Applied Industrial Technologies Inc (AIT) 2011 Q2 法說會逐字稿

Welcome to the fiscal 2011 second quarter earnings call for Applied Industrial Technologies.

My name is Kim and I will be your Operator for today's call.

At this time, all participants are in a listen-only mode.

Later, we will conduct a question-and-answer session.

Please note that this conference is being recorded.

I will now turn the call over to Richard Shaw, Applied's Vice President of Communications.

Mr.

Shaw, you may begin.

Thank you, Kim, and good morning, everyone.

On behalf of Applied Industrial Technologies, I would like to express our appreciation for you taking the time from your busy morning to join our fiscal 2011 second quarter investor conference call.

Our Earnings Release was issued this morning before the market opened.

If you've not received it you can retrieve it at our web site, applied.com.

A replay of today's broadcast will be available for the next two weeks, and the archive information is contained in the press release itself.

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 considered forward-looking.

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 also with other filings made with the SEC.

Accordingly, actual results may differ materially from those expressed in the forward-looking statements.

In compliance with SEC Regulation FD, this Webcast is being made available to the media and the general public, as well as to analysts and investors.

Because the Webcast is open to all constituents, and prior notification has been widely and unselectively disseminated, all content of the call will be considered fully disclosed.

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

You will also here from Ben Mondics our President and Chief Operating Officer who will discuss operational activities, and Mark Eisele, Vice President and Chief Financial Officer, who will discuss our financial performance in detail.

Here to start us off is David Pugh.

Thanks, Rick.

I have to say that these last six months are sure a lot more gratifying than the previous 24.

I'm pleased to share that the second quarter showed a strong 18.7% in sales growth.

Even more importantly, we improved the net income for the quarter by 102% compared to last year.

So I particularly like the quality of our earnings.

The impact of our restructuring over the past two years and our legacy focus on quality have allowed us to generate good returns as the market recovers.

We continue to believe that if we properly stress excellence, all else will follow.

We continue to run the Company conservatively, as I've always believed to be appropriate in an industry where sustainable change moves at a glacial pace.

We will continue to be investing where we believe that we'll see a good return and we expect to deliver very efficient return on solid sales gains.

While we're pleased with the double-digit growth for the quarter, we're far from euphoric or complacent at this point because it was achieved in a spirit of transparency against a relatively weak comparable.

If you remember, last year we were just beginning to emerge from the depths of recession.

So we still have a ways to go before we're all the way back to the pre-recession levels but we're definitely moving in the right direction and we are hitting on all eight cylinders right now.

Our operations in Canada, Mexico, and Puerto Rico had an exceptional quarter.

And as noted in our press release, our Fluid Power business continues to be a great contributor to our success.

As the largest fluid power distributor in North America, I'm very confident that the superior expertise and customization that we have to offer are a great fit for high demand automation and machine-controlled applications.

If you'll remember, back in August of 2008, it was right before the recession hit, we completed the acquisition of Fluid Power Resources, doubling the size of our Fluid Power network.

And while that timing wasn't great, we expressed our faith in FPR as a high caliber team of strong, well-performing companies and they've lived up to being just that.

As we expected, Fluid Power Resources has strengthened our presence in the distributional fluid power products.

Today our fluid power product sales account for 28.6% of our total sales.

Their expertise has increased our capabilities in the area of fluid power integration and numerous assembly processes, giving us capabilities to provide solutions and value which we didn't have before.

So we look forward to continued success in our Fluid Power business segment.

Our focus on cost control and efficiency throughout the operation helped us achieve an operating margin of 6.2%, up from 4.2% last year.

So this is a further demonstration that we are efficiently managing our business as the pace of the economy picks up.

And it bodes well for future strong earnings results.

Process quality is just one example of how operational excellence guides every aspect of our business.

Our pursuit for quality and organizational efficiency can be seen in the diligent efforts of every one of our associates.

And one of the key metrics that we use to track our progress in this area is our customer credits as a percent of sales.

This is a focus for us, and we are currently at an all-time low, so I'm very pleased at one of our key quality metrics.

In addition to the normal operating results, we paid off the remainder of our existing debt during the quarter, as we promised during our last teleconference.

So we feel our debt-free status further improves our capacity to grow the business.

I'm confident that our balance sheet is well-positioned at the fiscal year halfway point and we're delivering results which will continue to reward our shareholders.

We are continuing to see sequential sales growth on a month over month basis and that's good news.

