Bluelinx Holdings Inc (BXC) 2005 Q2 法說會逐字稿

Welcome to the BlueLinx Holdings second quarter financial results conference call. At this time all participants are in a listen-only mode. Following Management's prepared remarks, we'll hold a question-and-answer session. To ask a question, please press star followed by 1 on your touchtone phone. If anyone has difficulty hearing the Conference, please press star 0 for operator assistance. As a reminder, this conference is being recorded today, August 8, 2005. I would now like to turn the conference over to Ms. Jody Burfening.

Thank you, operator. Good morning and welcome everyone to the BlueLinx second quarter earnings conference call. On today's call, Chuck McElrea, Chief Executive Officer; George Judd, President and Chief Operating Officer; and David Morris, Chief Financial Officer will discuss results for the second quarter of fiscal 2005. A press release was issued earlier this morning and can be found in the Investor Relations Section of the Company's website at www.bluelinxco.com A slide presentation that accompanies George Judd's and David Morris's prepared remarks is also available on the home page of the Investor Relations Section of the company's website. Before turning the call over to Chuck, I would like to mention that Management is hosting today's call offsite, and is available to speak to investors and analysts during the day. We ask that you please call Chris Witty, Lippert/Heilshorn at Area Code 212-838-3777 to make arrangements for speaking with Management.

I would also like to remind everyone that on today's call Management may make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including all statements concerning future or unexpected events or results. Actual results could differ materially from those projected in the Company's forward-looking statements due to known and unknown risks and uncertainties, including, among other factors, the risks and uncertainties described in the risk factor section in the Company's Annual Report on Form 10-K, for the year ended January 1, 2005 and in it's period reports filed with the Securities and Exchange Commission from time to time.

Given these risks and uncertainties, Management cautions you not to place undue reliance on forward-looking statements. BlueLinx undertakes no obligation to publicly update or revise any forward-looking statements as a result of new information, future events, or otherwise except as required by law. With that I would now like to turn the call over to Chuck. Good morning Chuck.

Thank you, Jody. And thank you everyone for joining us this morning for our second quarter earnings conference call. Today, we are reporting our second quarter and year-to-date results. Sales for the quarter were $1.49 billion, slightly below last year sales of $1.56 billion, reflecting the quarter's weak pricing environment which overshadowed a 4.4% unit volume increase. Net income was $7.8 million, or $0.25 per diluted share. This compares to a $29.8 million, or $0.99 per diluted share for the second quarter of last year presented on a pro forma basis. This quarter's performance is in sharp contrast to a strong prior year that was characterized by prices at or near historical highs, extended vendor lead times, and product shortages. In short, these favorable conditions were beneficial to BlueLinx, as well as other suppliers last year.

Today, we are operating in a weakening pricing environment, and we continue to aggressively implement our business improvement strategies. We are taking the steps we believe necessary to diminish the impact of price declines on our financial results. We continue to advance our strategic growth initiatives and solidify the foundation for long-term growth of less price-sensitive specialty products.

We are gaining share in the building products distribution marketplace, leveraging our diverse geographic footprint, and broad product offering and extensive customer base. In a moment, George Judd will take you through our operational performance through the quarter, and then David Morris will review our financial results in more detail. Before turning the call over to George, I'd like to remind everyone that BlueLinx operates in an industry that is subject to pricing volatility. We are accustomed to managing the business in up and in down cycles. The current weakening price environment is not a new phenomenon to us. Through pricing cycles, we remain focused on increasing return on net assets by continuously increasing -- creating operating efficiencies and improved working capital utilization. I am confident that we have the right decision making approach and the strategy to produce profitable growth and market share gains over time. With that, I'll now turn the call over to George.

Thank you, Chuck. Good morning. I'm going to review your operational performance for the second quarter, starting with a brief market overview and then move to an update of our initiatives to grow the specialty products business. After that, I'll wrap up with a discussion about the current quarter's environment based on what we saw during July. As a reminder, we have posted a presentation to the Investor Relations Section of our website. These presentation slides accompany our operational and financial review. We invite you to view them during our remarks.

We continue to grow our market share, focus on our specialty products business, and improve our operating efficiency. Before walking you through the specifics of the second quarter operational performance, I'd like to take a moment and give you our thoughts about the price environment in the building product supply and demand balance. Both pricing and product level influence our decision making and financial results.

