Applied Industrial Technologies Inc (AIT) 2006 Q3 法說會逐字稿

Hello, and welcome to the Applied Industrial Technologies third quarter fiscal 2006 financial earnings conference call. [Operator Instructions] I would like to introduce Mr. Richard Shaw, Applied's Vice President of Communications. Mr. Shaw, please go ahead, sir.

Thank you, Tony, and good afternoon, everyone. On behalf of Applied, I would like to thank you for joining our third quarter conference call today. You should have already received our earnings news release that was issued this morning. And if you've not received it, you may retrieve it by visiting our website at www.Applied.com. A replay of today's broadcast will be available for the next two weeks, and that archive information is contained in our news 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 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 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 Dave 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 during the quarter. Dave Pugh will start us off. Dave?

Thanks, Rick. And thanks to all of you who've joined us today. Our third quarter results were pleasing to our entire team. I trust they were pleasing to our shareholders. Whenever our results are in line or exceed our expectations, we are gratified.

We're also pleased to announce today a 20% increase in our cash dividend to an annual rate -- from an annual rate of $0.60 per share to a rate of $0.72 per share. This is the fourth time in the last two years that we've raised the dividend, for a cumulative increase of 125%. We also increased our guidance today significantly.

Our strong sales came from the good solid market and set of balanced sales initiatives that include expansion of our product and services portfolio, as well as an expansion of our market access. All of our initiatives are moving according to plan on both the short term and the longer term. And we feel they are sustainable for the foreseeable future.

The efforts that we put forth in cost control and margin enhancement are creating the increased earnings leverage we desire. We're getting these results while making investments ahead of revenue stream in some key areas. These investments, along with our recent acquisition of Minnesota Bearing Company on March 31st, should provide for consistent future earnings growth.

Our overall rate at SD&A remains well managed, with the rate of growth still being lower than the rate of our sales growth. The record quarter had a couple of [blips and takes] that will take a little explaining from Mark, both as comparison to last year and as a bellwether for future periods. It's nothing of great concern. It certainly is nothing that would detract from the strength of our quarter. But it will be important to factor some timing issues as you do your future modeling.

Our markets overall remained solid in the third quarter, and we see it continuing. We've benefited from the addition of Spencer Fluid Power, the western U.S. fluid power distributor that we acquired in September of 2005. That business is performing very well, better than our acquisition assumptions. And we still see areas where we can improve with that acquisition.

During the quarter, as I mentioned, we completed the acquisition of Minnesota Bearing Company, which gives us additional strength in both fluid power and power transmission in the upper Midwest. And we believe that's going to significantly improve our opportunities for success in that area. This acquisition is consistent with our strategy of filling in our geographic gaps in North America, and strengthening our position in fluid power.

Minnesota Bearing has 14 operating locations in nine facilities spread across five states, and their annual sales are approximately $35 million. Now there is some overlap up there with existing Applied locations, so with the consolidations and blended results, we aren't going to be providing future discrete sales data from this acquisition.

Both the Spencer and the Minnesota Bearing acquisitions are in line with our stated strategy of growing our served available market. And concerning our product available market, we are pleased about the expansion of our relationship with Parker Hannifin, which we announced in February. Under the new arrangement, Applied is authorized as a national distributor for Parker's pneumatic products. Parker's been a good regional supplier to Applied for nearly 20 years, but this is the first time we've had the full agreement on all pneumatic products across the country. And we appreciate the faith that Parker Hannifin is putting in us.

We continue to make progress in balancing our business across geographies, across sales channels, across product categories, and across suppliers. Our catalog and our e-commerce sales channels continue to show promise. And we're making steady progress in our government sales initiatives. As I noted, we have succeeded in pursuing these and other growth initiatives, while keeping our costs well under control.

Now if there is one element of the quarter that does require some additional attention, it's our ability to extract gross margin from the marketplace. This can and will get better. We were somewhat disappointed in our ability to fully pass on price increases in the period. The good side is that it gives us opportunity for further improvement.

Now I'll turn it over to Mark and Bill for more detail, and a little bit more meat on the bones here.

