Applied Industrial Technologies Inc (AIT) 2007 Q1 法說會逐字稿

Welcome to the Applied Industrial Technologies first quarter, 2006 financial earnings conference cal. [OPERATOR INSTRUCTIONS] I would like to introduce Mr. Richard Shaw, Applied's Vice President of Communication and Learning. Mr. Shaw, you may begin.

Thank you, Matt and good afternoon, everyone. Just for the record, this is our first quarter fiscal 2007 conference call. On behalf of Applied Industrial Technologies thank you for joining us today. You should have already received our earnings news release that was issued early this morning. If you have not received it it, you may retrieve it by visiting our website at applied.com. A replay of today's broadcast will be available for the next two weeks and the archive information is contained in that 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 except as required by law.

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 expressed 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. And Bill Purser, President and Chief Operating Officer who will discuss operational activities. Here to get us started is David Pugh.

Thanks, Rick. And thanks to a pretty good group of folks joining us this afternoon. As we said, this morning, in our news release we did have a good start to what we expect to be a very good year. It's always good to come out of the chute strong. Healthy sales increase of 11% combined with the continued emphasis we have in operating fundamentals helped us post some very strong earnings.

We continue to make strategic investments in future growth areas such as the government sales. While still managing our cost structure to a rate well below that of the sales growth. Managing all of these processes to a good balance helped us to improve our operating margin to 6.8%. That was quite good for us. Our cash generation for the first quarter was a good improvement over our historical rate on a seasonal basis. We increased the earnings per share for the first quarter by 31% and that makes 16 consecutive quarters of at least a 20% earnings per share increase over the prior year.

Again, there were no single items of significance. We did enjoy a solid economy. And we managed the fundamentals very well. We think there is still more improvements to come in this company. We are going to continue to invest wisely. We are going to continue to stress quality in everything that we do.

In general, we are still seeing a good market out there. And we feel we have good opportunities with new contracts, with new market segments that we are entering, with additional products that we are adding to our portfolio. We think that these things will support any reduction in the rate of market growth that could occur. And speaking of that, when we look at the indicators the PMI is still in expansion territory, the MCU is in expansion territory.

Consumer confidence is recovering. There is really nothing that we see out there that support fears of economic doom and gloom. I'm going to let Mark and Bill take over from here to add few details to the results and I'll return later with a few closing comments. Mark, it's all yours.

Thanks, Dave, good afternoon, everyone. Let me provide some additional insight for our first quarter financial performance. Sales for the first quarter ended at $492.6 million. This represents an 11.1% improvement over last year's first quarter. We have 63 selling days this quarter which was 1 day less than the same period last year.

Total United States service center and fluid power operation sales for the quarter were up 11%. We estimate that approximately 1to 2 percentage points of this increase relates to the impact of passing along supplier price increases on our sales. We also saw our Canadian operations sales improve by 15% in the quarter of which about two-thirds related to currency translation from the strengthening of the Canadian dollar compared to the prior year and the remainder of the increase was from additional volume mix in pricing. Our Mexican and Puerto Rican operations had a combined sales increase of 13.1%. All in all, we saw continued growth across the board.

During the quarter, our number of operating facilities was reduced by 1 to 451 locations as we merged two of our California locations together. Our product mix during the quarter was 19% fluid power products and 81% industrial products. Our gross profit percentage for the quarter was 27.4%. About 20 basis points lower than last year's first quarter and 90 basis points ahead of the fourth quarter.

While the gross profit percentage is 20 basis points below the rate in the prior year first quarter, it is above our previously projected annual rate of 27.0% for fiscal 2007. This increase from our expectations is primarily due to additional supplier purchasing incentives recognized during the quarter. As you may recall, in the prior year we also had some additional supply of purchasing incentives which caused that quarter's rate to be higher than our normal run rate also. Our expectations for the go-forward gross profit run rate is approximately 27% for the remainder of the fiscal year.