We began the second quarter facing weakening prices, particularly for structural products. Prices continued to trend lower throughout the quarter. Confronted with a prolonged period of price weakness, we maintained our tactical plan to direct a greater percentage of structural products through the lower cost direct channel. As you may recall from your first quarter call, this approach reduces the bottom line impact of falling prices by reducing inventory risk. It's the same decision making process we put into practice last quarter.

Although demand has remained generally strong across our markets during the second quarter, we have continued to see less urgency from our customers to reorder, which is an indication that there is ample inventory through the supply chain and short manufacturing lead times. This is in contrast to 2004, where there was a relative shortage of inventory and long manufacturing lead times. I invite you now to turn to slide 3 where I will begin the review of the second quarter's operational performance. This slide displays our unit volume growth relative to the estimated end use market growth on a rolling 12-month basis, which is how we evaluate our market performance. BlueLinx's unit volume grew 5.7% versus estimated market growth of 3.1%. Our value added supply chain solutions approach continues to drive unit volume growth.

Turning to slide 4, which shows sales by region for the quarter, you can see a pattern similar to last quarter with robust unit volume growth in the Southeast and Mid-Atlantic regions, which together make up 45% of total sales revenue, partially offset by softness in the West and Northeast regions.

Turning now to slide 5, which show the year-over-year sales variance by product segment, you can see that the decline in structural product sales revenue was the primary factor behind the total sales revenue decline. Sales revenue for structural products declined 8.5%, as weak pricing offset a 7.8% unit volume gain.

Turning to specialty products, overall unit volume was flat with last year's second quarter. This result maps a 9.8% unit growth in products, such as insulation, specialty lumber, and roofing, while unit growth of other products, notably rebar, [inaudible] and hardwood plywood fell a combined 5.7%. Overall sales revenue of specialty products grew a modest 2%, increasing the proportion of specialty products, the higher margin, more stable price category is a strategic imperative for us.

To better utilize our strategic objective, we have created project teams focused on specialty product growth and margin expansion opportunities. As an independent Company we have identified focused product and supply chain opportunities that will drive both revenue and margin improvement. In addition, we have made organizational changes to better enable us to attack these opportunities.

Moving to slide 6, we present price trends of our three structural product, OSB, plywood, and lumber. As I mentioned in last quarter's call, structural product prices were trending down at the beginning of the quarter. This trend persisted through quarter end for each of our structural products, and was the primary reason we are reporting a lower gross margin this quarter. We expect this price decline and took steps to mitigate the risks of holding price sensitive inventory by shifting more structural product sales through the lower gross margin percentage direct channel.

This decision is consistent with the approach we took last quarter and illustrates a methodology we have in place to manage the business in a declining price environment. As a reminder, a direct channel represents both quantities shipped directly from a manufacturer to our customers and is less costly than the warehouse channel. The direct channel carries lower gross margin percentages, but also has lower logistics expenses and working capital requirements. As a result, although gross margins fall, certain variable operating expenses, particularly commission expenses, transportation, and warehouse expenses also declined. What is important to keep in mind is that the direct channel is profitable for BlueLinx, although it yields a lower gross margin percentage.

Turning to slide 7, you can see the gross margin by product category and channel compared to the normalized rate, representing the gross margins we have generated through pricing cycles. The combination of lower gross margin percent and greater amount of volume sold through the direct and reload channels caused the structural product gross margin to fall below the blended normalized rate. In the second quarter, gross margins for the structural products in the direct channel was 2.6%, compared to our historical gross margin of 3.4%, slightly higher than last quarter's 1.7%. In contrast, gross margin for structural products in the warehouse channel was higher at 5.6%, but also below your historical gross margin of 9.5%, and last quarter's 10.5%.

In terms of channel mix, about 41% of structural product sales revenue went through the direct channel this quarter, consistent with the first quarter's percentage of higher than our historical level of around 35%. By comparison, for the second quarter last year about 38% of structural product sales revenue flowed through the direct channel.

Continuing down slide 7, you see the second quarter gross margin for specialty products was slightly below the normalized rate, primarily due to price declines in rebar, molding, and hardwood plywood, but above last quarter's 10.3%. I would now like to give you an update on some of the productivity initiatives we have in place to enhance our operational performance. Regarding margin improvement, we have now completed one quarter of using our new pricing application. The orders that flow through the system, primarily spot orders, realize over 50-basis points higher gross margin. We are now focused on increasing the percentage of orders that flow through this prices system and we anticipate further benefits.