Thanks, Dave. Good afternoon, everyone. I assume you've had a chance to read and digest our earnings release. Without rehashing the details, there are a few things I would like to highlight. Our 11.4% increase in sales came with 1/2 more selling day in the quarter as compared to the prior year due to the timing of Good Friday. Price increases accounted for 2 to 4 percentage points of this gain. Most of the sales increase came from our domestic operations, with our fluid power business experiencing the highest rate of improvement.

Our Canadian operations rate of change was greater than the company average, as it was aided by a 6% improvement from currency translation. Mexico and Puerto Rico had slower rates of growth.

As a result of our acquisition of Minnesota Bearing, our number of operating locations has increased by 14 to a total of 455. Operating results from these new locations will be included in our operating results starting in April.

Gross profit improved to 27.5%, which is 80 basis points greater than the prior year third quarter. This primarily relates to timing on supplier rebates. We experienced some rebate benefits in the quarter that pertain to purchases made in previous quarters. Under generally accepted accounting principles, we were not able to accrue benefits for these until the current quarter.

While we fully expect these rebates to continue as a part of ongoing operations, if normalized on an annual basis, it would have had the impact of moving $0.04 of earnings per share from our third quarter to prior periods. This boosted the gross profit percentage for the March quarter to a rate somewhat higher than what we expect on a go-forward basis. Our expectations are that the fourth quarter gross profit percentage will be comparable to our nine-month year-to-date rates.

Our overall rate of selling, distribution, and administrative expense remains consistent and on a slightly downward trend as a percentage of sales with our previous six quarters. The incremental rate of SD&A growth is still lower than our sales growth rate, although it is a bit higher than you have been seeing. Our SD&A rate is impacted by our investments in new markets, by our growth through acquisitions, and by several compensation elements related to our improved financial performance.

Our operating margin improved to 6.5% compared to 5.4% in the prior year's third quarter. This continues our upward trend in quarter over quarter operating margins.

Our effective tax rate of 36.5% for the quarter was slightly lower than last quarter's, and brings the year-to-date rate down to 37.1%. We feel a rate of 37.1% is reasonable for the remainder of the fiscal year.

Our balance sheet remains solid, with shareholder equity at $412 million and a current ratio of 3.1 to 1. Our pre-tax return on assets continues to improve to 18.2% for the March quarter, and 16.0% year-to-date.

Cash provided from operations during the quarter was a solid $37.8 million, which resulted in our year-to-date amounts shifting to a positive $20.5 million.

We began working down our inventory balances in the quarter, and expect the decline in inventories to continue in the fourth quarter, with additional decreases of up to $20 million. Our June 30th, 2006, inventory balances should be close to our prior year-end balances, plus new inventories from the acquisitions.

We expect another positive quarter in cash provided from operations to finish out our fiscal year with levels approaching what we accomplished last year.

We did not purchase much of our common stock during the quarter. Our available authorization remains at 1 million shares. We plan on continually monitoring stock buy-back opportunities, and will execute trades when appropriate.

In addition, we expect capital expenditures for the entire fiscal year to now be in the $10 million to $11 million range. As a result of this quarter's performance and our outlook for the remainder of the year, we are increasing our annual earnings and sales guidance to an earnings per share range of $2.29 to $2.34 on sales from between $1.89 billion and $1.90 billion. Now Bill Purser will comment on sales and operations.

Thanks, Mark, and hello, everyone. It's a pleasure to be with you today. As you can see from our results, we continue to make good progress, and I am particularly pleased with the effort our associates have made.

This afternoon, I would like to one, review a few of the key industries that helped us achieve our sales increase for the past quarter. Then I'd like to share with you some thoughts on our international performance. Next, some comments on our new Parker pneumatic authorization that Dave referred to earlier. Then I'll give you an update on our government sales initiatives. And finally, provide an overview of where we see the economy going.

Let's begin by discussing the performance of our key industries and markets. Sales growth in the latest quarter was well-balanced across markets and accounts. While small and medium-sized accounts have been the primary driver of our sales growth since the economic expansion began, we're now seeing fairly even growth between our large account business and small and medium accounts.

We experienced double-digit growth in several of our largest market areas during the quarter. These included industrial machinery and equipment, forest products, which was driven really by lumber and wood, and primary metals. Growth was also strong in general manufacturing and petroleum and coal products.

