary in here is when you look at the ISM index and from May of 2004, it went down pretty steadily. We have seen the last two months pick back up, which has given us a little bit of optimism. But, it would be for the second half of our year. So, we are seeing some of the basic index drivers for this business have moved down over the past year.

Or plateaued, like the manufacturer's press utilization was plateaued and it kicked back up the last couple of months as well.

A couple of the drivers are starting to give us a little more optimism for the second half of the year.

Okay, very good. I will jump back into queue. Thanks.

Our next question goes to Holden Lewis at BB&T.

Good afternoon. Thank you. Just when you talk about your annual guidance, you sort of take the mid-range of your quarterly and the mid-range of your annual numbers and basically you are sort of arguing that mid range of $0.51 for Q1 and basically to get the 205, the mid-range of your annual guidance, it basically just runs that $0.51 straight through, which would seem to not give any real attention to natural seasonality in the models. And, I was sort of curious on what basis you are -- you think that we should be flattening out the historical seasonality.

Holden, this is Mark. I think when we look at the seasonality, a lot of that is driven by the number of selling days in any individual quarter. And traditionally, our second quarter has the fewest number of selling days of the year and that will be true also in fiscal 2006 where we will only have 61 selling days compared to the first quarter where there are 64 selling days which is the largest number for fiscal '06.

So, also the selling days in our second quarter they do -- some of those days happen around the holidays, which are, traditionally, maybe not always the strongest selling days as well. So, the sales dollars and the top-line numbers for revenues in the second quarter compared to the first quarter as well as the third and the fourth quarters will be lower.

Okay, and I guess I am really curious because last year that was clearly the case. But, that was a bit different relative to years prior where, historically, Q1 and Q2 have looked pretty similar in seasonal terms despite the fact that you always have usually two fewer days. I guess I am just kind of curious why nowadays that seasonality seems to be biting a great deal more than it has in the past.

I mean, I think on an overall basis that we are seeing less and less seasonality in our business as -- and it is really driven by the number of selling days.

Also, can you -- it seems like you did a fair amount of share repurchase in the quarter. The shares are actually up. Is that a function of stock price -- or how should we -- or was just late in the quarter? What is kind of the year-end tally for actual share count?

On the repurchases in the quarter, Holden? Or -- I mean, we were purchasing some out in the open market in the quarter and we were purchasing some through stock option exercises -- also through that.

And your share -- your shares -- your average diluted shares outstanding actually did not decline.

Oh, yes. And that went up just because of the stock price going up and the calculation on the number of diluted shares obviously that your stock price goes up -- the more shares that are assumed to be outstanding is from the options. So, that is the key driver.

Where is the fully diluted shares outstanding at the very end of the quarter, what number are we at?

I have that piece of information if you bear with me for a moment.

It is -- I believe it is right around 30 million actual shares outstanding at the end of the quarter. Those are weighted averages. The press release shows release shows weighted averages. But, the actual number of actual shares is 30 million at quarter end.

So, it is not much different from what you show for the average value.

Right.

And then lastly, the property sales -- does that go into the SG&A or does that go into the Other Income and Expense line?

Actually, Holden, it goes into SD&A. So, that was at $300,000 for the quarter.

Okay. Now, the other expense line -- the Other Expense and Income line actually swung from a negative the last few quarters to a positive this quarter. What was behind that?

The other main categories that are in that other income expense category are other -- just gains and loss on the corporate-owned life insurance policies for the cash-surrender values, for which most of those policies have anniversary dates within the fourth quarter and that is where you see the bump up in your cash-surrender value, generally, is on the anniversary date. So, we saw some of that.

Other items at impact that item relate to gains or losses on the mark-to-market valuation of the cross-currency swap that we have. That depends on how the U.S. currency versus the Canadian currency are going. In those items, all of those combined did happen for the quarter to have a $300,000 net positive.

There is nothing unusual in there?

Nothing really to forecast.

Okay. Great, I will jump back in. Thanks.

Next up, Jeff Hammond at Keybanc Capital Markets.

Can you hear me? Can you hear me?

You are a little bit low. No, go ahead. I think you are fine.

Okay, thanks. I guess on this 7 to 10% growth expectation for fiscal '06, do you have anything in there for pricing?

The only thing we have in there, Jeff, relates to price increases that are really on the board right now. They may not be implemented now but their suppliers may have announced some things that might be happening in the next couple of months.