Now, maintaining the high levels of gross margin profitability that we have realized to date is going to be a challenge in the second half, so that's going to require a close watch on the efficiency of our processes and overall asset management to balance that challenge.

We believe that in the second half, even with that cloud on the horizon, we're going to show solid improvement, driven by incremental sales growth.

With that I'm going to turn it over to Ben to talk about the details of the operating performance for the quarter.

Thanks, Dave, and good afternoon, everyone.

I'd like to reiterate Dave's comments, that we are very pleased with our second quarter performance.

I'm going to make a few comments about the overall industrial economy and the indices we follow, followed by some of the things we are seeing that are specific to our business.

And I'll finish up my comments by giving you an update on our ERP project.

Taking a look at the economic indices that we follow, industrial production rose in December by the largest amount in five months, providing the industrial economy with solid momentum.

Total industrial production in December was 5.9% above its level of a year earlier, and now stands at 94.9% of its 2007 average.

Manufacturing output increased 0.4% in December and rose at annual rate of 3.3% in the quarter.

The MCU rose by 0.3% in December to 73.2%.

However, it is still 6 percentage points below its long run average of 79.2%.

We've seen incremental increases in the ISM Purchasing Managers Index over the past three months, since its dip to 54.4% in September.

Today, the index stands at 57.0%.

The improvement in these key indices points to a level of economic sustainability and it further supports Dave's remark that we anticipate moderate growth in our second half.

Looking at our top 30 industries, 27 of the top 30 industries showed an increase over the prior year's second quarter.

16 industries posted double-digit growth, and among those seven posted growth of more than 20%.

For our second quarter, SD&A as a percent of sales was 21.0%, improved from 22.0% in the same quarter last year.

We attribute our SD&A improvement to leverage from stronger sales as well as our cost control efforts.

At first glance, it appears that we missed our goal of controlling our SD&A growth to 50% of our sales growth rate.

But there's more to the story, of course.

We achieved our goal within our base business.

However, the acquisition and inclusion of UZ Engineered Products and SCS Supply impacted our SD&A growth rate because they are higher margin, higher cost to serve businesses.

If we remove their results, we would be in line with our goal.

This trend will likely continue throughout the remainder of the year.

At quarter end, our employee count was 4,655, a net increase of 105 associates compared to last year's second quarter.

Excluding acquisitions, our headcount decreased by 122 associates.

As we mentioned in our last teleconference, we have selected SAP as our software provider for our new ERP system.

Over the past few months we have begun working with a systems integrator on the project.

They will help us transform our technology platforms and enhance our business information and transaction systems.

The cost, of course, is substantial.

We expect a total expenditure of approximately $71 million over the next three to four years.

Mark will provide additional information on the breakout of capital expenditures and operating expenses.

And, of course, I would be remiss if I didn't point out that our estimate is subject to change.

It's a big project and while we have pretty good clarity about the total cost at this point, much depends on our ability to control the scope of the project and our ability to execute our project plan.

I can assure you that we will work diligently to control the overall cost.

While we expect it will take three to four years to complete the project, we do expect to see some of the benefits in fiscal 2013.

Those benefits will begin to filter into our business in many areas of the income statement as well as the balance sheet.

Our new ERP system will provide a solid foundation for future growth, improve our business processes, and provide greater efficiency, enable better and faster decision making, improve our overall business controls, while mitigating business system risks.

We have worked over the last few months to assign the right people to this project from both an IT and a business perspective.

And over the last few weeks we have gotten off to a very good start.

I will now turn the call over the Mark Eisele for a discussion of the quarter's financial results.

Thanks, Ben.

Good morning, everyone.

Let me provide some additional insight for our second quarter fiscal 2011 financial performance.

Our second quarter sales average sales per day of $8.7 million is a 5.3% increase above our first quarter average, and 20.6% above our prior year quarter.

Our sales per day continued to increase sequentially in the quarter, as our December sales per day was approximately $8.8 million.

We also had 61 selling days in the quarter, one less than the second quarter of last year.

Overall sales grew 18.7%, of which acquisitions contributed 2.6% to our sales growth.

Our product mix during the quarter was 28.6% Fluid Power products, and 71.4% Industrial products.

In total, sales in our service center based distribution segment increased $59.8 million or 16.3%.

If you exclude the impact of our recent acquisitions, the sales increase for our Service Center-Based Distribution segment was 13.2%.

