Applied Industrial Technologies Inc (AIT) 2007 Q2 法說會逐字稿

Hello and welcome to the Applied Industrial Technologies second quarter 2007 financial earnings conference call. (OPERATOR INSTRUCTIONS). At the request of Applied Industrial Technologies, today's conference call is being recorded. If you should have any objections, you may disconnect at this time. I would like to introduce Mr. Rick Shaw, Applied's Vice President of Communications. Mr. Shaw, you may begin.

Thank you, Gwen, and good morning everyone. On behalf of Applied Industrial Technologies, thank you for joining us today. You should have already received our earnings news release that was issued earlier this morning. If you've not received it, you made retrieve it by visiting our Web site at applied.com. A replay of today's broadcast will be available for the next two weeks, and the 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, 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 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, and Bill Purser, President and Chief Operating Officer, who will discuss operational activities.

Here to get us started is Dave Pugh.

Thanks, Rick. It looks like a good group with us this morning, so let's just dive right in.

As you can see from this morning's earnings announcement, our sales for the quarter rose only 4%, which was certainly below our original expectations. We encountered an economic slowdown that occurred quite quickly for us, particularly in the United States. We had cautioned on a softening in the market, but we certainly didn't anticipate such a rapid decline. The economic tailwind that we had been enjoying diminished to a gentle breeze. And when we look back at how this happened, we were gauging our forecast on the rate of decline of our key economic indicators versus what we were doing (indiscernible) volumes. What we missed was the inventory build in key segments that took place over the second and third quarters.

For 2006, the PMI actually peaked in April at 57.3, and then it moved steadily down and actually crashed in November to 49.5. Capacity utilization peaked back in July (indiscernible) moved down more slowly over the second half. Manufacturing was a bit slow to respond to these changes, and we didn't feel the impact until the fourth calendar quarter, when inventory adjustments began.

Segments related to housing and transportation were most out of balance, and we've seen a big slowdown there. In addition, the warm winter has had a negative impact on energy-related sectors. There were some other segments that showed some nice growth. The excess inventory condition doesn't appear to be anywhere near as severe as what we saw in the fourth quarter of 2000. And we are optimistic that we are already through the worst of it. Indicators seem to be moving back up again; housing starts popped back up again this morning, I saw. But even with the recovery, we don't expect to see the markets approach the 2006 rate of growth.

From all discussions I've had across that industry, and there have been many, this quarter's slowdown was not unique to us. There was just an unsettled U.S. economy. And depending upon where your market segment strongholds were, some felt a greater impact than others. Bill is going to give you more details on the particulars a little bit later.

Now, on the very positive side, we were able to mitigate the earnings impact of this underperformance in sales growth with attention to detail in other areas, and thereby continue the earnings growth that you have come to expect from us.

A 21% earnings increase on only a 4% sales increase indicates continued improvement in productivity and efficiency. And we're happy about that. However, we would be a bit naive to expect to continue this level of earnings growth if sales don't recover somewhat. Mark is going to provide more details in our financial update.

During the quarter, we didn't feel the need to withdraw from any of our investment initiatives until we saw the full impact of the quarter. So, our SG&A growth rate was uncharacteristically higher than our sales rate. We're going to be making the necessary adjustments this quarter, and we are going to continue to fund our government growth plans, because we're very pleased with the progress we're seeing here. In fact, in that area, we were just presented the Excellence in Partnership award in recognition for being a top newcomer to this field. So, we're still very optimistic in that area.

While inventories followed their seasonal trend and went up, it was a very controlled increase and one for which we had planned, one that should be dissipated by the end of our fiscal year. Even with this inventory increase, our cash generation showed -- cash generation showed excellent improvement over the prior year period.

So, in summary, we were able to achieve an excellent bottom line for the quarter, despite a U.S. economy that presented a rather formidable challenge. That in itself is a good sign that we're still operating well.

Here's Mark to give you more of the financial details.

Thanks, Dave. Good morning, everyone. Let me provide some additional insight for our second-quarter financial performance.

Sales for the second quarter ended at $472.4 million. This represents a 3.6% improvement over last year's second quarter. We had 61 selling days this quarter, which was the same as last year.