Now moving on to working capital utilization, which you may recall is a critical performance measure in our business, working capital turn days for the second quarter 2005 on a trailing 12-month basis was 42 compared to 40 for the first quarter 2005 on a trailing 12-month basis. First quarter trailing 12 months includes a second quarter 2004 when turn days were uncharacteristically low due to supply chain inventory shortages.

Through examining working capital utilization further, I'd like to turn now to slide 9 which displays an analysis of quarter-end inventory levels compared to the end of the first quarter. Average inventory turn days continue to improve to 42 from 49 in the first quarter, with absolute inventory levels declining by $32 million, reflecting our success in managing inventory. Labor productivity, or the difference between unit volume growth and the change in average head count on a rolling 12-month basis, was 3.4%. Over that period we have grown unit volumes by 5.7%, with a 2.3% increase in head count, including the additions required to support BlueLinx's operations as an independent, public entity we continue to manage head count additions judiciously.

Our logistics productivity continues to improve, as a result of implementing a variety of programs through delivered cost -- through lower delivery cost. In fact, compared to the second quarter last year, our delivery cost per unit load equivalent improved despite significant increases in fuel costs. Turning now to strategic growth initiatives, I'd like to first recap the first -- the four pillars of our strategy with an emphasis on expanding our specialty products business. These are: A focus on targeted accounts that are growing and serve attractive high-growth markets; To increase volume in under-represented segments, particularly industrial segments, which is not directly affected by commodity price movements; To attract new vendors and expand existing relationships in order to broaden our product offering; and to augment our specialty product offerings through acquisitions. In the second quarter we made progress in each of these initiatives, through our value-added solutions selling approach, and by continuing to allocate resources to them. On a year-to-date basis, targeted accounts, which accounted for 42% of sales revenue, grew 4% faster than all other accounts. We continue to be successful in adding new customer programs for specialty products, such as [inaudible] lumber, vinyl siding, and Bostitch fasteners. As a result, we remain on track to achieve over $70 million of incremental revenue from these new specialty programs in 2005.

On a year-to-date basis, industrial and manufactured housing accounts, which include some targeted account, also grew 4% faster than all other accounts. These accounts make up 24% of total revenue for the quarter. Again, building on last quarter's success, we have added new industrial accounts, including cabinet and furniture manufacturers, as well as concrete fabricators. In the first half of 2005, we began to work with over 500 new industrial accounts which have contributed over $16 million in revenue to date.

In terms of increasing our vendor base, we're focused on expanding programs with current vendors and establishing relationships with new ones. Last quarter I mentioned we developed programs with four specialty product vendors we identified at last January's International Home Builder's Show. We continued to explore opportunities with half a dozen other vendors identified at the show. This quarter we continued to roll out product line expansions and to complement our offering in existing markets. One example of our product line expansion is launching a BlueLinx-branded maintenance free exterior trim which we expect should generate $10 million in incremental revenue.

Overall, I am pleased with the progress we have made in driving growth of higher margin specialty products since the beginning of the year. Compared to structural products, it takes longer to development specialty product programs and for our value-added solution sales approach to take root. Our results to date and response from both specialty product vendors and customers tell us our initiatives are bearing fruit in giving us a strong foundation for future success. Finally, in keeping with our strategy of driving specialty market share growth, with the addition of regional distributors, we acquired Lane Stanton Vance, a distributor of specialty products, including hardwoods, panel products, flooring and moulding to industrial and home center customers in California. This acquisition is an excellent example of our strategy to grow in the underrepresented, high margin industrial segment, deepening our customer reach and expanding our specialty product offering.

Now I would like to comment on our -- comment on our current market assessment. Starting the third quarter, we have continued to encounter regional variances in demand, the Northeast and West are busier, while the Southeast started out a little slower because of the hurricane. Structural prices continue to trend downward, although at a slower rate of decline. Given this challenging price environment, we continue to aggressively pursue specialty and industrial business and cost improvement.

In closing, we remain focussed in growing the proportion of specialty products by gaining share of underpenetrated markets, continuing to expand our vender base, and gaining share of existing customer purchases. For structural products, we will continue to add new, profitable customers, programs and vendors. Together, these initiatives will enable BlueLinx to continue to deliver profitable growth. Now I would like to turn the call over to David for a review of the financial results.