Segments that seemed a little sluggish included chemicals and allied products, transportation equipment, utilities, and mining, although coal mining remained strong.

In regards to our international performance, we saw strong sales in Canada for the quarter, although there are some signs of moderating growth. Looking forward, we expect steady performance from our Canadian operations in a continuing stable economy.

Our largest presence is in Western Canada, where natural resource production, particularly petroleum products, lumber, and mining, drive our business. In Eastern Canada, our GLM subsidiary has now been under the Applied umbrella for over a year, and it continues to perform well.

The economy in Mexico remains stable, and our sales are running ahead of plan. We currently have nine service centers in this market, and they primarily serve manufacturing and resource production.

Growth in the Caribbean has been weaker, but we're seeing signs of improvement as our three facilities in Puerto Rico continue to reach out and tap business in the region, particularly the Dominican Republic.

Overall, we're very pleased with our international performance, and attribute much of its strength to our local management.

As Dave mentioned in his remarks, we were very pleased to receive an expansion of our relationship with Parker Hannifin Corporation, as we announced in February. Although we don't anticipate any impact in this business year, we do believe that this authorization will add approximately $3 million to $5 million in revenue for our next business year.

Under the new arrangement, Applied is authorized as the national distributor for Parker's pneumatics group. Prior to this announcement, about, I'd say, a half of our service centers were authorized to sell Parker pneumatics. The authorization brings with it greater technical and training support for all of our U.S. service centers, as well as expanded product reach.

In regards to our initiative aimed at government business, we continue to make good progress on our government sales effort, a program that began last July. There is a sharp learning curve to this business segment, and we feel we're doing a good job climbing it. We've trained our sales force, and are now getting in front of government buyers with increasing frequency. Our first quarter is the Federal government's fourth quarter, which is when a lot of budget dollars get spent, so we're expecting to see a nice bump in the next six months, although this is from a relatively small base.

Government business is a large untapped market for us, and we believe it will help balance out the normal cyclicality of our industrial markets. We are pleased with the initial receptiveness with which we are being greeted as we make government purchasing officials familiar with our asset base, our intellectual capital, and application knowledge, our web-based capabilities, and our extensive training programs.

Finally, in my customer visits around North America, I still see optimism regarding the economy. However, there is a definite softness in the business climate. There is uneasiness about the high cost of energy and uncertainty about interest rates. As a result, some customers are telling us that they have temporarily put long-term capital improvement projects on hold.

The key indicators we track, including the manufacturers' capacity index, the purchasing managers' index, and the consumer confidence index, to name a few, all indicate our next quarter should be good, and we still foresee growth through all of calendar 2006. To summarize, I feel we are well-positioned in this industrial economy with good, focused marketing programs, a superior sales and service team, and expanding product available market. We will continue to keep our associates focused on all four of our corporate initiatives: profitable sales growth, asset management, margin enhancement, and cost control.

Now let me turn the program over to Dave for some closing remarks.

Thanks, Bill. And to conclude our formal comments, I just want to say it was another good quarter. And we have a positive outlook for the final quarter of the year. This optimism is reflected in our increased annual earnings guidance and in our increased dividend.

I'm pleased with the balanced approach we are showing to profitable growth. The market drivers indicate that the economy is going to remain solid for the remainder of the calendar year. And our strategy, based upon our results, appears to be well-considered. And for the most part, we're executing well. There is still room for improvement. We look forward to converting those improvements into additional operating leverage as we go forward.

Now we're going to open it up for questions. So Tony, it's all yours.

Thank you, sir. [Operator Instructions] And we'll go first to Jeff Hammond with KeyBanc.

Hi. Good afternoon.

Hi, Jeff.

I guess I wanted to go back to two comments. Dave, I think you mentioned early in the call about trying to kind of [flavor out] timing of trends. And I don't know if that goes to Bill's comments about near-term strength, with some maybe medium-term caution. If you could just clarify that a little bit.

Well, Jeff, I think we talked about it a little bit in past conferences. With the investments in the government business, that's a long-term process. And we knew we were going to be investing ahead of the revenue stream there. Some of the new things we're doing with our catalogs as we seek to light a fire under that are also ahead of the revenue stream. So we have made some conscious decisions in this year to allow the SD&A to move at a rate a little higher than we have in the past, but still below the rate of sales growth in order to put some things in place that'll give us the future growth opportunities we feel we're going to need.