Total United States service center and fluid power operations sale for the quarter were up 2.6%. We estimate that approximately 1 percentage point 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 10.6% in the quarter, of which a little less than half relates 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 and pricing. Our Mexican and Puerto Rican operations had a combined sales increase of 9.7%. All in all, we did see continued growth across the board.

During the quarter, our number of operating facilities was stable at 451 locations. Our product mix during the quarter was 19% fluid power products and 81% industrial products. Our gross profit percentage for the quarter was 27.6%, about 100 basis points higher than last year's second quarter, and 20 basis points ahead of the first quarter. This is quite an accomplishment given the shortfall in sales.

The gross profit percentage is above our previously projected rate of 27.0%. This increase from our expectations is primarily due to improved margins on customer pricing and additional supplier purchasing incentives. Our expectations for the go-forward gross profit run rate remain at approximately 27% for the remainder of the fiscal year.

Our selling, distribution and administrative expenses as a percent of sales was 21.4% for the quarter. This rate is slightly higher than what we had been experiencing. The absolute dollar increase in SD&A dollars for the quarter was 5.2%, compared to a sales increase of 3.5%. This increase primarily relates to SD&A expenses from the acquisition of Minnesota Bearing Company, as well as additional compensation and increased benefit costs.

Our second quarter (technical difficulty) margin increased to 6.1%, compared to 5.5% in the prior year's second quarter. This achievement continues our upward trend in operating margins. This improvement was primarily driven by our increase in the gross profit margin during the quarter.

Our effective tax rate for the quarter was 36.1%. For the remaining two 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 $436.9 million for the quarter and a current ratio of 2.6 to 1. During the quarter, we did reclassify from long-term to current the $50 million of debt that matures on December 9, 2007, as our plans are not to refinance this debt, but to pay it off with cash.

Our year-to-date pre-tax return on assets rose to 17%, compared to 14.9% for the prior-year period. Inventory levels increased as anticipated in the quarter, but are projected to return by our June year-end close to prior-year levels. Accounts receivable and days sales outstanding at 42 days remain competitive, but with room for improvement.

Year-to-date cash provided from operations was a solid $3.9 million, an improvement of $23 million from the comparable period a year ago. This improvement relates to improved operating results, a decreased level of inventory purchases through the calendar year end, and a reduction in receivables levels compared to prior periods.

By our news release this morning, you will note that we have tightened our sales and earnings guidance for the full year ending June 30, 2007, because of the slowing U.S. economy, which lessened the demand for the products we sell. Going into this second quarter, we had expected sales for the year of $2.03 billion to $2.09 billion, which we now believe will be in the range from $2.01 billion to $2.04 billion. As a result, we are also narrowing our earnings per share guidance to a range of $1.80 to $1.85, which is within the range of our previous earnings per share guidance of $1.80 to $1.90.

Now, Bill Purser will comment on sales and operations.

Thanks, Mark. Good morning, everyone. It's a pleasure to be with you as we present the results from a solid second quarter.

As you've already heard, sales during the quarter were softer than we expected. But we are pleased that our continued focus on enhancing margins, managing assets and controlling costs enabled us to increase operating margins despite the lower sales. Our associates worked hard to deliver the numbers, and deliver they did.

Looking at the various industries we sell, we saw more divergence than usual among the various segments, reflecting, we believe, a similar divergence in the overall North American economy.

As an overview, eight SICs saw strong double-digit growth during the quarter, while five others saw some level of moderating growth compared to the trailing quarter. Heavy construction contractors showed an impressive gain, building on the prior quarter's double-digit growth. Metal mining, coal mining and [amusement] services continued to show strong growth as well.

I need to have a caveat here, though, because metal mining and coal mining, even though they were strong, there is a definite trend downward from last quarter. And we saw a rather significant drop in the month of December in both those two SICs.

Electric and electronic equipment, primary metals and miscellaneous manufacturing also showed some impressive gains. Our gains in primary metals were basically gains in market share.

Several other industries were up slightly. These include fabricated metal products, food and kindred products, transportation equipment, industrial machinery and equipment, and printing and publishing. In regards to transportation equipment, the slight uptick was driven more by aerospace than aircraft, because the automotive segment of transportation equipment was down double digits.

Lumber and wood products, as you might expect, continue to slow. In fact, they showed the largest dollar volume decline of the quarter. Also, industries associated with aggregate production were down. We, obviously, think that that's likely in response to the slower housing construction.