Quarterly sales from our Fluid Power businesses segment increased $23.5 million, or 29.4%, from the same period in the prior year, due to greater economic activity from OEMs serving the technology and agricultural markets.

From a geographic perspective, sales in the second quarter from our US operations were up $66 million, or 17.2%, with acquisitions accounting for 1.6% of the increase.

Sales from our Canadian operations increased $14.4 million or 29.4%.

This increase includes $5.4 million from acquisitions and $2.4 million due to foreign currency translation.

Our Mexican operations sales increased $2.8 million, or 22.7%, of which $800,000 is attributable to foreign currency translation.

On an overall basis, positive foreign currency translation increased sales by $3.2 million or 0.7% in the quarter.

Our North American operating facilities decreased by two due to the merger of one US service center location and the closure of one shop location.

As of December 23, we now have 473 operating facilities.

Our gross profit percentage for the quarter was 27.2%, as compared to 26.2% in the prior year's quarter.

The current quarter's gross profit was positively impacted by 32 basis points, or $1.7 million, due to LIFO benefits recorded in the quarter related to the effect of increased volume rebates.

Similar to what we discussed on our last call.

You will recall, these LIFO benefits are the result of effective supplier price decreases in certain products due to increased volume rebates realized in fiscal 2011 purchases versus 2010.

These flow through our LIFO calculation as a benefit, as the price paid for these products, net of volume rebates, is lower this year than last.

The second quarter benefit is less than the first quarter benefit and we do not anticipate further benefits in quarters three or four from this impact.

Our selling, distribution and administrative expenses as a percentage of sales for the quarter increased slightly to 21% from our first quarter rate, but is 100 basis points below the prior year's second quarter rate.

SD&A expenses increased from the prior year in absolute dollars by $13.2 million, or 13.5%, compared to a sales increase of 18.7%.

As Ben noted earlier, acquisitions increased our selling, distribution and administrative expenses as these organizations have a higher cost structure to support their operations when compared to our historical structure.

Other absolute dollar increases are due to expenses related to improved performance levels, the reinstatement of our 401(k) match, the reinstatement of our traditional profit sharing levels, also.

We expect SD&A expense as a percent of sales for the remaining half of fiscal 2011 to be similar to the second quarter rate as we layer on incremental ERP expenses.

Our effective tax rate for the quarter was 35.8%.

The decrease above our previously communicated estimated rate of 39.0% to 39.5% is the result of a one-time adjustment eliminating a valuation allowance against a deferred tax asset no longer deemed necessary.

We believe an appropriate go-forward effective tax rate for our operations is still around 39.0%.

With that said, we expect the third quarter effective tax rate to be slightly lower as we recently received $1.7 million of life insurance proceeds which will flow through our third quarter income statement as a non-taxable benefit.

Our consolidated balance sheet remains strong.

Shareholders equity is $589.2 million, up $34.2 million from June 30th.

Excluding the impact of foreign currency translation, inventories grew by $2 million in the quarter.

We expect inventories to remain stable in the March quarter, as well as for the remainder of the year.

Our DSOs increased slightly, consistent with historical norms reflecting normal seasonality around the holidays.

We paid off our $25 million of debt and the related cross-currency swap liability of $12.8 million which reduced our overall cash balances.

We expect overall cash levels to increase in the second half of the year as we are now debt-free and have no unusual projected significant payouts other than ERP expenditures expected at this time.

We expect fiscal 2011 capital expenditures related to the ERP project to be around $18.7 million, of which $10.8 million has been spent through December.

We expect incremental SD&A expenses pertaining to the ERP project to equal $4.2 million for the last half of fiscal 2011.

While the overall ERP project will continue into fiscal 2014, the majority of the estimated $71 million cost will be incurred in the first two years.

For fiscal 2012, we estimate our ERP spending to total around $30 million.

We estimate this will break down as approximately 75% capitalizable and 25% to be immediately expensed through operations.

We provided updated annual earnings guidance for fiscal 2011 in this morning's press release which included increased sales to between $2.15 billion to $2.25 billion, and with increased earnings per share to a range of $1.90 to $2.10 per share.

Now for some closing comments by Dave Pugh.

Thanks, Mark.

Solid second quarter contributing to a good first half.

As we said, pleased with the results.

Continuing to make investments in the Company, smart ones.

At the forefront of these investments is the ERP that we discussed a bit here which is targeted at improving the operational side of our business and giving us the flexibility to consider a wider opportunity for expansion.