Okay. So as you look out to fiscal '07, some of those near-term investments maybe go away, and you get a little more leverage on the SG&A line?

We're still going to have that government piece up there for some time to come. We see that -- I think we stated that's probably three to five years out at maturity.

Okay. Mark, you mentioned 2% to 4% price -- can you give us maybe a little better sense of is some of it -- are you seeing 2% somewhere, 4% somewhere? I mean, is there a better number you can give me? And then going forward, we've seen some reacceleration in commodity costs. What are your vendors signaling in terms of price? What should we look for for price two, three quarters out, or near-term?

I think with our numbers that we're seeing, we're seeing a slight deceleration in the rate of increase from supplier price increases. When you look at the 2% to 4%, that's different than what we were talking about let's say a year ago, when it was 5% to 6% at that point in time. And we continue to see that when we're looking at the impact of supplier prices.

In the March quarter this year compared to the March quarter a year ago, the increases were only in the range of 2% to 4%. So it's a much smaller impact that what we've seen now than what we've seen in the past. And on a go-forward basis, I don't -- we don't have really any knowledge from the suppliers of any increases coming. So Bill, do you want to talk about that?

Yes. We just received notification this afternoon of one increase with one of the bearing manufacturers. Literally, the ink is not dry yet. And it's going to be approximately 6%, effective July. First of July. That's fresh news.

And that would presumably be steel input costs going higher?

Jeff, I can't comment on that because I really haven't read it in detail the notification, quite honestly.

Actually, Bill, the announcement related to the fact that while raw materials had stabilized at an albeit higher level, they were being impacted more by energy costs right now.

Okay. And then finally, if you look at your Parker and your Vickers authorizations, is that making -- as you look at fluid power acquisitions, is that making it easier to look at those in terms of retaining those types of authorizations? I know that it in the past had been kind of headwind to the acquisition environment there.

I think as you strength your relationship with some of the suppliers, I think it does help with some of the national authorizations. As we acquire fluid power subsidiaries, that gives us the -- I wouldn't say leverage, but it does give us more of a position with certain manufacturers. And I think we get to know them even better, and I think that it helps our case.

Okay. Thanks, guys.

Thanks, Jeff.

We'll go next to Mark Koznarek with FTN Midwest Securities.

Good afternoon.

Hi, Mark.

On the SD&A question, I guess maybe just to ask what Jeff might have been driving at a little more directly, is it likely that for the foreseeable future we're going to see SD&A growth above that target of yours of limiting it to 50% of the sales growth? In other words, is this investment in the government initiative and other things going to persist beyond June 30th?

Mark, from my standpoint, yes. And in combination of the fact that we're going to be investing ahead of the growth curve on some things, and that we're going to be assimilating some SD&A from acquisitions in at the current SD&A rate, and it's going to take some time to put the full integration process in place on those. So yes. We're going to see SD&A, I would say, for the foreseeable future at a rate above the 50% sales rate that we've proposed in the past. But still, we would have a target of having it below our sales growth rate.

Okay. So the new bandwidth for maybe the next year plus would be 50% to 100%, rather than below 50%?

That would probably be a good enough range to put it in without having to pinpoint it. We're heading into business planning sessions now. We want to see what all the opportunities are and which ones we want to fund. And so at this point, we can't be more definitive than that. That's probably a good range.

Okay. And then could you guys explain to me again -- maybe I just don't understand my accounting for these rebates well enough. But what the issue was why you had to break out this particular rebate, whereas usually you just roll them into your gross margin.

Mark, obviously, all the rebate benefits, when they go to the income statement, they go to the gross margin benefit. We felt it was prudent to discuss the impact of this rebate situation, because it related to a program that ended on March 31st. And at December 31, we had nothing accrued for benefit for that, because at that point in time, we felt that we were not going to hit any of the thresholds to qualify us for some of these purchasing incentives. Through some negotiations and some -- we were able to hit those thresholds in the March 31 quarter.