Looking at our selling distribution and administrative expenses for the quarter, we achieved an SD&A rate of 20.7%, 60 basis points than last year. This rate is 30 basis points lower than our SD&A for the full year of 2006. The absolute dollar increase in SD&A dollars for the quarter was only 7.7% compared to a sales increase of 11.1%. This increase primarily relates to the acquisitions of Spencer Fluid Power and Minnesota Bearing Company as well as additional compensation and incentives resulting from our improved financial performance.

We are continuing to succeed at holding selling, distribution, and administrative expense growth to a rate substantially list than our sales growth rate. Our first quarter operating margin increased to 6.8% compared to 6.3% in the prior year's first quarter. This achievement continues our upward trend in operating margins. This trend has been driven by our increase in sales and by limiting the growth of SD&A expenses. Our effective tax rate for the quarter was 35.6%.

This was lower than we originally expected due to items. First, we had a favorable resolution of a state and local tax issue during the quarter. Second, and relatively smaller was the benefit from the recent favorable decision by the IRS regarding the federal excise tax on long distance telephone calls. For the remaining three-quarters of fiscal 2007 our expectation is for the effective tax rate to be in the range of 36% to 36.5%.

Our balance sheet continues to strengthen with shareholders equity at $421.1 million for the quarter, and a current ratio of 3.1 to 1. Our pre-tax return on assets rose to 18.1% compared to 15.6% for the prior year period. Inventory levels remained stable compared to year end although we do anticipate a seasonal increase in inventories during our second quarter. This inventory increase is expected to flow through our system in our third and fourth quarters so that inventory levels at June year end should approximate our prior year end levels.

Accounts receivable and day sales outstanding at 42 days remain competitive but with room for improvement. Cash provided from operations during the quarter was a solid $16.1 million. An improvement of $18 million from the comparable quarter a year ago. In this morning's press release, we kept our annual sales guidance the same, at an increase of 7 to 10% to be between approximately 2.03 to $2.09 billion for all of fiscal 2007.

We raised our guidance for full year earnings per share from the range of $1.76 to $1.80 per share to a new range of $1.80 to $1.90. Therefore our guidance is for an EPS increase over fiscal 2006 of up to 21% on a sales increase of up to 10%. Also, our EPS guidance does not include any significant gains on sales of property or other nonoperating events. Now, Bill Purser will comment on sales and operations.

Thanks, Mark, and good afternoon, everyone. It's a pleasure to be with you this afternoon as we present the results from a solid first quarter. I was extremely pleased with our quarter results from the strong start to our 2007 business year. Our associates worked hard to deliver the numbers and deliver they did.

As an overview, 11SIC saw strong double digit growth during the quarter while eight others saw some level of moderating growth compared to last year's quarter. Metal mining and coal mining showed exceptional growth and we also saw some strong growth in amusement services, primary metals, electric and electronic commitment, petrochem, and heavy construction contractors. I might add that the growth in primary metals was the result of market share gains.

A number of other industries did very well. Just not at double digit growth. These would include transportation equipment, fabricated metal products, rubber products, and chemicals, food and kindred products were up slightly, as were paper and allied products and industrial machinery.

Lumber and wood products slowed some as did those industries associated with aggregate production. We think that's most likely in response to the slower housing construction. The largest decline was in printing and publishing as well as textile products. These are areas that our involvement is lower.

During the quarter, we continue to make good progress with our government sales efforts. This effort is starting to bear fruit and I'm pleased to tell you that we won an award sponsored by the coalition for government procurement for being the most successful newcomer. This award was the most significant gain in or was the most significant gain in scheduled business combined with making significant contributions to the overall program. We've launched many programs to help us in this fertile area and it's nice to be recognized.

We are also in the final stages of redesigning our applied.com e-Commerce site and plan to launch these changes in the near future. This site will be open to all buyers with credit card ordering capability. A feature that we feel will help us develop more business with small and medium sized accounts. Our efforts in this area continue to grow as more and more customers choose to order electronically. Our combined electronic sales including the internet now exceed $35 million per quarter.