Utilities and petroleum and coal products both declined after four consecutive quarterly gains. We feel this is a sign of the mild weather over the past several months and the lower demand on energy resources. The largest declines that we experienced were in trucking and warehousing and business services, but these are small SICs in terms of sales.

During the quarter we continued to make significant strides with our government sales efforts. We are now tracking quarterly sales as a separate line item. Quarterly sales in this sector showed our largest quarterly gain percentage-wise, although again, this is from a relatively small base.

As Dave mentioned, we are proud that we received the Most Successful Newcomer award as part of the Excellence in Partnership awards program, which is sponsored by the Coalition for Government Procurement in conjunction with the General Services Administration.

In January, we launched a redesigned e-commerce site, www.applied.com, which now provides an open buying environment. For the first time, our Web site, which features rich information content on over 500,000 items, is available to all buyers with credit card ordering capability. We view this new capability as a valuable tool to 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 and electronic data interchange, now exceed 35 million per quarter.

As I mentioned in our last teleconference, we've completed an assessment of our catalog effort. In January, we issued a new 100-page supplemental catalog and distributed it to over 100,000 targeted customers. By July 1st, we will have merged our two catalogs, Maintenance America and the Fluid Power Connection, 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. This comprehensive catalog will now include information on over 38,000 products. These moves will have an added benefit of putting new catalog distribution in sync with the beginning of our business year, and this is a schedule that we intend to keep as we go forward.

In December we announced the expansion of sales efforts for 3M's industrial MRO products in the United States. We now offer more than 15,000 3M products, including abrasives, adhesives, cleaners, lubricants, tapes, wire connectors, matting, safety and facility care products. This full line is being integrated into our print and online catalogs. These products are a great fit for us and represent a product mix that our customers have been asking for.

Our Spencer Fluid Power and Minnesota Bearing acquisitions 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 of which contributed to this quarter's success.

In general, most of the markets we serve continue to show growth, although at a slower rate than earlier in our business year. And as indicated in our press release, we feel we are on track to hit total sales of the year of 2.01 billion to 2.04 billion. Our conversations with customers, as well as economists, tend to support these numbers. I believe many of our customers are in a strong cash position as a result of good business performance. I just don't believe that they will be using all of it to buy back stock and increase dividends. I feel that many will invest in new machinery and capital projects. All in all, we're looking for some business improvement over the next two quarters.

I'm going to turn the call back over to Dave for some closing comments.

Thanks, Bill. Two quarters under our belt -- the first one [in] was a fairly nice economy; the second one, a little blow to the chin. But we've shown we were nimble enough to take advantage of the (indiscernible) shifts in the industry by continuing to focus on basic operating fundamentals. We've delivered record earnings results in both quarters.

The next six months are going to be tough to predict. We're approaching them cautiously. We are going to remain alert. We're going to continue to execute what, we think, is a well-balanced strategy. We're going to execute it with an experienced and committed team of managers and associates.

We have had solid, sustained progress in those things which we do control, and we all believe there's more to come. We also feel there are still some inventory adjustments to come in our key market segments. So, with a true spirit of openness, I don't believe we are going to make up all of the topline softness of this past quarter. Accordingly, we have lowered the range of guidance and sales, and we've narrowed the range of earnings for the year.

I want to thank you all for your interest in us. Thank you for being with us this morning, and we will be more than happy to answer your questions. Operator, will you jump in please?

(OPERATOR INSTRUCTIONS). Matt Duncan, Stephens Inc.

First question here, can you give us a sense of what your business trends were like sort of on a month-to-month basis throughout the quarter? Did you see business weakening or strengthening, or was it about the same the whole quarter?

What we saw was the about -- I'm going to say mid-October-ish we started seeing the decline in business, October, and then it continued into November and December. There were some upticks on some indicators in the month of December, but we didn't see really any rebound in December. Again, several other indicators did show an uptick. But the business decline and the trend began about mid-October.

I guess given where customer cash levels are, inventories are, the indicators ticked up in December, did you expect, then, business to strengthen a little bit in the March and June quarters because of that?

We do believe that we'll see strength in the third and fourth quarter. It's not going to be like last year, but we do see some strength opportunities. Again, depending about how some of these industries respond, to my point that I made, there is cash in quite a few of our customers, and we are anxious to see what they're going to do with it.