Thanks, George. Before reviewing the second quarter financial performance I would like to remind everyone that for purposes of comparative analysis I will discuss the results for the prior year's second quarter and year-to-date ended July 3, 2004 on a pro forma basis. The pro forma results reflect the acquisition by BlueLinx of the operating assets of the building products distribution division of Georgia Pacific and are presented as if BlueLinx Holdings had been a stand-alone entity since December 29, 2002. Pro forma results have also been adjusted to the Company's initiative public offering and the mortgage refinancing transaction, both of which occurred in the fourth quarter fiscal 2004. For your convenience an appendix following the presentation shows the reconciliation of the as-reported statements of operations to pro forma results presented.

I'll start by presentation with slide 11, which presents the quarterly sales analysis. For the quarter ended July 2, 2005, BlueLinx reported sales of $1.49 billion, down 4.7%, or $72 million from last year's second quarter. The sales decline was caused by lower structural product pricing, as George has explained, partially offset by a 4.4% increase in unit volume.

Turning to slide 12, you will see BlueLinx generated $115 million in gross profit in the second quarter, down 29.5%, or $48.4 million from last year's record second quarter. Similar to the first quarter of this year, the decrease in gross profit primarily reflects a decline in structural product margins. Additionally, margins in the second quarter of 2004 were favorably impacted by strong steel markets. Gross margin for the quarter was 7.8%, down from 10.5% last year.

As shown on slide 13, total operating expense for the quarter was $92.5 million, down $11.7 million, or 11.2% compared to prior year's results. The reduction in expense was primarily the result of lower incentive compensation and reduced sales commission. Operating income for the quarter was $23.2 million, versus $59.9 million in the second quarter of 2004, reflecting the decline in gross profits, partially offset by lower variable operating expenses.

Turning to slide 14 and moving down the income statement, interest expense for the quarter was $10.7 million, up $1.2 million from the pro forma prior year number, primarily as a result of higher interest rates. BlueLinx' reported tax rate was 37%, lower than last year due to job retraining tax credit. Net income for the quarter was $7.8 million, or $0.25 per diluted share, compared to pro forma net income of $29.8 million, or $0.99 per diluted share last year.

Now let's turn to year-to-date results, starting with slide 15. The six months ending July 2, 2005, BlueLinx reported sales of $2.84 billion flat with last year. Structural product sales fell 3.1% during the six months to $1.62 billion, while sales of specialty products increased 5.7% to $1.25 billion. Year-to-date unit volume rose 3.9%, while pricing was a negative 4%.

Turning to slide 16, you will see that BlueLinx generated $235 million of gross profit year-to-date, down 26.6%, or $85 million from last year. The decrease in gross profit primarily reflects a decline in structural product margins. Gross margin year-to-date was 8.3%, down from 11.3% last year. As shown on slide 17, total operating expense year-to-date was $188.2 million, down $17.2 million, or 8.4% compared to the prior year's results.

Reduction in expense was primarily the result of lower sales commissions and reduced incentive composition expense. Operating income for the six months was $46.8 million versus $114.6 million last year, reflecting a decline in gross profit partially offset by lower variable operating expenses.

Turning to slide 18, in the year-to-date income statement interest expense was $20 million, up $2.2 million from the pro forma prior year number, primarily as a result of higher interest rates. BlueLinx' recorded tax rate was 39%, lower than last year due to the aforementioned tax credit. Net income for the six months was $16.2 million, or $0.53 per diluted share compared to pro forma net income of $57.2 million, or $1.89 per diluted share last year.

Now let's turn to slide 19, which shows the balance sheet at the end of the second quarter. Assets on July 2, 2005 totaled $1.3 billion, essentially equal to the first quarter. Accounts receivable were nearly flat at $510 million. Total liabilities of $1.1 billion include $378 million in accounts payable and bank overdrafts, and debt of $715 million consisting of $550 million outstanding on our $700 million revolver, and a $165 million mortgage note. The drawdown on our revolver declined $13 million from first quarter levels. Note that after the end of the second quarter on July 14, BlueLinx reached an agreement with Wachovia Bank to amend the terms of it's existing revolving credit agreement to enhance liquidity. As of August 4, we had approximately $150 million of borrowing availability under the revolver.