So, what would be the order of magnitude?

I think anywhere from 2 to 5% probably with an average --

It is in that range, Jeff.

Probably the total average would be 2 to 3% impact on us, even though --

So, of the 7 to 10% growth, 2 to 3 would come from price?

Yes. The amount of percentage growth coming from price will -- should be smaller than the year we just finished.

And then conversely, with steel costs coming down have you seen any vendors or really any pushback from customers asking for pricing concessions?

Well, we haven't heard asking for pricing concessions, but I think this next round of price increases will be interesting to see how the market reacts to your point -- the fact that the raw material prices have come down. We were somewhat surprised that we were going through another round of increases. The early forecasts were that they would not come to fruition but now they are being announced. So, this will be interesting to see how the market reacts.

Okay. And then, Dave, you mentioned you are hitting your 5% margin target for the year. I guess as you step back and look longer term and recalibrate that margin target, how should we think about that as two, three, four years out? What is your internal goal.

As much as we can get, Jeff. Six will be the next target and the sky is the limit. We are going to touch every base that impacts that. So, trying to put a number on it could be self-limiting.

But there is not say a new three-year target?

Not at this point in time, no.

And then, you mentioned a little more focus on growth and I think you mentioned external growth. Can you just talk about acquisition pipeline? I mean, obviously your balance sheet is meaningfully over-capitalized and it seems like acquisition opportunities have been pretty sparse over the last couple of years. Anything changing on that front?

Well, when you say the acquisition opportunities are sparse, to me the ones that are -- that make sense have been sparse. I wouldn't say the acquisition opportunities have been sparse.

I think we are still trying to get a closer -- to close the gap between seller expectation and buyer expectation. That is closing, and I would feel good about -- we are in more of a realistic M&A market right now and we always have things cooking.

And then finally, you mentioned new markets like HVAC and Power Gen. What types of customers are you targeting there? Are you targeting HVAC OEMs or a service component of that? Just maybe broadly touch on where you are focused.

It is more the end user with the HVAC. It is -- we have a tendency in this industry to look for smoke stacks -- a lot of the steel, paper, et cetera. HVAC -- anyone who has heating, ventilation, and air conditioning has products that we can sell. That includes universities, hospitals, department stores so it really opens up a tremendous market for us that -- we have had some success, but we really haven't had a focus program toward that particular market. And that is -- we will be looking at the end user more than we will OEs.

But, more commercial focus?

Yes.

You would maybe, in that light, be competing a little bit more with some of the more traditionally building-products oriented distributors?

To some degree, but it -- there is not as much overlap as you might think.

Okay and then, Power Gen?

Aimed at the utilities, the deregulations. We are seeing continued consolidation in that industry. We think there is good opportunities. We are in that industry now. We feel like we have some expertise. We have developed market and program that we think will help further penetrate it.

Great. Thanks, guys.

[OPERATOR INSTRUCTIONS] Next, we will go to Brent Rakers at Morgan, Keegan.

Good afternoon.

Brent.

I guess to follow up on the question just asked, you addressed kind of some specific numbers with the GSA contract at 12 to 15 in '06 and 50 million run rate at the end of the year. Could you give us a sense of how large -- I mean, I think you gave total market size for a couple of the other areas, but could you maybe give us a better feel for your targets there?

I will be able to next quarter. I would like to answer that next quarter because these are programs that are mid-year programs.

So we should factor in second-half contributions pretty much across the board for all the areas including the GSA?

The GSA will -- I believe I gave you the ramp-up numbers that we are looking for, which would be basically the first business year, this 2006, and that is going to be in that 12 to 15 million range. We do believe that we will be at a run rate of around 50 by the end of the calendar, 2006. That one is fairly specific.

The other programs, the government marketing programs, is already in place. The other two programs that I referred to are mid-year programs. So, the ramp-up we probably will see -- not probably, we will see some impact from those programs. But, the situation will be that it will be less than a full year.

And then I guess, somewhat related and maybe from Mark -- I believe that you said earlier you have shifted your SG&A targets up a little bit. I guess you targeted before at a rate less than half the growth rate of sales. And now, I believe you said that you are going to be above the growth rate in sales there. If that is so, how much of that can we tie directly to some of these new programs here we are talking about?

I think we can tie them 100% to these new programs. We are not necessarily changing our goal. I think when we look at the growing SD&A at half the rate of the sales growth, we can't always just look at a one-year window. That is an artificial time period.