There is still some excess inventory to be adjusted in the housing-related field and the automotive field. So, that's going to be a little bit of an issue as we go through this next quarter. They did say that the housing starts were up this morning. That's a very positive sign. So, we will be encountering the impacts of that adjustment as we continue through this next quarter.

Sure. Dave, remind us, as a percent of total revenue, what housing and automotive would represent for you guys.

The total transportation business is still around 4%. That includes the aircraft piece, too. But the majority of that is automotive. There's not one housing industry; there's a number of housing -- aggregates is affected by that; the lumber products is affected by that. So, there's not one thing impacted by housing.

Sure. I guess I'm just trying to get a feel and understand that, obviously, it's parts of many different segments. I'm trying to get a sense if you guys have a feel for just how much of total revenue it may be impacting.

We tried to reflect that in our change in guidance for the full-year sales. You can do your calculation from there.

Sure. On the SD&A line, as a percent of sales, obviously, there was a pretty decent tick-up there, and it was up year-over-year as well. Do you guys feel like now that you have a better feel for what's happening with the economy, you can manage that going forward and get those sales -- those expenses down as a percent of revenue going forward?

We will continue to make some moves there, but we told you going into this year that we were going to be investing for the future. There's still some things in there we want to continue to invest in for the future. We will (indiscernible) some of the discretionary spending. A lot of the strategic spending, we feel, is still solid and futuristic for us. I guess -- heading into the quarter, we didn't feel the need to be tightening the purse strings, because what we were viewing at that time was still very positive. So, we're going to be making the moves, just like you've seen us do in the past; not a knee-jerk reaction, but we will certainly -- (indiscernible) a bit.

Fair enough. On pricing, Mark, I missed your comment on how much pricing impacted the quarter. Just real quick, how much was that? And then going forward, are you guys expecting pricing increases from any of your suppliers over the next six months?

The impact on our sales was a little under 1%. So, we basically said about 1% was the impact for that. And on a go-forward basis, we don't really expect to have a big push forward from supplier price increases. There was another round of increases that happened right around calendar year end. We don't expect that to give a big push, so we're not expecting much change in the run rates that we've been seeing the last couple of quarters, which is around 1 to maybe 2 percentage points at the most of an impact of supplier price increases on sales.

Last question and I'll jump back in. The interest and other expense line and income line was sharply different sequentially. You actually had income on that line rather than sort of the $500,000 to $600,000 expense that we have been seeing. Is that something that should carry forward, and what caused that in the quarter?

That line has a conglomeration of a couple of things in it. Some of that is the impact of foreign currency. Some of that is the impact of the various deferred compensation plans, for which there are assets that we revalue the assets on a mark-to-market basis that are down there. So, that line is really what I view as not necessarily trendable. And when we look at those lines on a go-forward basis, we basically project out almost zero, because we don't really know if it's going to be positive or negative at any one time.

Andrea Sharkey, Sidoti & Co.

Just a couple of questions. I guess on the gross margin line, Mark, you talked about it was better than expectations, but you still expect it to be in the 27% range. I'm just kind of curious as to why you wouldn't see it kind of staying up in the higher range where it is. I think one of the comments had been that suppliers had given some better rebates, and, I guess, why you expect that won't continue.

We're forecasting some supplier incentives going forward to be slightly lower than what we actually realized in the December quarter, based upon our projections for that. And the supplier incentives don't necessarily happen ratably throughout the years, or throughout the year, but they do come in some fits and spurts at periodic times. We expect them to be comparable on a dollar basis from prior-year numbers in those same quarters. But that would still potentially have a smaller impact on the gross profit percentage with the sales going up.

That's fair enough. I guess just to follow-on to that, do you think that maybe you're seeing some better supplier rebates in the past couple of quarters because maybe your suppliers are trying to push some inventory out the door? Do you think that they're maybe getting backed up on inventory? Do you have any sense from their perspective?

I don't really feel that that's the case, quite honestly. In some of our [keyer] suppliers, there's actually been some concern about shortages in certain product lines. But I don't really think that is the case.

Great. And then, I guess, another question that I was thinking -- if we're seeing a little bit more of a slower economic environment, have you guys seen -- it might be too early to see it yet -- a decline in maybe multiples for acquisition targets? And maybe in that environment, do you think you might be a little bit more aggressive in seeking out additional acquisitions?