Slide 20 shows second quarter and year-to-date cash flow for BlueLinx. For the quarter, BlueLinx generated $25 million in cash from operations, positively impacted by reduction in inventory. Year-to-date net cash used by operations totaled $57 million, primarily driven by the seasonal increases in receivables, partially offset by a corresponding increase in payables and a decline in inventory. BlueLinx spent $4.3 million in property plant equipment during the quarter and $6.3 million year-to-date, mainly for mobile equipment, consisting of trucks, trailers, folk lifts, and sales of automobiles. Year-to-date cash from financing activities is $74 million, primarily reflects additional draw on our credit facility to support seasonal working capital requirements. That concludes my prepared remarks. I'll turn the call back now to Chuck for closing remarks. Chuck?

Thank you, David. In summary, we performed well during the second quarter, while operating in a weakening price environment. We took the necessary steps to diminish the impact of price declines on our financial results, while continuing to focus on building the less price sensitive, but higher contributing specialty products business and improving operational efficiencies. As George mentioned, structural prices have continued to weaken, and we anticipate they will continue the trend downward, although at a slower rate of decline, reflecting ample supply throughout the supply chain. As a result, gross margins will remain under pressure.

We will continue to manage the business as we have in the first and second quarter of this year. At the same time, we will stay focused on driving unit volume growth at a greater pace than our induced markets, expanding specialty products and ringing costs out of the business. We believe our share gain strategy is working based on the top 150 distributors scorecard for 2004, recently issued by Home Channel News. Based on our analysis of this data, BlueLinx remains the largest distributor of building products and we have increased our market share of the products we distribute from 10.9% to 11.8%. This 90-basis point gain in share is greater than any other large distributor's gain. With that, I'd now like to open the call to questions. Operator, would you please give the instructions for Q-and-A?

[Operator Instructions.] One moment, please, for the first question. Our first question comes from the line of Yuri Krapivin with Lehman Brothers.

Good morning, everybody.

Good morning.

My first question is on inventories and cash flow. You saw a nice decline in inventory sequentially, which allowed you to generate positive cash flow in the quarter. Could you elaborate a little bit more on that inventory reduction. What caused it? Is it solid execution by Management? It is because the channel mix, or direct channel? Is it seasonal? What is the story here?

Hi, Yuri, this is George Judd. Good question, we -- we started the first quarter out with inventories a little higher than we would have liked as we talked about on the last call. Right now, we're very comfortable with our inventory position and, really, what we see is increased volume and managing those price sensitive inventory items more aggressively. We right sized our inventory from the first quarter, and then we aggressively managed those price sensitive inventories so that we have just in time inventories for our customers and our fill rates are still strong, but we don't have excess inventories in our warehouse.

Okay. And correct me if -- if I'm wrong, but I believe that typically you would generate negative cash flow in Q2. Am I -- am I correct? If you look and your historical cash flow.

It's one of those push quarters. It could be negative or positive. We have hit peak inventories, typically, sometime during second quarter and it would start to go down, moving toward the fall and sales are about at a peak, so it's -- it's just a push.

Okay. And then my second question is regarding the volume growth in OSB market. I noticed that year-over-year your OSB volume was up over 20%, could you comment on that? Is it the result of the overall shift in the marketplace from plywood to OSB, or does it have to do with recent start up of Georgia-Pacific's new OSB mill?

Yuri, as you know we are the sole distributor for Georgia-Pacific's product that doesn't go through the big box channel, so they started up their new mill, so that contributed to the second quarter. Also, we have improved our relationship with Louisiana Pacific. That's also adding to that volume. So it's driven by actions within our Company, as opposed to a shift from plywood to OSB.

Thank you. And my last question is on LSV acquisition, could you provide a little bit more color on that transaction? Specifically, we know what the amount of sales that business generates, but maybe you could comment on the current profitability of LSV, and also maybe you could comment on the valuation multiple and what kind of synergies would you expect to achieve with that acquisition? I know that's, overall, you operate 11 facilities in California, following the addition of LSV, I was wondering if you are going to close down some of those facilities?

Hi, this is David. I'll begin to answer that question and then I'll turn it over to George for followup. First of all the acquisition was consistent with our strategy, strategically, and financially. As you noted in the press release, $62 million of revenue. We expect it will be accretive, at latest, early next year. It would be this year, except for some start up in transition expenses. In terms of booking the transaction, we expect little or no goodwill. And in terms of operating strategy and synergies, I'll turn that to George.