It's always difficult, if not impossible, to assign a definitive number for return on investment for such a project as this.

Hopefully over time we've earned a bit of credibility with you in handling our investments wisely, and providing a good return for each one.

In summary, we are optimistic about the second half and that's reflected in our increased annual guidance.

So stick with us.

Hope to show you more in the next quarter.

With that, we'll open it up for questions.

Thank you.

We will now begin the question-and-answer session.

(Operator Instructions).

At this time, we have a question from Matt Duncan from Stephens Inc.

Please go ahead.

Hello, guys.

Nice quarter.

The first question I've got is on gross margin, just want to make sure I understand what your expectations are here.

If you strip out the benefit of rebates this quarter, it would have been about 26.9% instead of the 27.2%.

Is that 26.9% a good baseline going forward, Mark?

And obviously you're going to get some benefit with higher sales the back half of the year, if that was the case.

Yes, right.

The incremental benefit of those 32 basis points related to the LIFO impact, the rebates flowing through that calculation, so that really was a LIFO expense benefit that we are not projecting will continue on.

So yes, if everything else stayed the same, yes, it would be 26.9%.

Okay, but if things were to accelerate and your purchases sped up a little bit, then that's going to drive higher rebates so theoretically that would drive a little bit better gross margin, right?

You've got some offsets against that, too.

As we're looking out, we're expecting, with the increasing commodity prices, we're expecting to see a higher rate of price increases as we go through the second half, from our suppliers.

That typically takes some time to run through the system.

So we'll have a little bit of offset against that increased rebate with the pressures between announced price increases and market acceptance.

That actually leads well to my next question which was what type of supplier increases are you guys seeing right now, and what was the impact of price on the top line in the second quarter?

I'll answer the first part of that and then ask Mark to cover the second part of the question.

If you look at price increases from our suppliers, we had a period of time, probably if you look at from a calendar basis, calendar 2009, where price increases from our suppliers were few and far between.

And most of the time our price increases hit -- we have a group of suppliers, major suppliers, that come in the September time frame and we have another group that usually come in the January time frame.

And in the past calendar '10, 2010, we've seen a return to more normal price increases.

And if you remember, going into the downturn, we had a number of shortages out there, and the increases were extreme and very high levels.

So I would say that coming out of this, the increases are returning and the levels are lower than what we saw going into the downturn.

On the impact, I'm not sure if you have that.

I don't have the exact number here, Matt.

It's a challenge for us to actually calculate a detailed number for that.

But I believe it was probably less than 1.5%.

Okay.

Thanks.

And the last thing I've got is looking at the balance sheet, you're now debt-free.

You've obviously got a lot of borrowing capacity.

Clearly some of the use of your cash over the next few years will go towards the ERP project.

But it seems as though there's a lot of acquisition activity kicking up in the industry.

Are you guys seeing a number of attractive properties?

And is that high on the list of uses for cash for you right now?

Matt, that's always been high and we will continue to pursue that to the extent that we can make good purchases.

The money is not burning a hole in our pocket.

We're going to make wise investments.

And there are some that appear to be out there.

Okay.

Thanks, Dave.

Thank you.

Our next question comes from Adam Uhlman from Cleveland Research.

Please go ahead.

Hi, guys, good morning.

Ben, you made a comment that there were a couple of served end markets that were down on a year-over-year basis, I think two or three of them.

Could you point out which ones those are and why?

Yes.

We have a few industries that, good times and bad times, they're not highly cyclical industries.

And so they're flat, sometimes up slightly, down slightly.

The one that really probably sticks out more than anything is on the transportation equipment side of things, and probably a little bit of a pullback there in auto manufacturing.

I haven't dug into the details of the number because there is more than automotive in there too, but that's probably the one that sticks out.

On the positive side, when we have 27 out of 30 that are up, it's very positive.

Machinery manufacturers is very strong, primary metals is strong, durable goods.

Even some of the housing related industries are up, although they're coming off of historical lows.

So lumber and wood products and cement industry, some of the aggregate industries.

So overall very positive.

When you talk about the transportation, aerospace would fit into that, with some of the delays in some of the major new airliners coming up.

Okay.

Got it.

And then what are you seeing in your government business?

The government business is, on a sequential basis, we had a better quarter in December than we did in September.

We have some spotty activity going on with projects, and we had a little bit of a downturn in some of the project related business.

I think the market is going to be a challenge with some of the budget issues.