As I mentioned in our last teleconference, we've completed an internal assessment of our catalog effort. As a result, we were in the process of making some changes. First of all, our two catalogs--Maintenance America and The Fluid Power Connection are being combined into a single catalog branded under the applied name. We feel this will make our catalog more useful to our customers since they generally buy products from both product areas. Second, we were adding new products and expect to have it on the street by July of 2007 with information on over 38,000 products. In the interim, we plan to issue a large 100 page supplement in January of 2007. These moves will have an added benefit of putting new catalog distribution in sync with the beginning of our business year. A schedule which we intend to keep going forward.

During the quarter, we expanded our relationship with 3M and will now offer more than 15,000 of their products. This will make a nice fit and will fit a nice product niche that our customers have been asking for. Our new acquisition, Spencer Minnesota Bearings continue to do well and certainly have contributed to our profitable growth. Mark gave you details regarding our operations in Canada, Mexico, and Puerto Rico as well as our Fluid Power subsidiaries. All contributed to this quarter's success.

In general, the markets we serve continue to show vitality. We are still confident that we will meet our top line growth estimates for this business year. Our conversations with customers as well as economists tend to support those numbers. I believe many of our customers are in a strong cash position as a result of good business performance. I don't believe that they will be using all of it to buy back stock and increase dividends. I feel many will invest in new machinery and capital projects.

All in all, we are looking for continued strong performance over the next three quarters. Our sales during the quarter were slightly better than we expected and our continued focus on enhancing margins, managing assets, controlling cost, or providing strong leverage for our earnings. I'm going to now turn the call back over to Dave for some closing comments.

Thanks, Bill. Again, a strong start for a fiscal year and we are feeling pretty confident. But staying alert. The continuity of our performance is indicative of an effective execution of what we think is a well balanced strategy by our management team and all of the associates here. It's solid, sustained progress. And we all believe there is more to come. Our view is that the economy still has a lot of opportunity left in it. And that the economic cycle is in the middle innings. The cheese may move a little bit but we feel we are nimble enough to move with it.

Full year contributions from Spencer Fluid Power and Minnesota Bearing are going to give us a boost in 2007. New products in our market basket are going to help us. The government sales growth is certainly going to help us. We anticipate some price increases that would help the top line, although temporarily challenging gross margins and there's nothing new to that. We are going to continue to evaluate our relationships both internally and externally that fail to provide adequate returns as we continue to strive to grow to be a stronger company.

As I've said before, we are going to have a balanced attack. We will be balanced with regard to sales, margins, cost, and assets. We aren't going for broke in any one area. That is simply not wise nor is it sustainable. We are going to maximize where it's possible and where it's prudent. And we will adapt when and where it's necessary. I want to thank all of you again for your interest in Applied for being with us this afternoon and now we will do our best to answer your questions. So, Matt, back to you.

Thank you. [OPERATOR INSTRUCTIONS] And we will go first to Holden Lewis of BB&T Investment Bank.

Good afternoon, guys.

Hi, Holden.

The first question is we have seen some of your industrial peers, companies like Caterpillar put out some pretty detailed guesstimates for next year and talking about some deceleration. I think Parker Hannifin talking about a slower second half. Generally it seems like the machinery area, just companies are looking for some weaker conditions.

That would seem to fly a little bit in the face of you guys saying that it's steady as we go. Can you talk about sort of -- are they being cautious with the Street in telling you something or you are seeing something different from them? Why would we be seeing the difference in your field versus theirs?

Holden, this is Bill. In regards to Caterpillar, I think there are a couple of issues there. One is some advanced buying on truck engines because of the new federal regulations that are supposed to take place around January. I think they anticipate some drop-off in sales for that reason. I think that's one of their reasons maybe for having a little bet less optimism about 2007.

As we look at the landscape, we still see the vitality in our customers. The input I'm getting in the travels and from our sales group don't lead me to believe that the doom and gloom is there. Will it be as robust as the last couple years? No, we don't expect that. But we do see good opportunities for us. And in some cases we are taking some market share in certain segments like I mentioned in the primary metals.

Can you give a sense how much does mobile machinery represent of your total sales? Can you give us some ballpark on that?

I really can't. I don't have that off the top of my head. I would have -- I would not want to make a guess.