I haven't seen that at this point, and we're certainly active in that field. And hopefully what you are anticipating will happen. We do intend to stay in that arena. But right now, I can't say that we have anything substantial that we could tell you as far as seeing anything go down.

I guess just one last quick thing. Bill, you were talking about government sales and how you're breaking them out quarterly now. Could you give us a sense of what that quarterly number was for this quarter?

Let me give you the run rate. I think I earlier told you we were running maybe around, I'd say, 1 million a quarter -- 1 million a month, and we're bumping about 2 right now. That includes -- that's federal, state, local and defense contractors.

The key thing there for me is every month we are seeing very high double-digit growth over prior year. So, we are continuing to see the growth on a sequential basis. I'm very happy about that. We're still in a period where we're gaining awareness. So, I don't think we have actually hit the absolute upturn on this thing, but we're making very good progress in line with our expectations when we put our five-year plan in place.

Lastly, on the e-commerce, you said that exceeded 35 million a quarter. I don't know, maybe refresh my memory what it was last quarter and maybe this time last year, just to get a sense.

That's up slightly. It's still single digits as far as growth. We think this open site, as I mentioned, is going to speed up the process, and we'll see more orders coming through in that fashion. But it's too early to tell. The site just went live a couple weeks ago, so we're still waiting to see the results.

Holden Lewis, BB&T.

Just to (indiscernible). Can you comment -- you commented on trends during the quarter. Can you comment on what you've seen sort of January to date?

We're taking a little step out of character, but normally we're pretty tight-lipped on that. But it's following the trends of what we saw last quarter. So, we have not seen a sharp uptick, but it hasn't gone down. So it's very similar to what we saw over the fourth quarter. And that's one of the few times we will step out of character and become un-tight-lipped. But that's ones that we thought you should know.

The quarter sort of got worse, didn't it, as the quarter went on? So, is it looking more like December, where it's getting worse, or it's just kind of holding in at December's levels?

November and December were fairly similar, and we're holding in at about those levels.

November December -- got it. Now, in terms of the gross margin, when you talk about incentives, rebates, that sort of thing, doesn't the accounting (indiscernible) kind of make it a forecast, and then for the year, based on expectations, then you run it through the year? So, if you're expecting lower incentives going forward, wouldn't that have necessitated sort of a true-up this quarter, which actually should have hurt the margin?

Actually, for the rebate accounting, it is all driven based upon your purchases that you're making from the suppliers, and based upon the programs that you have in place with those suppliers. So, it all depends upon a mix of your purchases, your inventory levels and your sales of -- what you're having. So, the forecast that we have for the third and the fourth quarters for rebates is not necessarily -- that's for transactions that will happen in the third and the fourth quarter.

These are never synchronized, Holden. We work with our purchasing group and our product managers very clearly to understand what's coming in, when and where with regard to the rebates. And when we plug it in, just like that, it does not line up to sales all the time.

I understand that. But presumably, you're not anticipating your terms getting worse, so your purchasing behavior probably slows down along with your sales trends, which means if you're purchasing less, you get less incentive -- I just would have thought -- it's a very good gross margin in the quarter. I would have thought if you're anticipating lower incentives than you thought at the beginning of the year, that you would have had to true up and maybe take some negative to adjust to the new expectations. And it doesn't look like that's in there.

We always true everything up at every quarter end based upon expectations. There is nothing in the third and the fourth quarters that, we believe, will negatively impact our first and second quarter rebates and what we've recorded so far in those periods.

Fair enough. Also, I guess you were reasonably quiet on the share repurchase this past quarter. Any -- it's the first time in a long time you haven't bought a single share. Any comments as to what was different this time?

We just look at the market from an opportunistic point of view. We look at the situations. And we still have an active program that's out there, and we're going to look forward as to the third and fourth quarters about seeing whether or not we'll be jumping in the market at those points in time. So, we continually look at that.

Brent Rakers, Morgan Keegan.

I guess first, Mark, to your comments about the price inflation you expect to see going forward -- I know there were some bearing guys that pushed through some price increases through January. My understanding was that those were sticking at more to the 4 to 5% kind of number. I guess, if you can elaborate on that.