But we did see growth in some areas of government.

We saw strong double-digit growth.

Other areas was a little bit of a challenge.

So with our low share in this market and it being a large market, even if there are budget issues and challenges there, we still expect to see growth.

That's good to hear.

Just one last clarification for Mark, if I could.

When I look at the ERP costs that are going to be coming through the P&L, how much of that is going to be a step up in depreciation and amortization?

As of right now, none of it is.

So these are all incremental costs.

The amounts and the dollar amounts that we're capitalizing at this point in time, they will begin to be depreciated or amortized basically once those systems go in.

And I say that with -- that's the main software piece.

There will be some very small hardware amounts that will get some small amounts of depreciation, but for the most part, all of the costs that we talked about are just the incremental expenditure costs and how they're flowing through.

We would expect major depreciation amounts to start once we begin implementing.

Thanks for the clarification.

Thank you.

Our next question comes from Jeff Hammond from KeyBanc Capital.

Please go ahead.

Hi, guys.

Just back to the whole price/cost issue.

Historically you've been pretty adept, other than timing issues, at passing that along and actually getting the margin on the price increase.

If I recall, last time the rapidity of numerous price increases caused some issues there.

Are you seeing these as normal course of business price increases or are you starting to get concerned that you see two and three price increases back to back like last cycle?

I think it's more the normal.

We're not expecting to see the back to back, more frequent than once per year.

Okay.

And then just back to M&A, it sounds like normal course of business activity, should we signal anything that you're not in buying stock, that there's more to do, more of size?

Or just maybe talk to me about balance between share buyback and M&A.

I'll jump in here, Jeff.

We still have available shares for the buyback.

It's obviously that we haven't been in the market for the last couple of quarters.

We will continue to talk about that in our Board meetings and our strategy as an organization.

But currently we'll talk about that and I think we'll evaluate when to get back in the market.

We have not put that on the back shelf.

Okay.

And then just back to this ERP.

Can you walk through the spend by year to get to the $71 million?

And then what's capitalized versus expense?

The total expenditures that we have for this fiscal year is around $18.7 million that will be capitalized, and about $5 million that will be expensed.

So some $23 million.

Fiscal 2012, we expect to spend $30 million, and we believe the ratio will be 75%, 25% between capitalizable and expense.

And then the amounts dwindled, obviously, for the year three, year four for fiscal '13, fiscal '14 to add up to the $71 million.

And during the final two years, the ratio between capital and expense will change and it will become a greater percentage of expensed immediately at that point in time.

And I just don't have those numbers with enough solid conclusions on that, Jeff, to really give you an estimate of what those percentages might be.

Let me jump in too because I want you to appreciate the magnitude of what we're doing here, and it's clearly a new process, certainly with us, and even within the industry.

It's not that prevalent in our field.

So there are going to be things that we encounter as we go along that may speed it up.

It might slow it down.

So trying to slot the timing on the expenditure on this is going to be very difficult.

We're going to be making decisions almost on a daily basis as we go forward with regard to what makes sense and how we can improve the return on investment and get it faster.

So this is one where you want to listen closely each quarter because the facts could change rapidly.

Okay.

And then just thinking of the SG&A leverage target, holding that to half of the sales growth, is that more difficult to do with some of these expenses coming through?

Or is the goal to keep that despite this additional spend?

I'd say yes to both of them.

The goal would still be there, and yes, it's going to be very difficult to do with this exceptional expense.

I would agree with what Dave is saying.

These really are new incremental expenses that we are layering on to our operations.

And I think our official goal is we're going to increase SD&A at half the rate of sales as from a normal operations perspective.

So we're going to work on achieving the goal for these things because the goal is the goal.

But these truly are incremental expenses.

And Jeff, the other thing is that we are absolutely focused on putting our best people in each functional area onto the team that puts this forward.

And we would love to do it without back-filling every one of those people.

But as you can appreciate, if you put your best people there, obviously they were doing something.

So we're going to be watching this on a head by head basis with regard to how we have to put in incremental expense.

Okay.

Thanks, guys, appreciate it.

Thank you.

Our next question comes from Joe Mondillo from Sidoti & Company.

Please go ahead.

Good morning, guys.

I have a couple just quick questions.

First off, what was the LIFO one-time benefit?I didn't hear that.

The LIFO benefit recorded in the quarter was $1.7 million related to the effective price decreases.

And just to recall, the similar benefit in the first quarter was $2.7 million.