Because Cat, in particular, they also talked about seeing too much inventory for tractors and I think Parker Hannifin, which, of course, is a supplier directing one of the major sort of category you guys supply and they also talk about second half kind of slowing.

It' interesting that you mention Caterpillar because our business with Caterpillar is up.

Okay. Fair enough. And then you mentioned that the gross margin was down about 20 basis points. Obviously last year you had a -- you are coming up against a tough comp because last year you had some true ups to sell into the first quarter that better belonged in fiscal '05. Is that right?

That's correct.

Now these -- some of these -- the gross margin stuff you are referring to this quarter, is that also trueups that happened in Q1 that are better applied to '06? Or is this a different animal helping your gross margin here?

It's both, Holden. And there are some situations where we did have some trueups that related to purchases that were made by June 30, or before and also some that were related to this current quarter. Both of those situations occurred.

But nothing in order of magnitude to what you had last time around?

Well, the reason that the gross profit percentage was greater than our projected expectations from our last conference call was because of these additional supplier purchase incentive items that we had.

Right. I guess I'm wondering, if you had the same issue this Q1 as you had the last Q1 and numbers are apples to apples, then you could say that your margin actually slipped 20 basis points. But I guess I'm kind of wondering is if it's apples to apples or whether you just had a bigger sort of component last -- in Q1 last year that applied to the prior year than you have this year, does that make sense?

Yes. There is lots of components in coming up with the gross profit percentage. Lots of moving pieces, moving parts, so thing going up, things going down. The thing that stands out for us for this quarter is the increase above our guidance was the supplier purchasing incentives. Last quarter -- a year ago of the quarter, that was the big item as well that pushed it forward at that point in time. For the relative levels, I mean, it's nothing huge, differences between those relative levels.

And then I guess it sounds like you are looking for some additional prebuy, one reason your cash flow is so strong is that your inventories really didn't move sequentially much which is great. But does that say something about the lack of prebuy activity this year versus last which is going to impact us next year? Sounds like that's not the message.

We actively look to evaluate all inventory purchases to make them at the opportune times and when it's appropriate. So we will be making some inventory purchases we expect in the calendar fourth quarter so that at calendar year end inventories will be higher than what they are at September. We evaluate those every day.

But no sense if the opportunities are greater this year or lesser this year than they were last year?

No. No sense -- I wouldn't say there is any differences or changes.

The same timing on this, Holden. We make the fourth quarter purchases and we burn them off in the first and second quarter of next calendar year.

And then last thing I will jump in, why did the guidance range widen? You increased the guidance but you also widened the range?

We just -- that was just our best judgment at this point in time.

We were a little tighter than normal on the first guidance that we put out for you.

All right. Thanks, guys.

Sure.

We'll go next to Adam Uhlman with Cleveland Research.

Good afternoon.

Hello, Adam.

Great quarter.

Thank you.

Dave, at the beginning of the call you had mentioned that you had won some new contracts. I was wondering if I heard that right and could you dig into that a little bit? And also what you are seeing from your national account base?

Yes. We won some new contracts. We tend not to name names in this setting. But we have picked up some very nice national contracts. It will increase the percentage of business as they ramp up that we have in the national contract arena. That's always good news from the top line. It's always challenged the margins a little bit. We are going to have to work hard to make sure the gross margins continue to be where we want them to be. We feel like we have plans in place to do that.

Okay. Could you remind us how big your national accounts are now as a percent of the total?

Last I looked it was around 30%.

And then you had also mentioned that you were anticipating additional price increases from your suppliers. Could you talk a little bit about how the negotiations are going with them right now and kind of help ballpark the magnitude of those potential increases towards the back half.

I'm going to let Bill take that one.

Adam, we had a couple of the bearing companies announce price increases for January. We don't have enough details at this point in time to really know what the impact is. These are relatively new announcements so we are still gathering information. But it appears that we will have several in January.

Okay. And then the last question for you, Bill, could you talk about the daily sales growth that you saw as you progressed through the quarter? You had mentioned that sales were a little bit better than you had expected for the quarter. So could you comment on that and could you give any comments on what you are seeing here halfway into October?