So at that point in time, we were able to record rebate benefits for purchases for the 12 months ended March 31st, as opposed to our normal practices of, on programs that are in the money, we would have them -- would be recording it every month as we purchased material. So the bottom line means that there was purchases of inventory that we made prior to December 31st that we were able to receive rebate incentive benefits for in this quarter ended March 31st that have flowed through the income statement. And we discussed about that in the press release.

Mark, let me just add one thing. We struggled with that one a little bit as to how to portray it, but in the spirit of transparency and fairness to shareholders, and looking at true results, to have accounted for that just simply as a pure period increase or boost to our margins I don't think would have been fair. So we tried to be as in compliance with good corporate governance, be as transparent on this as we could.

Mark Koznarek. Yes. That's actually very helpful. I applaud you doing that, because otherwise, we would have all been surprised even more than we were this morning. But it doesn't sound like, in theory, that the set of circumstances you just described would necessarily be all that unusual for Applied. And so will it be likely that on a regular intervals, we'll have gains like this when you trigger a sizable rebate that hadn't been expected?

Well, that's a good question, Mark. If you recall, back in our September 30th quarter, we had discussed a similar situation at that point in time as well. That happened in September. And these things are -- we don't know. I mean, they could be happening in the future, but they could not. There's -- it all depends on what the suppliers are offering regarding purchasing incentives.

Mark, the good news basis on this is on annual results, it should all even out. And so we expect to continue to get the annual level of rebates that you will see that boost -- that impact our total margins for the year. And when we do get concentrated rates of rebates within any given period, we're going to try to be very open and make sure you understand which are period related and which are out of period related. Just so, again, we don't muddy up the waters over what the true earnings picture of this company is.

Okay. Thanks. And then just one final one is Minnesota Bearing's reasonably sizable acquisition. And on some of these larger acquisitions in the past, you guys have offered some comments about what to think about with regard to earnings accretion. Is there anything you can help us with with regard to the impact of this acquisition?

Mark, let me speak to that. With Minnesota Bearings, we will be having some more integration costs, as we will be looking at consolidating certain service centers that they had in certain locations and we had in the same locations. And so this is a little bit different than some of the other recent acquisitions we've had, because most of those other recent acquisitions, I'll call them [inaudible] acquisitions, where we didn't have a lot of these other integration thoughts. So I think from what we're looking at for this -- the remainder of this fiscal year, we're not looking for any tailwind from Minnesota Bearings for our earnings at this point in time.

Great, Mark. That's helpful. Thank you.

We'll go next to Andrea Sharkey with Sidoti and Company.

Hi. Good afternoon, everyone.

Hi, Andrea.

Hello.

Just a couple of quick questions. I noticed that the D&A, depreciation and amortization, looked higher this quarter than it has been for the year, and I was just wondering if you could comment on why that was, and if that was something that was going to be a better level going forward?

Well, Andrea, one of the reasons the amortization was a little bit higher was because we purchased Spencer Fluid Power on September 30th, and so some of their intangible assets that we're required to amortize started amortizing in the December quarter, and then obviously in the March quarter as well. So for the annual run rates, it's a little bit higher for that.

That's the only thing I can think of off the top of my head. I think the depreciation rates year-to-date are running a little bit lower than what they were a year ago. I have not gone back and looked at each of the last three quarters to see the different impacts for that, though.

Okay. And then just another quick question was I know you guys had talked a lot about investing more money in your catalogs and doing some things there. And I was just curious if you saw any meaningful increase in sales through the catalogs this quarter, and if you could quantify that at all?

Andrea, this is Bill. We're -- part of the investment that we talked about with the catalog is a study as to do we have the correct method to market with our catalog. We're in the process as we speak of having final meetings on a go-forward decision there. So at this point in time, we really haven't seen any major increases.

Our run rate is basically the one that we gave in the past. We're running in excess of $40 million a year as far as the two catalogs, the Maintenance America and the Fluid Power catalogs are concerned. Again, the investment that we discussed earlier, part of that is toward a study to make sure that we have the correct model to market.

Okay. Great. And then just to go back to the comment you made earlier about the 6% price increase for the bearings starting July 1st, is that something you think that you'll be able to pass on pretty quickly, or are we going to see maybe a quarter lag in that when you can price increases on to your customers?