So on a cumulative basis that's $4.4 million year-to-date.

Okay, great.

Thanks.

And in terms of acquisitions for the quarter, what did sales make up per acquisitions?

I think we said it was 2.6% was the sales percentage from acquisitions.

Okay.

That's fine.

I can figure that out.

And then looking at acquisitions, what kind of ROIs do you guys look at?

And what kind of size of acquisitions are you targeting?

I'll chat a little bit about that, Joe.

I think a lot of our discussion with acquisition candidates, we look at them multiple ways to pay a fair multiple of EBITDA.

We also look at it to cover our cost of capital from a discounted cash flow perspective, and so that it would have a positive return to the shareholders from that.

I think one of the reasons that we're very disciplined on the price that we can pay is because we are looking at how that's going to affect our bottom line on a go-forward basis.

We could do a lot more acquisitions if we wanted to pay a higher price for these organizations.

And then from a relative size perspective, most distributors out there are relatively small in size.

I think from the various trade groups that we belong to, the average size of a distributor is around $10 million to $15 million in annual sales.

Obviously, we try to look at distributors for which we have needs in certain markets where we want to expand to, and they could be smaller one or two location places or maybe places that have five, six or seven.

And there is virtually nobody out there in our industry that would be too big for us to look at.

We would look at everybody.

Okay.

Great.

And then in terms of associated with the ERP, could you talk a little bit about what exactly you're spending on, what is the $71 million associated with, what are those costs associated with?

And at a point in time when this is all initiated, 2013 or '14 or whenever that is, have you determined savings that you're going to benefit from this huge investment that you're making?

I'll start out here with the various categories of expenses.

Obviously, there's an expense for the actual software.

That's the initial acquisition of the software and then the ongoing software maintenance costs that are charged by the software provider.

Then we also have a large expense related to the integrator.

And this is the system integrator who are outside consultants that we bring in here to help work with the software, with our people and the system integrators and then SAP consultants to work together to build the system that we're going to put into place within our organization.

Those categories of expense are the three largest.

And then the next one is our people that are going to be dedicated to the project.

As Dave mentioned these are incremental people that will be pulled out of our operations and go to the project and we will be back-filling a large portion of them.

So that's extra expense that's going on for that.

There obviously is also some additional cost for some hardware for the system.

And then there's training costs to train the people to use the new system.

And with all of those training and implementation teams, our T&E expense is a big expense, also, because we have 470 locations across North America for which we'll be implementing this, and people will have to travel to those places to do those things.

So anyway, I think that hopefully gives you an idea of that.

From a benefit perspective, we expect that we'll get benefits all up and down the income statement, from sales gains, from margin improvements, from efficiencies within our operating costs.

And we definitely expect that the benefits that we're going to get will exceed, hopefully far exceed, the expenses that are going to flow through to the income statement.

Is there any way that you can model hypothetical year in terms of sales and expenses and everything, and figure out what kind of savings the software is going to provide?

That's hard to do.

I'll jump in.

It is very hard to do, and obviously we've done that analysis and we've decided to go forward with the project.

From talking to other industrial distributors who have implemented software like this, we've heard various comments about how you'll find benefits in places where you never even thought of.

So I think as we get closer to implementing, and we will have a phased roll-out, we'll start to see some of those benefits where we expected to gain them and others where we didn't expect to gain them.

These are great comments.

At the end of the day there is a certain leap of faith that's involved in making this move.

So we don't want to say that everything -- every I is dotted and T is crossed.

I don't think anyone goes into a project like this and has that luxury.

There are things we will manage along the way and just ask you to trust us to manage it as prudently as we've been managing in the past.

Sure.

Could you talk about maybe some of the benefits, like possible examples through some of the procedures that your business goes through that the software will increase productivity, or just some examples that this is going to help the business overall.

That would take too long.

We've probably got a list of 100.

Just to get an idea, I guess?

I think, Joe, the thought process is this will be a true business transformation on how we do business and so we'll see it up and down the income statement.

And that's really -- that's really the answer.

Okay.

All right.

Lastly, you were mentioning government sales.

How much does that make up of your total sales?

About 4% of our total sales.

Yes, with the acquisition of UZ and their government sales, we'll be probably end up --

4% to 5%.

Closer to 5%.

It had been running 4% but including that we'll be closer to 5%.

Just lastly, you mentioned, Mark, I believe, that you said SD&A expenses are going to stay at the rate that you're at.