Yes, we're looking at the entire Company. There wasn't 11 facilities, that included some offsite reloads that they had some inventory in, as well. There was really five facilities, and -- and as we evaluate that business, we -- right now we have not decided --or evaluated to close any of those facilities. One of those facilities actually borders one of our warehouses, and there are synergies that are inherent with those two companies -- or two businesses. We are in the process of looking at the synergies in the customer channel, as we have a wider variety of products for their sales team, to sell to their existing customer base, and the BlueLinx original sales team is also looking at being able to sell the LSV products. So we have an expansion of specialty products into a wider group of customers, and there was very little customer overlap between our two sales organizations so we have a nice addition of new customers and specialty products in California.

Did you pay in cash or stock for that transaction, or a combination of both?

This is David. We paid cash.

Okay. Thank you. That's all I have.

Our next question is from the line of Edings Thibault with Morgan Stanley.

Thank you and good morning gentlemen.

Good morning.

Just a quick followup to start with on the LSV transaction. I just wanted to make sure where I think you guys would see the greatest opportunities. I guess I'm a little surprised there's very little customer overlap. Can you talk about some of the specific products that they're offering that you didn't offer them, nationwide, you didn't offer them in California?

Edings, this is George, in most cases we didn't offer those products anywhere in our -- in our company. Those are higher-end architectural mill work and deeper into the specialty products line, where we might have touched with just the -- the really faster moving portion. You the -- we call it in our business skimming the specialty code. We had the top fast-moving products in that code where Lane Stanton and Vance has a nice business of getting very deep, and being able to supply a customer, or a project, all of that architectural mill work, or all that custom specialty lumber that they might need in that job. So there really was very little overlap on customers, and there was very little overlap on products. It's new products for BlueLinx and it's new customers for BlueLinx.

And presumably you'll integrate the existing sales force into your sales arm?

Yes we're doing that. Their sales management was in Denver last week with our Vice President, our Executive Vice President of the West, and they are integrating that as we speak.

Any plans to announce -- you know, any synergies that may come out of this process, when you might conclude that analysis?

Not at this time?

All right. And then just sort of stepping back a little on the overall business. I thought it was a useful chart that you provided, George, and talked about where your margins were relative to trend on both -- on a product side, as well as a channel side. I was wondering if you could number one, if you could refresh us what trend means, in terms of what the period you've looked at to come to that number, and, second of all, I was wondering if you could talk about some of the differences that you are seeing in this market? I guess the concern, really, is to cut to the nub, is, clearly, we're in a period of weak pricing, but is there anything else going on? And as a follow onto that did you have to take any inventory adjustments in the quarter?

This is David, I'll take the first part of that or the middle part. The trend pricing, or trend margins, were 2001, 2002, and the first three quarters of 2003, and if you go back and see that we had declining prices in '01 and '02, and flat and low prices in the first half of '03, and then one up quarter in the third quarter of '03. So that's the trend line basis.

And with regard to what the numbers tell us -- you know, the structural products, obviously we had -- we had expected some price decline as last year we had record high pricing through most of the year, and when -- when you have record high pricing, we had capacity creep, and capacity expansion and even though volumes remained high there was weakness and pricing pressure. As far as where we are today, as both Chuck and I mentioned, prices have continued to be somewhat weak. Plywood is approaching lows, until we -- we're not expecting huge declines in plywood, but you know, that's up to the manufacturers, and how they continue to run their manufacturing facilities. OSB still is -- is -- you know, in our opinion, still has some room to fall. So those two panel products are -- have seen huge declines from record highs, and we expect plywood and OSB both to slow down on their decline.

And Edding, just one -- you asked about were there any lower cost or market adjustments in the quarter, yes, but it was inventory.

Okay. But as I look -- as I look at the second quarter, I mean one of the interesting things about it was there was actually a nice wave right in the middle of it, basically, prices starting to recoverer almost immediately after your conference call. When you guys said inventories were low, right? You sort of triggered the market, apparently.

You know, the interesting thing about these spikes that we have seen, really, throughout this year, on the panel side in particular, there -- they are short, quick spikes where the prices are trending down and then the prices spike up sharply. There's very little buying when the prices are going up. So you know, the -- the -- as I mentioned in my prepared comments, that customers are slow to replenish, so when the market starts to move up, our sales fall very, very quickly. So we haven't been able to -- the industry, really, hasn't been able to see a prolonged uptick that we could have some momentum and some buy as the market recovers. Although there's some upticks, our volume shrinks dramatically when the prices start to trend up a little bit.