Well, our intention is always to pass those price increases through, with the exception of any contracted accounts, so where we're not permitted to do so. So are we 100% successful all the times? No, we're not. But I'm going to say that we're going to be driving that very hard to make sure that we do pass that along.

Okay. Great. Thanks. That's all I have.

Thank you.

[Operator Instructions] We'll go next to Brent Rakers with Morgan Keegan.

Hi. Good afternoon. Just wanted to follow up maybe one more I guess take on the rebate. The $0.04 rebate benefit in the quarter. Did that additional amount trigger because the revenue in those products that you sold in the quarter was better than you thought it might be?

No.

Okay. And I didn't know if that meant you hit certain thresholds that you didn't think you were going to reach in terms of sales of certain products, and maybe that kicked the rebates to a higher level? Is that not correct?

It's really, Brent, in the negotiations, the thresholds that we did not think we would be able to hit were made a little more realistic through the negotiations.

Okay. And just to clearly understand it for my benefit, and that's done retroactive to the actual sales themselves?

Brent, these rebates were based on our purchases from the suppliers. So if the target of our purchase dollars over the 12-month time period, and the targets that were presented to us through December 31st, were so high that we believed that we were not going to hit them. And like Bill mentioned, we were able to renegotiate those targets in the quarter ended March 31st to a lower level. So in essence, the supplier came back to us with a different deal.

Okay. Great. Now that's helpful. Thanks, Mark. And let me -- just to clarify. You made the comment about gross margin guidance for the fourth quarter, saying it would be comparable to the first nine months of the year. When you look at the first nine months, are you including the benefits you got here in the third quarter in that number?

Yes. Yes. Because basically, those are spread over the prior quarters. So yes. That was our view of that.

Again, Mark, that implies about I think 27.25% gross margin for the first nine months. So that sounds like where you're talking about for Q4.

Yes. In that range.

Okay. And then I guess shifting gears a little bit to the SG&A for some of the growth initiatives going forward. I appreciate the help in terms of the growth rate in proportion to the sales growth, but I was hoping you could maybe walk me through a little bit more on an absolute basis. Or obviously, the variability of sales is not necessarily going to be directly linked with your expenditures in these programs. So I was hoping you could help out a little bit more on a dollar basis, and maybe talk about the different areas you might spend on. Whether it would be all new employees, or other types of spend.

Well, Brent, as I mentioned just a little earlier, we are in the initial stages or our FY 2007 business plan. We have not made the final decisions on which investments will give us the biggest bang for the buck. What kind of a blended rate of investment we need to both support initiatives in the current year and to make sure that as markets cycle down in the future, we have things three to five years out that we are starting to invest in right now.

So I don't know how to put as the definitive on the SD&A at this point. For future quarters, it's a little difficult because it's still in the planning stages, and there are a number of pieces to the puzzle.

Okay. Perfect. Okay. So we'll look for more of that, Dave, it sounds like, on future calls as well.

Absolutely. And when we give your our business plan for FY 2007, we should be more definitive in those areas.

Great. Okay. And then just one other wrap-up question. You talked, Mark, I think, about that 2% to 4% price increases year over year that were realized, or that benefited you guys in the quarter. I guess two questions. First of all, can you give us the sense of what the sequential increase, or was it flat with kind of the fourth quarter trend there? And then secondly, related to that, I believe Dave, you mentioned comments about some lingering gross margin uptick that you hadn't passed that all the way through. I was hoping you could comment further on that.

Sure.

Let me start with the first part of that question. We're seeing sort of the overall rate of decline with those percentage increases from supplier price increases. And so as I go forward and I'm looking at that out into let's say our fourth quarter, I'd expect the numbers to be between 2% to 4%, maybe even on the downside. You know, a little bit light of that, or short of those numbers. So I think we're seeing sequentially that these impacts have gotten less as the system has absorbed all those major price increases we were having 18 to 24 months ago.

Okay. And then maybe, Dave, if you could also address the margin side of that question?

Sure. The thing that had us disappointed, Brent, was in domestic same store operations, we saw a decline in the gross margins for the period, which is something that's kind of unusual for us in a quarter. And it was significant enough that Bill and I have made several trips with all of our guys. We've put some key planning processes in place that our guys accept, and they think that are positive. And to make sure that this doesn't continue.