Were you talking on an absolute terms or as a percent of sales?

As a percent of sales.

Okay.

Okay.

Great.

Thanks a lot.

Thank you.

Our next question comes from Brent Rakers from the Morgan Keegan.

Please go ahead.

Good morning.

First, just a housekeeping.

The $1.7 million life insurance gain, that's an after-tax number; correct?

And is that in the guidance for the year?

Yes, generally life insurance proceeds are tax-free and so that will be recorded in our third quarter results.

And, yes, we do have that incorporated in our view of the guidance.

Okay.

And then maybe if you could talk through a little bit what occurred in the month of December.

It sounded like a pretty strong month of performance.

I know there was a lot of gives and takes in the market with the weather conditions the way they are, maybe affecting the business, the holiday timing, how that may have affected the business.

And then maybe if you could also comment on the level of plant shutdown activity over the last couple weeks of December.

Yes, Brent, we had a good December.

I don't think on a year-over-year basis we had anything outrageous from a plant shutdown standpoint, even from a weather standpoint.

We have seen a small impact, weather-related impact, in January, especially in the southeast.

Okay.

And then it looks like, and you guys have referenced this a little bit, about the profile of margins on the two acquisitions being different.

And I was hoping maybe you can elaborate a little bit more on how much those businesses may have boosted the gross margins in the quarter from the run rate?

And then I'm assuming that also had a pretty significant impact on SG&A as well?

Their margins are at higher levels from a gross profit perspective, and we really haven't disclosed their individual income statements and we really would rather not.

And Mark, let me follow up.

One of the things that surprised me, when you look at the sequential jump in SG&A, I think it was literally the highest in the last decade at the Company, and I guess a lot of the explanation has to go to the acquisition.

Would that be a correct assumption?

I'm not sure what you mean by the highest jump.

On a percentage increase.

From the first quarter to the second quarter?

First quarter to the second quarter, yes.

I'd have to think about that, Brent, before I could respond.

That's fine.

A couple more questions on the ERP conversion.

Regarding what looks like about approximately $50 million or so in CapEx on the project, when would the start of the capital spend begin to amortize and depreciate?

And roughly how many years would that be depreciated and amortized over?

Good question.

We don't have all those etched in stone but generally depreciation on ERP type systems are amortized over a 10 to 12 year period.

We haven't locked down exactly what we're going to do.

And then they ramp up as things are ramped onto the system.

So if we have 10% of our business that is converted to the system, then 10% of the depreciation expense would then happen at that point in time.

And as things ramp up, the depreciation should ramp up commensurate with the conversion.

And when would the first go-live date be, whether it be a geographic region or division of the Company?

Probably towards the latter end of next fiscal year.

Okay.

Great.

And then just last question on this.

The way the timing looked to break out on an OpEx basis for the ERP system, it looks like you're anticipating the peak operating cost to be incurred in the first two quarters of initiating this program.

Is that a correct assumption?

Because that somewhat surprises me.

I think some of that, Brent, is because, as you march through this whole three to four-year process, certain categories of expenses are either capitalized or expensed, depending upon where you are in the project.

So certain things that we're doing today are expensed, whereas similar activities in a couple of months may be capitalized for a while.

Mark, last question, I apologize for so many, but at what period in this cycle do you expect to incur the peak number of AIT people on the job and the peak number of integrators on staff, or on call, if you will?

Oh, gosh.

I've seen the charts downstairs.

I don't have the numbers exactly but I would say we will be ramping up the number of folks on the project over the next two quarters.

So I would say the peak would be from there, for the next three, four quarters.

Yes, probably fiscal '12 will be the peak time period.

That's very helpful.

Thanks a lot for the details today, guys, appreciate it.

Thank you.

Our final question comes from Holden Lewis from BB&T Capital Markets.

Please go ahead.

Thank you.

Good morning.

Just a bit of housekeeping here.

You said that the reason the tax rate was lower in Q2 was because of the true one-time item.

What was the amount of that one-time item in Q2?

It was about -- it decreased the tax rate by about 4%.

So I think it -- I'm going off of my memory here, Holden, I'm not exactly sure, so I think it was around $400,000 or something like that.

I need to check that, though.

And it was just what they call a discrete item that you're required to record the entire benefit or expense, as it may be, in the time it happens.

Sure.

But it would have been more like a 40% rate or 39.8% rate if it hadn't been for that item?