Let me talk briefly about the -- when the manufacturers generally have an increase, and they say, let's just take for example, your 4% number there, and they make that their announced price increase -- when we figure out the impact on us for the specific products of theirs that we are selling, and the weighted average impact based upon individual line items, we traditionally find that the impact to us is about half of the rate of their stated increase percentages. And we don't expect that necessarily to change. So, the thought process that we had with some of the suppliers that had increases, whether -- at December 31st, whether it was 3% or 5%, we generally try to factor in our projections about one-half of that rate when we go forward.

Mark, just to elaborate a bit on that, so you're assuming both that the announced price increase will actually be reflected at about half of that, and then also, though, there's -- I assume that's not your entire mix of products that are affected by that price increase. Is that also correct?

That's correct. And it's not to say that those manufacturers' increases aren't sticking; we're just saying that within their increases, they have very different increases by individual products. So, some products have much smaller increases and some have larger; they're just giving you the weighted average of the increases, and then what we see is that the impact to us for the products that we're actually selling is for the product that had the lower percentage increases.

It's as if you bought one of each of their products, and that would be the average, weighted average of the price increase. And as Mark said, the product mix, you don't buy it that way.

Fair enough. And then, Bill, you talked about the government now running at a pace of about $2 million a month now. If I recall, again, in the past, you've referred to this target of a $40 million to $50 million run rate by '08, '09. It would look to suggest that the ramp you're getting -- do you want to up that target possibly at this point? Are you still shooting at the same level there?

I don't want to, but our chairman keeps upping it on me. I'd like to see some of these other programs that we have in place take hold a little bit before we want to change that. I certainly like where we are today. This is one of the areas where, to Dave's point, we've made investments a little bit ahead of the curve. We'll continue to do so. I would say it would be reasonable that we probably would want to up that goal.

Fair enough. Just a couple more comments on the monthly data within the quarter. Just wondered if there was anything unusual about sales patterns possibly. I've heard about slowdowns between the holiday, between the Christmas/New Year's period. And then I also wanted you -- if you could comment on any plant shutdowns that possibly helped sales, what plants were shutdowns, or anything like that.

Nothing jumps out at me. I was thinking as you were making the comments that we did have within the auto industry several lines that were closed, shut down. Those, for sure. There are -- within the lumber industry sawmills were closed, especially during the holidays. Now, in the Northwest that was a combination of weather and holidays. But those are the ones that jump to mind that actually I could put my finger on that were closed, shut down.

Bill, (indiscernible) when an event like that happens, do you see deferred maintenance schedules kind of pick up pretty good with you guys when something like that happens? Or is that basically in terms of -- come actually -- come -- subtract from your revenues?

You catch up the day before the end of the world, I guess. But really, when you think about it, if they're down for any period of time and then they fire back up, normally there is that deferred maintenance that you're talking about. But whether it would make up in the period of time of this business year, that's going to be a tough one to call. We're just going to have to see how it goes in the next two quarters.

To your question -- what happened between Christmas and New Year's, I don't think we saw any decline that was abnormal. That's always a down time. But what we saw for the slow growth across December was pretty straight lined across the month.

Also a follow-up, Dave, on your -- your break from normal trending, and commenting on the January trends. Does that lead me to believe, then, that volumes -- if I kind of compute the volume growth in the quarter, it looks like 3/4 to 1 percentage point of volume growth in the quarter, outside of acquisitions. Is that kind of the volume growth trend we're experiencing thus far first couple weeks of January?

We don't comment on quarters anymore. Just take a look at -- I think we're going to be comfortable just talking about the second half of the year, which would be reflected in our guidance. And I did -- the only reason I stepped out of character this time is because what happened to us in this past quarter, versus the tone we had in our last teleconference, certainly didn't want you to feel like we were trying to surprise you with anything. And we want to make sure our credibility is still strong with you guys.

Let me, I guess, wrap up. I have just one more question again. Back on the gross margin, just trying to maybe understand a different way -- you, obviously, had the gross margin uplift in the first fiscal quarter of the year, and now again in the second quarter. Can you maybe characterize how much of this was -- and again, unusual is obviously not the right term -- but maybe not directly tied to trends in the second quarter, but maybe tied to trends in earlier quarters? And how much is kind of structural improvement, if you will, in your business?