We would need to look at it, sometimes, at a broader time period. Because at certain points in time, you will need to exceed that rate. I think maybe in fiscal '06 is one of those points in time where we will be exceeding that rate -- for instance, just to build the system to support the government sales.

That is the excellent example where we are having to spend money to make money. And, the expense will occur before the revenue in this particular case because we have had -- have new programming to make sure our systems were capable of handling GSA requirements.

This is Dave. And I don't see this as violating the process we are on. Because when we headed into this, we had stated that that 50% goal was going to be over any given three-year period of time which allowed us to have a year like we are looking at this coming year.

In the past, two, three, four years, we have been so successful in doing it each year, we may have gotten -- lost sight of the fact that we set out the goal to be 50% over any given three-year period of time.

So obviously, I guess then, it goes without saying there is some head wind here in '06. And, obviously, you hope to benefit with more accretion in 2007 from these?

Absolutely. Absolutely. And we are still in the core businesses where we are in there solid right now -- we are still looking at the 50% or less number. But, we will allow some room for investment for the top-line growth to get back to better earnings because the leverage has gone down over the last two to three years.

And I guess, given your guys' comments earlier in the call about the volatility in the ISM and some of this soft-patch I guess we have had in the manufacturing economy -- could you give us a sense of kind of the flow of revenue growth -- kind of April through June and even into July? I mean, is July better than June in terms of year-over-year growth or a little worse still?

July is traditionally a slow month. I mean, it is always a slow month because there is lots of plant shutdowns in July. And, so we don't necessarily look at how the July run rate is compared to the quarter-end run rate.

But we are going against tougher comparables because a year ago right at this time -- in the April, May, June timeframes, there was another round of supplier price increases at that point in time that we aren't experiencing right now necessarily. So, the percentage increases are shrinking. Our guidance is 7 to 10% for the quarter of the sales improvement and so that is what we are projecting forth with.

Mark, I guess I was getting a better handle on kind of where your lag to this soft-patch kind of bottoms out. I mean, it looks like some of the trade association numbers kind of show a slowing year-over-year growth rate in June, but I haven't seen a July number yet. And, I wondered if June or July was kind of the bottom before kind of we reaccelerate there.

That is a tough one to call, Brent. I mean, I don't think we call it that finite. I mean, we look at it at more of in cycles of several months at a time.

And Brent, if I just look at -- follow ISM -- I tell you, we probably got a slowing year-over-year, probably through the first half.

Okay.

And we are seeing -- we see the uptick the last couple of months and typically we lag that by six months.

And then, last question and I will jump back in the queue. It looks like -- I think you disclosed what the physical inventory adjustment was for the fourth quarter and I guess that is probably some sort of accounting regulation that you do so. But, I know you also had some similar adjustments in Q1 through Q3. Can you maybe give us a sense for how this number looked versus the previous three quarters?

Brent, let me address that. The disclosure we had in the footnote in the press release has historically been there because we are disclosing the fourth quarter impact of the physical inventory adjustments that had -- that a reader could say -- well, some of that impact should have impacted the first, second and third quarters. As we have been discussing over the past year or so, we are doing quarterly physical inventory true-ups and we are recording those entries on a quarterly basis so that the expectation is that we are not going to see a large blip upwards in the fourth quarter any more.

And, the dollar amount that we disclosed in the fourth quarter this year -- we are hoping that next year we don't have to disclose it. We are just showing it now for comparability purposes but once each quarter stands on itself and we are recording those more contemporaneously within each quarter, the plan is not to record those.

I don't want to necessarily give you the dollar amounts on each of the quarters. But, if we are planning on not showing that number any more, I think that tells you a little bit about how the other three quarters were, too.

Mark, just as a point of clarification for my understanding. It is possible that there was 1.6 million of physical adjustment in the third quarter, 1.6 in the second, and 1.6 in the first. It was just not disclosed for whatever reason, is that correct? Or will it be 1.6 million more in the fourth quarter.

No, your first discussion would be the correct interpretation. It would be possible.

Perfect. Thanks a lot, guys.

And we will go again to Mark Koznarek at FTN.

Thanks. Your fluid power subsidiaries seem to have throttled back a lot with only 7% growth this quarter after 20% growth in the third quarter. Can you discuss that, and what the '06 outlook is there?