Well, as far as the daily sales rate for last -- I'm looking up at this point in time. Well, it's -- we have seen an increase each month of the quarter as far as the sales per day. Little early for me to make any comments on this month. I think it would be premature. But we have seen an increase as far as the sales rate per day.

We are getting some increase from the two acquisitions that we didn't have in the same period last year.

And from a same store sales perspective, I mean, it's nothing dramatic.

Slightly.

So it's maybe up slightly as you progress throughout the quarter but still steady overall.

Yes.

Okay. Excellent. That's very helpful. Thanks.

Thank you.

We will go next to Matt Duncan with Stephens Investments.

Good afternoon, guys congrats on a great quarter. The first question I have here, kind of going back to the last question that Holden was asking, looking at the widening of the range of the EPS guidance. I just wanted to ask this, it looks like the top end of your range is the one that really went noticeably higher and that's where the widening occurred. Are you seeing some things out there that may be in your margins or in the marketplace that give you the confidence to raise that higher end more than that bottom end? Is that kind of relationship be the take away from here?

Matt, I think we, as we stated in the conference call and what we talked about here is that we feel when we look forward we feel confident with the vitality of the overall economy and with our opportunities there within that. And we feel that looking at the results that we have been -- we put forth in this first quarter and then projecting out for the next three quarters for the fiscal year that that's the appropriate range and -- because we kept the sales increased exactly the same on our guidance. We just increased the earnings quite a bit.

Sure. Thanks. On the operating margin side, Dave, maybe you could go into this, or Bill, even, can you go over some of the strategic initiatives that you feel like are really the most important ones that are driving your operating margin expansion?

It's the four cornerstones. It's growing the sales, it's controlling the costs, it's increasing the margins, and managing the assets. Nothing earth shattering. No rocket science to it. It's managing the fundamentals well on a daily basis.

There is really not any one or two things that are most important here? It's really just all across the board?

It is. It is across the board. We continue to watch every element of it. We pull the levers weekly. As we see the need and we have a lot of guys watching us. We don't claim to be brilliant in any one area. We do plan to have a good balanced attack and make this wheel rolling in a good fashion.

Okay, thanks. Bill, I missed a couple of your comments on your end markets that seem to be the strongest right now. Would you mind mentioning a few of those again?

Sure. Let me make sure that I get you exactly the ones that I mentioned as I'm going through. What I said was that they were 11SICs that we saw with strong double digit growth. The strong ones I assume is what you're interested in. Metal mining and coal mining are showing exceptional growth. We've also had strong growth in amusement services, primary metals, and I mentioned that was more market share gain than necessarily the industry itself. Or the FAC itself, electric and electronic equipment, petrochem, and heavy construction contractors. Those were our strongest.

Thanks. Then last question and I will jump back in the queue here. On the catalog initiatives I guess I'm just trying to get a feel for what that really could mean for you guys longer term. What are your quarterly catalog sales today and what do you think these initiatives can do to help grow those sales and maybe what do you expect or hope they will be in the future?

Well, catalog sales are running around 40 million, a little north of 40 million I believe it is.

Is that a year or a quarter?

Annual. I wish it were a quarter. But, no, it's annual. I think what we did with internal assessment was viewing how operating with two separate catalogs made sense. We had a lot of conversations with our customers that are telling us that they don't want to go two places to look for products. We also wanted to pull through the Applied brand a little stronger by using the Applied name. And we do believe adding products and increasing breadths of products covered in the catalog will be beneficial. We are targeting small and medium accounts with the catalog and we think that will be a big help to us.

Great, thanks.

You bet.

We will go next to Jeff Hammond with KeyBank Capital Markets.

Good afternoon.

Hi, Jeff.

Just wanted to close the loop on the rebate accrual. Would it be fair say that without that your gross margins would have approximated that target of 27%?

Yes. That would be a fair assumption. There is a lots of pluses and minuses here. So it's not the entire thing. That is the main reason for our increase over what our guidance of 27.0% was.

And then help me understand the timing of those. Are your customers starting to act a little bit differently in terms of the magnitude of rebates they are offering or--?

These are suppliers.