One last question, you know, clearly you guys are making progress on the volume side and making some choices on where to take volumes by the looks of it. As we look at the gross margin scenario, you mention you are not really expecting too much of a recovery in the third quarter for all of the reasons we talked about on the price side. What has to change in the industry in order for you guys to get better margins? Do you just -- to have prices bottom at a level where people will begin to buy into some of the strength, as well. Do we need to see a real bottoming here? In the sense there seems to be structural overcapacity people are not going to be tempted in buying into rising markets again. I guess some comments on when -- maybe a gross outlook for next year in terms of what would you expect -- what kind of environment you might expect -- don't talk about next year since you're probably reluctant to do it, but what kind of environment do we need to get for higher prices?

Let -- let me talk about speaking about higher prices, okay?

Got it.

As you can tell from looking at the graphs, and I know the people who follow our industry have views on how low prices can go, the majority of the price falloff has already occurred. Our margins are hurt in two ways by falling prices. One way is our ex -- our inventory we own, which is a couple hundred million dollars worth of inventory depreciates. Secondly, our purchases that we have flowing toward us have to move aggressively when we go take them into the direct channel. That also costs us margins on that. So when you drop away the falling prices and strip that out, our margins against replacement costs -- and that's really how we look at our business day-to-day, came through to be what our actual margins are. So right now our reported margins are lower than the margins against replacement costs. I -- so as we come to a bottoming process, our margins should start reflecting the margins we're earning against replacement costs.

Replacement cost is what you buy on a given day versus what you sell on a given day.

Yes.

Got it. Thanks very much.

Yes.

Our next question is from the line of Rick Skidmore with Goldman Sachs.

Good morning, just two follow up on edings' questions with regards to margins. If I look at the pro forma margins on a gross margin basis, it appears that this quarter is the lowest gross margin quarter for the last couple of years. Is that correct?

That's correct.

And what is different about this quarter relative to some of those other prior quarters where you did actually have declining prices in the market?

The price decline -- this is David -- quarter-end to quarter-end, I think as we noted in the pre-release was just very, very sharp. OSB went down 24%. Plywood, 8%, and lumber, 19%. That's a, benchmark grades in those grades overall declined in the total product categories were similar, just very sharp price declines.

So we f we look at say what appears to be the third quarter of '04 where OSB was 4.50 ended at about 2.50, similar trend in plywood, and a bit of a decline also in lumber it appears, those seem to be a lot more steep declines than what we experienced in this prior quarter and yet the margins were better, if I'm not mistaken. Is there something else that's happening other than just the price?

No.

Okay. Thanks you very much.

I -- I think -- to help David with that question, all three, lumber, OSB, and panels had significant falls this year in Q2. Lumber was significant. And the other -- the other more price sensitive item that had a very, very significant uptick in 2004, and saw continued downward price pressure in the first two quarters this year was rebar, which is another main product for us, and that effected our specialty margins. When you look at the specialty margins, and you look at the impact of lumber and OSB and plywood, really, in that order, it's a significant impact on our gross margin percentage.

Thank you, George. And Rick, I'm now looking at the charts that you were looking at. And there were very sharp drops right at the end of third quarter, which had an impact on margins, but it was more than offset by large increases throughout the middle of the quarter, very large increase throughout the middle of the quarter. Point-to-point, quarter-end to quarter-end the decreases were not as large. So those were some other factors in third quarter last year.

Okay. And just following up, you mentioned that you expect that prices will continue to gradually move lower. Correct me if I'm mistaken, but in that environment aren't your margins worse off than if the price just fell to a new level and one step change and you had established a new base, so would we expect that margins will continue under pressure inasmuch as prices just gradually erode over time?

I don't know the answer to your first question, whether we're better off if they just go down all at once or work their way down, but our experience is they don't go down all at once, they work their way down, so we don't spend a lot of time thinking about that, but we -- it's the rate of change that impacts our margin. We expect the rate of change to decline going forward.