Mark, this is Bill. I think probably a little bit of the softening in the economy as far as the OEs. Our fluid power group is real strong with the OE market. And usually, OEs are a good forecaster -- a good indicator for us.

They almost go exactly hand-in-hand with the manufactured capacity, MCU, and even the PMI to some degree. And I think we saw the turndown, the softness there faster than we did in the MRO accounts. We still feel strong about fluid power and the opportunity, obviously, going forward in this next business year. I think it is probably they saw the slowdown quicker than some of the MRO accounts.

Is that a business that is more focused on stationary fluid power, like factory applications, or does it include mobile OEs?

It includes mobile as well. We feel like that mobile, and even marine, offer a large opportunity for us. I would say the bulk of it is probably industrial at this point in time but we do believe that mobile offers some great opportunities for us.

Okay. And then, are there options -- do you have to reflect options expense in fiscal '06?

We actually started expensing options two years ago, Mark, so fiscal '04 was the first year we expensed stock options. And, we did it for the full year in fiscal '04. We have done it for the full year in fiscal '05. So, the implementation of FASB 123-R on stock options, we believe, will have no impact on us because we have already -- we are doing it, what needs to be done.

That is great. And then one final thing here, with these marketing programs that are being rolled out across these -- the new end markets as well as your GSA ramp-up. Just doing some math back of the envelope in terms of your increased SG&A expense, it seems like it is same order of magnitude as the expected revenue increase, especially from the GSA side. And, I guess what I am driving at is -- is it expected that these initiatives for '06 will be dilutive to earnings and that we will really see the benefit in fiscal '07?

I believe that our operating margin percentage in fiscal '06 will be better than fiscal '05 and we looked at it in total. I mean, if you would say per -- if you would carve out one initiative, maybe for a specific initiative, it might be, but other initiatives it is completely the opposite, where we are getting those benefits. We continue to expect to see operating margin improvements as we march forward toward, like the goal Dave said, of a 6% operating margin sometime in the near future.

Would that be by year end? Not necessarily. By '07?

Tell me what the market is going do in '07, Mark? If it drops, you know what that does.

What if it is just flat by '07, Dave? Would you be able to hit it just because of your internal initiatives and the fall-away of these expenses.

I wouldn't put that out of the realm of possibility.

Okay. Thank you.

And, we do have another question. This is from Brent Rakers at Morgan, Keegan.

Just a quick follow-up on the pricing increases that are, I guess, forthcoming. You talked about a 5% number in the June quarter. On a sequential basis, are we looking for another 2 percentage points of increase on a firm-wide basis? Or, could you maybe give us a sense of a number and kind of a target date when these price increases will roll through?

Brent, we don't have all the announcements from the suppliers on the increases. That is kind of a little bit of a difficult question. Most of the power transmission suppliers have announced. Only one of the bearing suppliers has announced. So, it is somewhat difficult for me to give you an exact -- and, I don't even know if the other bearing manufacturers have decided on dates at this point in time.

Bill, we are talking, though, about I guess significantly less probably than a couple of the previous increases, correct?

Yes. Over a 12 month period, you can bet on that.

That is our expectation. We don't necessarily know all of those for facts.

Well, that is a good point.

And, Brent, not only last -- fewer of them, probably lower in magnitude in the question of how much sticks on adjusted-by basis is another issue.

And then I guess, one final question. You talked a bit about the gross margin in '06 versus '05, and I think you expected it to be I think better than '05. However, the '05 year had that second quarter where you got kind of caught between all those price increases, and if you throw that out, a flat number would be a pretty good number. Is that something that is realistic in light of your commentary about rebates -- something like a 26.7 or something for the year?

Well, for an increase up to that amount? I mean, I think our comments were that we expect the gross profit percentage would be flat to slightly better. So, I mean, we ended up at 26.5% for the fiscal year of '05.

Brent, if you throw that ugly second quarter out with regard to what the price increases did to our gross margins -- probably did even better this year. So, I mean I think it is a positive.

Okay. Perfect. Thanks, guys.

And gentlemen, we have no other questions so I would like it turn the call back to Mr. Shaw for any closing comments.

Thank you, Abe, and thanks to everyone for joining us today. We hope you found our call and our commentaries of value. I know your questions are always insightful and we enjoy taking them. We look forward to talking with you again in October when we report our first quarter results. Thank you very much.

Thank you. That does conclude the call. We do appreciate your participation. At this time you may disconnect. Thank you.