Yes, yes, I'm sorry, yes, your vendors.

What each program from each supplier is different. They can have different period ends. Some are monthly, some are quarterly, some are annually. And the annual programs some could end on our fiscal year end. Some on their fiscal year end or on the calendar year end. And so there is a smorgasbord of these programs.

I guess what I was asking is as the economy had been getting better, your rebate opportunities were diminishing. Is that -- if you look at fiscal '07 versus '06, do you see yourself having more rebate opportunities or less?

I would say it's about the same, Jeff. I was pondering that question and going back in my mind. I really don't think there is a markable difference between the two.

Okay. And then on your -- Dave, you mentioned these new national account wins. I just wanted to understand a little bit better. Are these wins versus some of your major competitors, are they people that previously used more regional and are going to a national account? And in your view what is really driving their decision as they look at the various alternatives?

Jeff, that's a little more information than I can share under the circumstances. We believe the reason that we are gaining this business is the value proposition we offer. I don't care to comment on where the business is coming from.

Okay. And then just finally on -- from an end market standpoint, where are you seeing the greatest deceleration or anecdotally, Bill, as you talk to your customers, where are you seeing the greatest caution?

Well, I think the no-brainer as I see is probably the segment of forest products which is where lumber resides. You have got to remember, though, that housing has been on steroids for a couple of years. The fact that it's getting back to where it probably makes more sense, there is still going to be opportunity there. But at the run rates particularly in some markets those run rates have really drastically been reduced. So I would say the lumber is, and wood products is probably going to be the one that will be -- let's say the near future that will be the one we will see. It may impact aggregate to some degree. But quite honestly, there is enough highway work and bridge work that they may offset the aggregate. It might not take quite the dive that some people have forecast.

Okay. And then maybe as you look at your free cash flow, maybe just give us an update on how the acquisition environment is looking, any material change from an appetite standpoint or valuation levels?

First of all, the opportunities are out there. Certainly today's M&A activity gets more competitive with the financial buyers that are sitting out there. So we are being cautious about this. The money is not burning a hole in our pocket. If we find the good opportunities, we certainly will go after them and the more strategic they are, certainly the more aggressive we will be. So I'd say there are opportunities out there right now. I'm not trying to bid up the market with regard to where the financial buyers are. And we are going to bide our time and make the acquisitions when we can. Again, we have other uses for our cash if we cannot make a good sound acquisition.

Okay, thanks, guys.

Thank you.

We'll go next to Fritz von Carp with Sage Asset management.

Good afternoon, gentlemen. Most of my questions have been answered. Let me just ask two, one of them you may have asked, but I missed it if you did. First of these end markets that are good and not so good and so forth, that you've been talking about, have any of those changed recently? Like any of the -- anything that you would have put in double digit category last quarter isn't there or vice versa? And then my second question is sort of how did things trend through the quarter? Did they get stronger, weaker or stay the same?

Fritz, this is Bill, I will try answer that. Actually, the double digit SICs that I mentioned were pretty strong last quarter as well.

Were there any that were strong last quarter that weren't in the double digit camp this quarter?

I don't believe so off the top of my head. But I don't really have that information right at my fingertips. But the majority of those that are strong this quarter were a continuation from last quarter.

And it's the same with the weak markets, nothing has gotten weaker or left the weak list?

Well, I would say that the housing has declined a little bit more.

In the trend through the quarter overall?

At this point in time I think it -- we'll continue to see those that we are strong in now, we have every reason to believe that they will continue to be strong. Don't see any major surprises on the horizon.

And was October all the trends of the third quarter carried into October so far?

Prefer to wait until we do the second quarter conference call to give you that information.

Thank you.

We will go next to Greg Halter with Great Lakes Review.

Good afternoon and thank you for taking the questions. Congratulations on the excellent results.

Thanks, Greg.

One question on your debt, I know you have some term debt, but would you pay that off early and under what circumstances, if so.

Greg, we have two debt issues that are outstanding. They are both bullet debt. And they both have early prepayment penalties, so to speak, that would make it financially unwise for us to pay them off early. We have the capabilities of doing so, but in essence, what we would have to do is pay all of the interest assuming they were still outstanding up front when we paid them off early. So we would prefer not to do that.