That's really hard to try to quantify there. We were just very happy with the accomplishments that we were able to do in the gross margins. But as we go forward, like we're stating in our guidance, we're expecting in the third and the fourth quarters a small step backwards potentially in the gross profit percentage rates.

And you've seen every time we have price increases, it takes us a little time to get the full thing through. So there's -- every time there are announced price increases, we take a temporary impact on that (multiple speakers)

So, Dave, what you're implying by that is that's probably the typical six-month effect. And obviously you're not willing to, but if you look forward to fiscal '08, as you recover the full effect of that, you might have higher gross margin, or modestly higher gross margin guidance for '08.

Without giving guidance, that would be a realistic expectation.

Andrew DeAngelis, KeyBanc Capital Markets.

Just wanted to understand better, within the revised guidance that you provided, the margin, the operating margin implied by that revised guidance. Were there any changes there?

We don't really comment specifically on that from the operating margin perspective. As we talked about for the various items that we're going to be working on going forward the rest of the year, we are obviously working really hard for sales increases, we're going to work hard for the gross profit percentage, and we're going to work hard, like Dave mentioned, about SD&A costs, to make sure we can continue our trends that control those costs in a good way. So, we're still going forward with our bottom-line earnings per share guidance for the rest of the year, basically within the guidance range that we had previously. So, we're just trying to fine-tune it.

And then, in terms of the strategic growth spend that you guys have been talking about for a while now, it sounds like maybe at abnormally high levels. Just trying to understand kind of when that begins to tail off to. I understand you guys are always making strategic growth investments, but maybe to a more normal level.

That holds questions that I can't answer until we get through our next strategic planning cycle and see what the opportunities are. And we're just heading into that. So, we will know better by the end of this next quarter with regard to what we're going to be doing for fiscal 2008. Until we go through a strategic planning cycle, I'm not sure exactly what level of strategic spending we're willing to go to.

Adam Uhlman, Cleveland Research.

Mark, what was the -- your organic sales growth for the quarter, excluding the benefit that you got from acquisitions? I guess another way to look at it -- what was the same-store sales growth?

We don't really break out that information, Adam. I mean, if you go back and look historically, when we do an acquisition we will disclose the rate -- the annual rate of sales they have at that point in time. Really the acquisition that's in play right now is the Minnesota Bearing acquisition we did in March of '06. And at that point in time, we stated that the annual run rate for sales was around $36 million a year. So, you can utilize that to try to come up with an estimate based upon your model.

It would seem, then, that sales in the U.S. would be -- for the quarter were down then, excluding the benefit from that acquisition. Is that a fair statement?

No. We don't show them being down.

Because going forward, your guidance implies that the second-half sales growth is going to recover to 4 to 7% growth. And so far here in the third quarter, sales growth is still kind of sluggish at that same pace that we saw in the second quarter. So, could you talk about -- a little bit more about where you expect the recovery to come through, or what industries had the abnormal inventory build that might be turning around right now?

I think Dave made some comments -- the automotive is, obviously, one sector where there is excessive inventory. Depending upon what happens in the housing markets, the commercial side of building is pretty strong right now. Have we bottomed out with the downturn in homebuilding? That's the question. If that is the case, then we would probably look for some rebound in the lumber and wood products group. Again, some of the energy industries are weather related. We've seen downturns, and we relate that to the mild weather. So, if winter returns, which it seems to have in Cleveland, then maybe we'll see some upticks there. The quickness of the downturn, I think, was what really caught us more by surprise than necessarily the individual SICs themselves.

What SIC was -- or a handful of them was the biggest surprise of the downturn versus your plan?

We anticipated the lumber and wood, but I think they went a little bit quicker than we thought. I mean, it was not as if it happened overnight. We were all being warned. There was lots of publicity about what was going on. But it reminded me somewhat of what happened in the oil patch in '83; it was a very quick downturn and caught us a bit by surprise.

Just relate this back a little bit. Again, go back to the PMI and the way that went down from April on, and manufacturing was slow to respond. We may have been lulled into a false sense of security with the rate of sales we had back then. And so, when you looked ahead with regard to decreases in the PMI to that current sales rate, it didn't look to be as bad as it what it turned out to be. The issue was that the current sales rate probably should have been a little lower than what it was the last quarter. There was some buildup there as inventories built. And so, we went through a correction in the fourth quarter. Hopefully a lot of that correction got through in the fourth quarter. And again, if the housing comes back up, I think, it's going to help us quite a bit.