Correct, it would have been in our guidance of that 39.0% to 39.5% range.

Okay, got it.

And then in Q3 you're talking about another one-time item of $1.7 million coming out.

I would think the rates would be -- and I don't have this exactly -- but it would be in the 36% to 37% range in Q3 because of that benefit.

But without it, you should be at 39%, 39.5% again?

Exactly.

And that's why we're saying in the call that we really think 39.0% is a good range of rates on a go-forward basis, long term.

Okay.

But just to be clear, these are not true-up sorts of things, these are truly one-time unusual items.

True, yes.

For the life insurance proceeds, we do disclose in the footnotes to our annual report that we have $14 million of death benefits that when they come to fruition they will be a benefit on our income statement.

And we got $1.7 million of that right now.

Okay.

Shifting over to the gross margin, again, looking at what the gross margin is, when you back out the impact of the LIFO, so taking your reported gross margin, subtracting out the impact of LIFO, the picture that you get really is throughout fiscal '10, you had 25.8% and 26.2% type gross margin.

In Q1 that stepped up to 26.6%.

And in Q2 it stepped up to 26.9%.

Versus last year, Q2 was probably about 100 basis points better than what you achieved in fiscal year '10 in round terms.

What are the causes to that, because I know volumes are up.

There's not a ton of fixed cost in the COGS.

What are the elements that are driving that 100 basis points?

Is it all rebates?

Is it all mix?

Is it M&A?

What are the pieces?

I'll jump in here.

I'd say it's a number of things.

One of the things you mentioned was mix, and from a customer mix standpoint, our growth in the quarter was better at the non contractual customers than the larger, contractual customers.

So that's a little bit of a bump for us.

And then also the acquisitions were a little bit of a bump.

The market competitiveness is still very difficult right now and our folks are working very hard to provide value to our customers and convince them that we're worth the value we provide.

So it's a lot of small things and hit on a couple of the larger ones there.

I assume Fluid Power is also part of the positive mix.

Is that a higher margin business?

Yes.

Okay.

So when you factor out the mix and the acquisitions as part of that, how do you feel about the price/cost relationship right now?

Do you think that that is a negative right now to the overall, or do you think it's a positive?

How would you expect the price/cost relationship -- what is it now and how do you expect it to change over the next few quarters?

I think it's a challenge and it's mixed, depending upon our segments.

If you look at it by the different segments of the Company, different challenges, different industry challenges.

And I think our folks are doing a great job of managing through it.

Okay.

So would you expect the price mix side of the equation to erode the next couple quarters or get better the next couple quarters based on what you're seeing your vendors doing and what you're seeing your field doing?

Holden, I don't expect it to erode because I think we're going to pay attention to detail.

But the challenge, I expect the challenge to get a little stiffer but I think we're up to the challenge.

Okay.

So from a price/cost standpoint you're expecting flat to up in terms of what the impact on the margin might be?

More in the flattish range.

Okay.

The last thing, you commented about the strength that you saw through Q4 with your DSRs.

Is it typical for your DSR in the December quarter to be up versus the September quarter?

It seems like October's usually a good month but then you would expect November and December, with the holidays, to perhaps back off a bit.

And when you net it all out, the idea that your December DSR was above October, November and Q1, that just seems a little bit peculiar.

I didn't know if that was the norm or how you look at that.

I think we definitely look at the September and the December quarters as our two weakest quarters from the sales per day perspective.

And I think we would traditionally say, without looking at the actual numbers, that we would expect them traditionally to be flattish, not to see a big change in the sales per day rates for each of the quarters.

We were happy to see that we continued to see improvement throughout the quarter and for the numbers through December.

Okay.

And is there anything that would worry you about the normal seasonal patterns going forward into Q3, Q4?

I don't know if any of those 27 industries that are doing really well, if any of them look like maybe they're running out the string or anything like that.

Is there any reason to think the trend you've seen so far won't just continue on and seasonal patterns won't remain in force?

We're hearing very positive comments from customers, from suppliers right now, so generally positive comments about the industrial economy.

Okay.

All right.

Thank you.

Thank you.

This concludes our question-and-answer session.

Okay, great.

Great having you with us today, guys.

Appreciate being able to give you the numbers that we gave you.

And hopefully you're walking away with an understanding we are optimistic about the remainder of the year.

We will be talking to you in April.

Thank you.

Thank you, ladies and gentlemen.

This concludes today's conference.

Thank you for participating.

You may now disconnect.