You know, there are some tough competitive issues out there in the marketplace. Some feedback we got that said some things have changed on a competitive front. But we want to make sure we don't overreact to that, and make sure that we continue to manage the margins properly. So I am looking for this to turn around in the fourth quarter.

All right. Okay. Thanks a lot, Dave. That's helpful.

Thank you.

We'll go next to Holden Lewis with BB&T Capital Markets.

Great. Thank you. Good afternoon. On the question of the D&A, I mean, to put numbers to it, in Q2, you had $4.2 million in D&A. Q3 had $4.9 million, and I think Spencer was in both of those. And yet Q2 was still a pretty good spike up. And I guess the question is that [inaudible] trying to get to is, is the $4.9 number something we should be using going forward, or is that for some reason blown up?

Holden, that's a good question. Actually, after Andrea asked that question before, I went back to some of my notes. And we did have some additional amortization expense in the quarter just ended in March related to some of the stock options that were issued.

We do have, as you see in our proxies, we do issue stock options to our Board of Directors. That generally happens in January. And those stock options, they vest immediately. So based upon the accounting requirements, the entire FASB 123R expense happens immediately, whereas when stock options are issued to employee associates, they vest over four years, and so those sort of layer into the amortizations. But we do see a -- that's a periodic spike in this March quarter for amortization expense because of that.

Okay.

That would then be smoothed out over a whole year.

Right. That'll happen forever as long as you're doing options?

As long as those options are offered to the Board in the month of January. Yes, that'll happen.

Okay. And then on the gross margin, I guess you said that the domestic same store ops had a gross margin that was down. I mean, that's a pretty big chunk of your overall business. And I think even if I strip out the call it $1.92 million sort of true-up benefit, you still get about a 27.1% gross margin. That compares to 26.7% last year. So even with domestic ops down a little bit, and stripping out some of that stuff, and without getting all of the gross -- without getting all of the pricing through, it looks like you still had about a 40 basis point improvement in gross margin. The question is, am I looking at that correctly? And then if so, what other things drove that higher?

Yes. Holden, obviously there's a lot of components within the gross profit percentage besides what we've talked about so far. We are receiving additional supplier incentives. We're also having additional improvements in the margin in some of our international operations. We've had some experience with lower scrap expense that have helped in the quarter. And then also we continue to march forward with improvements with the overall freight recovery in those initiatives that we have for that arena.

So all of those go into the mix with that, and we see pluses and minuses in various of those areas. And you're right. After you take those one-time things out of the mix, we're still forecasting and looking going forward at around the 27.1, like you said, percentage point.

And Holden, I don't want to be overly critical. This wasn't a fall off the edge of the earth decline in margin. It was just different from what the trends we had been seeing, where we had been doing a fairly good job of getting margins up. So anytime we see a change in direction, it's of concern to us.

And did the U.S. -- for the same store ops, has that gross margin been down all year, or was this the only quarter that that was an issue?

This was the only quarter, Holden.

So it sounds like there was -- it sounds like you'd been going along all right in Q1, Q2. Q3 hit a bump. In Q4, you're going all right again. What was the catalyst in Q3 exactly?

Still don't know. There's some tough competitive issues out there. And we may have overreacted to issues of the marketplace that weren't necessarily needed. But like I say, we will change this in the fourth quarter.

Right. There's not one specific thing we can point to, Holden, as to why those came down. But we will continue to work all of our gross margin improvement initiatives as we go forward.

But does it dovetail with your comments about being disappointed on the degree of pricing that you were able to get through? I mean, basically, did the circumstances of the market get such that the stores were not pushing through the price that they should have been? I mean, was that -- then you'll tell me there's a dozen different things, but is that a big piece of this?

Holden, again, we don't know. Wish we could clarify it down to that level of detail. And we just -- if we had it, we could tell you. But we simply don't have that level of detail.

Okay. Well, on the pricing, when you said that you weren't all that pleased with how much you got through, what do you change or what do you do to improve that? What levers do you trigger to make sure that in Q4 and beyond, you are getting a fuller accountability of pricing?

Well, we have some things defined, but we're not about to discuss them in a public place. So I appreciate your attempt on that one, Holden, but no, thanks.