Still, some segments were very good. The persistent product segments such as food and beverage stayed up there very nicely for us. So, it's not a fall-off-the-end-of-the-Earth type of a situation here, where all segments went down at one time like we experienced back in the last recession. So we've got some things that are still sustaining us in just a couple areas. If it comes back, we should be in pretty fair shape.

Thanks, Dave. That's helpful. The last question from me here is, circling back to this growth investment topic for the year, if AIT had planned on spending x amount of dollars for fiscal 2007, do you think that you're halfway through that spend at this point halfway through the year? Or are you below average right now, or have you spent more? Was the front half of the year more front-end loaded?

I haven't even looked at it that way, Adam. I know we had committed to spending some things on markets that we feel very certain are going to pay off for us in the future. And we have said regardless of what the marketplace did this year, we're going to spend that money, because it is true investment for areas that we truly believe in. So, we haven't tried to time that out. We've let the guys who are running those initiatives spend the money. They know they've had it. I can't say whether they're on a 50/50 spend level now or if they've spent a third versus two-thirds. Don't know the answer to that one as we sit here.

It seems as if you have most of that behind you now, with the revamped Web site up and running and the supplemental catalog mailed, and a lot of the headcount added to support the government initiatives and your other growth initiatives. Is that --

There's still a lot of awareness out there in the government area that we want in establishing our beachheads and that sort of thing. So, as I said, I'm not holding those guys back at all.

Holden Lewis, BB&T.

I guess related to the SD&A question, your guidance in the past has been that initially you would want to limit your SD&A growth to half of revenue growth; then this year, because you're making investments, it would be less than revenue growth. But it's really not at the half level (indiscernible) delivered up to this quarter. Given the slowdown that we're seeing in revenues, do we sort of throw that relationship out the window, or do you think that you can ratchet back the discretionary spend enough to reestablish that sort of relationship in Q3 and beyond?

We'll probably answer that better in a few more weeks. But let me tell you, we are [giving that a strong look]. I think we've shown you in the past our ability to control that properly. Finding out how far we want to draw that back is something that's in planning stages right now. But you can expect it to come under better control than when you saw -- what you saw this last quarter.

Just so I understand, you guys actually kind of feel that underlying demand for the industrial cycle is decent, it's just that there's some inventory to work through. Is that sort of what you're saying?

That's what we saw as the major reason for the rapidity of decline in the fourth quarter. The market has softened from what it was 12 months ago in total, and we said that going into the fourth quarter. We were -- I just don't think the underlying market fundamentals support the rapid decline that we saw in the fourth quarter. I think the overall market is a little bit better than that. But it's certainly not where it was a year ago.

And then, I guess, lastly, if you can comment on the seasonality of the earnings stream. And I ask because, typically, you'll see a pretty good step up in Q3 and Q4 at the bottom line. Sort of the guidance you're giving now might even suggest that Q3 might come in below the Q1 earnings level. And you haven't typically seen that except in bona fide recession-type environments, which is not what you think we have here. So, I guess I'm a little bit surprised at sort of how you're forecasting the seasonality, given your macro outlook.

We had 11% sales growth in our first quarter, and we don't expect to see 11% sales growth, certainly not in our projections to you. So, I think the topline impact on a quarter-over-quarter growth is going to impact the seasonality you've been seeing. If we had straight-line sales growth throughout the year, yes; the seasonality would probably have stayed there. But you're going to see some impact. We're not having that straight-line sales growth throughout this fiscal year.

There are no further questions at this time. I'd like to turn the conference back over to you for any additional or closing remarks.

Let me and end it up this time instead of Rick, because -- appreciate the questions, appreciate you sticking with us. We hate to come in with a quarter that's significantly different from what we had led you to believe heading into it, but this one did surprise us a little bit on the topline. I tried to explain why it surprised us a little bit, and we certainly want to recover our credibility with you. It's going to be a challenge over the next six months. We think we're up to the challenge. And we expect to continue to present earnings that are reflective of a company that is continuing to improve its operating fundamentals. So, thanks for being with us; looking forward to talking to you again in about three months.

Thanks, everyone. That concludes today's conference. You may now disconnect.