And one I believe is December '07, the other is November 10?

Yes. That's correct.

And second question is, do you have a forecast for what you think your capital spending will be for the year and what percentage of that would be maintenance?

Well, we do have a capital spending number. We talked about that in the last quarter's conference call. I believe we stated our projected CapEx expenditures will be in the 10 to $12 million range. And for us it's really no maintenance since we don't manufacture anything. The CapEx, most of that is computers. Probably about two-thirds to three-fourths of that is IT related items for our systems and there is really no maintenance items. Anything that is a maintenance thing obviously we would expense that.

Great. And I'm -- on the selling days, did you say there were 63 days, one less than the prior year's quarter?

That's correct.

Okay great, thank you.

We will go next to Andrea Sharkey with Sidoti and Company.

Most of my questions have been answered, so just two pretty quick ones. First, just to talk a little bit more about the gross margin. The past couple of years the gross margin declined sequentially in the second quarter. I was wondering if you could maybe refresh my memory on why that was? Is that related to pricing and if you expect that to happen again this year?

I don't recall off the top of my head, Andrea, about the prior year's second quarters for that, to speak to. I do think when we look at our projection going forward of 27% gross profit for the rest of the fiscal year that we will see some variability go in that as we go forward. But I don't really have the forecast broken down by quarter from GP percentage. But I think you will see some variability from the second, third, and fourth quarters.

And then to clarify with the 27% gross profit that you are projecting, is that for the full year or just on average for the next three quarters that would be a little bit higher for the full year because of the exceeding your expectations this quarter?

That 27% is for the next three quarters. Then you average that out with this first quarter it will be a little bit higher.

Great.

A whole 12 months.

And then the other question was, Bill, you were speaking about the government sales and how that seems to be finally starting to show some results. I was wondering if maybe you could just quantify that a little bit more for us. I know it's been -- I think the last time you mentioned about 1 million monthly rate, run rate, if that has increased much and if you could quantify that at all?

That's about the rate we were looking at. And that would be strictly government sales without any defense contractors added into it. Which is we also consider in many cases. We have seen large percentage increases, but we were starting from a small base. So I hate to use percentages because that really doesn't mean a lot in this particular case. I think the plans that we put together on strategies that we are using for the government sales are really getting us where we want to go. Probably have a little bit better conversation about it when we give you the next quarter results. Because we are into a large portion of the government's buy season so to speak and we will have better numbers to talk about next call.

And then I believe that -- in the past you had spoken about the possibility of maybe adding on more of a direct sales force that would be really more specified on the government sales. I was wondering if you had started to do that or if that was still on the table and we might maybe see an uptick in some of the SD&A expense just related to building that out more?

We have proceeded to do so. We have had some opportunity to bring some talented people with lots of experience in the government arena into our company. I don't think you will see a major impact from an SD&A standpoint. But we do expect to see an impact from the sales standpoint. The experience and the expertise that they bring is invaluable. We were very pleased at some of the associates or those people have joined us as associates I should say. Looks very good for us.

Great. Well, thank you very much.

Thank you.

We will go next to Brent Rakers with Morgan Keegan.

I guess, Bill, just to start -- to lead off with the question about the government business. I believe on earlier calls you had mentioned targeting 40 to 50 million in annualized revenue by '08, '09, are those still good targets and if they are would that include this chunk that you believe has readied these defense contractors?

It would include it and those are good numbers.

And then secondly, you refer to some bearing price increases possibly being, coming through in January. I guess first I would assume that that's steel related. And if not, correct me on that. And then I guess, more importantly, there was another price increase that was, I believe, scheduled for a mid year increase and that ended up fading away. Can you maybe assess what your confidence is that these price increases actually go through from your vendors?

Let me see if I can answer the questions. First of all, it is a materials related increase we are being told. all, it is a materials related increase we are being told. It is a combination of materials and labor, but mainly materials. I have 100% confidence that these increases will stick. As I mentioned earlier, it's early in the game as to what the impact is going to be on us at this point in time.