All right. That's it. Thank you.

We'll take our final question as a follow-up from Jeff Hammond with KeyBanc.

To follow-up on government sales, can you give us a sense of what your revenue run rate is, and as you get to maturity, maybe two, three years out, what you think the revenue opportunity is?

Jeff, the current run rate -- you know, we realize we're starting from a small base.

Sure.

The current run rate's roughly $1 million a month.

Okay. I mean, where would you like to see it two, three years down the road?

Where would I like to see it?

I mean, what's a reasonable expectation or goal?

Oh, now you want to be put that on me. A reasonable expectation. Well, I had some stars in my eyes when we began, thinking that -- I think some experience has taught me that this is not going to be as easy a ramp-up as I thought maybe. But we -- I'd like to see us in that $40 million, $50 million, in a couple of years, three years at the max. I don't see any reason, with the investments we're talking about, why we can't get in that ballpark.

Okay. That's helpful. And then, Bill --

I'm talking about annual, you understand.

Oh, right.

Not month. That was [inaudible].

Monthly's a stretch, Bill. Right.

Yes.

Then, Bill, you made some comments I guess about capital projects being put on hold. I just wanted to get a little more color there. Are there any specific areas? How broad is it? Or is it just kind of a select few situations?

It was probably confined to a few industries more so than -- I wouldn't call it across the board, because there's still some of the key industries that are continuing with the projects. But it was a sense that we were getting from some of the SICs that they're concerned over what's going to happen with interest rates. The energy costs. They were becoming a little uneasy about going forward with projects.

I'm not going to say that they cancelled them. They're just -- put them on hold to try to get a little better viewpoint. Now whether that's going to be a month or another quarter or until after the Fed meet in May, I can't answer that.

And what were the specific SIC codes?

Yes. They were, but I'd rather not get into those details.

Okay. Thanks.

You bet.

And we will take a question from Greg Halter with Great Lakes Review.

Good afternoon, gentlemen.

Hi, Greg.

I wondered if you could provide some quick comment on your progress in the HVAC and power generation markets, or maybe you'll elaborate on what you may have said earlier.

Okay, Greg. Regarding power gen, we have a brand new marketing program aimed at that particular industry that will be introduced the first of July. We are doing business within the field as we speak, and it is -- been a good field for us. We did see a little bit of a slowdown last quarter, but that's the first quarter that we've really experienced any kind of settlement. It's been a very good industry for us. And we think with the new marketing program and the focus through the marketing program, it's going to even be better.

HVAC, we have a marketing program that we entered into, I'm going to say about -- I believe it was the beginning of this business year. And so that's relatively a new program for us. I'm encouraged by what I'm seeing. We've been in several of the large HVAC shows. And attempt to make ourselves known as a supplier in this market. We have had success in certain areas of the country without the marketing program, but this is the first attempt to have a national program aimed at that market. That's a very, very good potential market for us.

Okay. And one quick question for Mark regarding Minnesota Bearing Company.

Yes.

It shows in your press release it was acquired on March 31st, 2006. Does that mean that their -- all of their financials are consolidated into yours?

It means all -- that their balance sheet is included on our balance sheet, but none of their income statement is included in our income statement yet.

Okay. So there was no additional debt taken on for that year?

No. We paid cash.

Okay. So your debt levels on a sequential basis are basically the same?

Right.

Okay. Great. I just wanted to make sure that was clarified. I think a source I saw was showing it acquired on April 4th. So I want to make sure I had that in the figures.

Oh, yes. March 31st.

Okay. Thanks a lot.

Thank you.

This now concludes our question and answer session today. I would like to turn the conference back for any closing or additional comments you'd like to make.

Thank you guys for the interest you're showing. Good questions. I hope you appreciate some of our dodging at times with regard to, you know, in a public forum, not revealing all of the plans we have.

I do think we have a well-balanced program of focusing on growth, both short-term and long-term, with good asset management, and good cost control, that will allow us to continue to keep showing you the kind of results we've been showing over the past 13, 14 quarters. So we feel good about what's out there ahead of us. And we're committed to keep giving you good numbers. So again, appreciate you being with us. Thanks a bunch.

This does conclude today's conference. We do thank you very much for your participation.