Bill, given your high degree of confidence in it occurring, have you blended that into the guidance numbers for the second half of this fiscal year? Or is it too small to really put in there at this point?

Brent, this is Mark. When we came up with our original overall sales guidance over the summer and when we talked about it in the conference call, we did have some based percentage of sales increases due to supplier price increases built in there. Obviously we didn't know what the relative levels were and we were putting forth our -- an estimate in there. We did have some numbers baked into that. So I think we are okay.

That's pretty consistent with what you were looking for previously, it sounds like?

Yes, and at this point in time I don't see any reasons to make any changes.

Fair enough. And then on to the guidance, I guess -- and I know you guys are no longer giving a quarter by quarter guidance, but I was hoping you could give us a sense, it sounds like with this trueup kind of issue on the rebate issue on the gross margin side, then that added $0.03 over maybe what you would have thought before and then you talk like the revenues were above what you thought. I just wanted to get a sense for how much of the guidance change relates to what happened in the first quarter versus how much relates to the next nine months of the year?

I think, Brent, when we look at our guidance, I mean, we don't quite break it down that way. We do expect as we go forward for the remaining quarters for the fiscal year to continue to see steps forward in our operating margin percentages. And quarter over quarter expectations. So we are looking -- we continue to look to see improvements for that. The thought process is that we are looking at the next three quarters keeping our sales guidance the same as what we've previously stated and we have raised the bottom line guidance for the EPS to that new range. Sure, a portion of that was related to first quarter, but I'm not necessarily going to quantify that because that's just not exactly how we look at it.

Fair enough. And then last question, and I guess kind of following on what Holden asked right out of the gate on the call, I know you guys focussed a lot on the MCU and I just wondered in light of your comments about the economy still being strong, how are you reconciling that with what capacity utilization has done maybe the last four, five, six months or so?

Brent, looking at -- looking at the chart right now, with -- that chart has basically been on an upward stream since April of 2003. It dropped a tad in September, but still a very strong 81.9 as we sit here looking at it. And that is still an expansion mode as far as we are concerned. We don't -- I'm not scared of the MCU as I see it right now at all.

Bill, did it get specific so much that you guys have a target in mind where you need or want that to be at the end of next year in order to hit the guidance numbers?

As far as the MCU?

Absolutely, yes.

No. We don't use that as a target. I think anything over 80 is good. But we don't specifically intertwine that into our forecasting.

Great. Thanks a lot, guys.

Thank you.

We have a follow-up from Jeff Hammond with KeyBank Capital Markets.

Hi, guys, can you guys give me the quarter end share count and what you'd expect from a share count standpoint for the full year?

Okay. The actual shares outstanding at quarter end -- I got to look that up real quick.

Maybe while you are looking at that, if you could just -- obviously the stocks moved up here, you have been fairly aggressive when the stock was under pressure buying back stock, does your view in terms of share repurchase change at all in light of the opportunities out there?

As we stated in the past, Jeff, we look at share buy-backs as an opportunistic situation and we are not looking necessarily to chase the stock price if the stock price is on an upward trend, we will generally not be purchasing as much in the marketplace at that time. We will be there on downward ticks looking at that from a floor perspective and looking at it opportunistically. We will not be buying just to buy on any given day. So that's how our philosophy is.

The numbered shares actually outstanding at September 30 are 43,650,000.

Okay, what are you thinking for the full year? Because it came down fairly substantially on a sequential basis, but as I look at fiscal '06, you bought back quite a bit of shares and the share count was more flattish.

Yes. We don't really know. And I think we are going to project it out as being flat at this point in time.

So if we use -- inherent in your guidance is what you put up for this quarter?

Yes.

Okay. Helpful. Thanks, guys.

Thanks, Jeff.

That does conclude today's question and answer session. And would like to turn the call back over to our speakers for any additional or closing remarks.

Thanks and thanks to all of you for listening today and for your interest in Applied and all the great questions you asked. We look forward to talking to you again with our second quarter results in January. Have a good day.

That does conclude today's conference call. Thank you for your participation. You may disconnect at this time.