Rick, one -- this is George -- one of the things that impacts the results -- results of our Company, with regard to the market declines, is the inventory and the supply chain. So this year, really, every time the market goes up, there's very, very little energy to buy, to participate with any uptake. That's unusual. So we're seeing the market, the market fall down, as soon as anybody steps in to buy, the prices go up, everybody closes their PO book. That tells us is that inventory in the supply chain, and our field people tell us this, as well, is good enough to pretty much wade out the next fall in prices, and that's -- that's fairly unusual.

Thank you.

Our next question comes from the line of Keith Hughes with Robinson Humphrey.

Thank you, a couple of questions. We talked a lot about the third quarter, what we're going to be seeing in the third quarter. As we go into the fourth we would again see a seasonal fall in revenues, correct, as you go into the slow part of the building season?

Correct. Historically.

So in terms of just the financial results, there will be a falloff from that? Is that correct? I would normally assume your second and third quarters, numerically to be your strongest quarters, and then the fourth quarter to be the weakest. Is that a fair assumption? Pricing being constant, would that be the case?

That is what we normally see, but -- as I said not always, but that -- that is a reasonable expectation.

Okay. Now I have heard from some other companies about this inventory in the channel. Do you feel like -- and I think you may have said this in the previous question. Are we going to be in a weak inventory buying period for the rest of this building season and wouldn't really see an uptick til we get into the pre-buy next year? Is that a reasonable assumption at this point?

Historically, that would be a reason assumption.

Okay.

However, one of the things that we are feeling, and we are being told by our customers, you know, the mood in the -- in the industry is very positive still from a demand point of view.

Right. Why do you think that the -- the inventory levels have gotten to the levels they are when home building has been very strong for this year and, you know, prices coming down, this would be a good time to buy at least over the prices we have seen in the last year or two? What do you think is going on? Just your personal opinion.

What I think is going on is we had a great year last year. Last year in Q4, when the seasonal slow down started to happen, the supply chain in general started to build inventory. They built inventory based on the strong housing for 2005 that was forecast.

Right.

Throughout with -- had some -- some weather issues in the early part of Q1 -- or really all of Q1 that slowed demand down and created a little bubble in the inventories, and that bubble has not worked it's way out. And that's what I wanted to say about Q4.

Okay. Now you -- you had mentioned earlier on the specialty products you had seen some nice volume growth and I believe it was roofing, and a couple of other segments. What were those again?

Roofing, insulation, [inaudible] lumber, we continue to grow all those businesses very well, and we continue to add some specialty products to our basket of products to sell.

Okay. How is pricing in insulation been? I know we have had seen some increases there. Has that calmed down now?

It's calmed down, but there's been increases in insulation. There's been increases in vinyl siding, and those are, you know, fuel --

Right.

-- products.

Okay. Thank you.

I would just like to add, I don't want to leave the impression that the inventory -- the inventories in the channel are very high at this point. I don't think they are. Production is sufficient, I think, to cover consumption. We're going into our busiest six to eight weeks of the year, and you could see some bump up in pricing in structural products due to that -- this period. We, as a Company, have quite low inventories in structural products.

Our next question is from the line of Steve Chercover with D.A. Davidson.

Good morning. I hope I don't belabor the whole issue of margins and where we are in the cycle too much. But, clearly, we're coming off the greatest of all years, and the throughput is still really good, so if we were to look at your earnings power now that -- you know, primarily the panels are coming back towards their long-term trend prices, is that kind of indicative of what you can do, in terms of earnings?

What -- what we think about on our long-term earnings power is we expect to grow our business at 50% to 100% faster than our end use market. We intend to be somewhere around trend margins, and think over time we can improve that through productivity measures, and how we buy and how we sell, and improvement in the mix of products we sell more to the specialty range. And we expect our cost to go up at less than our volume goes up. So I think that's how we think about our long-term earning power in this business. But we believe the trend margins that we presented are in line with what you should expect going forward.

Okay. Thank you for that. With respect to the balance sheet and the ability to deliver, I'm assuming that some of the seasonal inventory builds kind of obscure the cash flow that otherwise would have been dedicated to paying down debt. Can you tell us if you have any target debt levels, or debt to caps, that you hope to achieve in the next year to two years?

This is David, our normal seasonal pattern is that we're negative cash flow in the first quarter. I think we talked earlier the second quarter can be a push either way. And third quarter can be a push. And fourth quarter is usually very strong cash flow coming in as you work down seasonal inventories and receivables. In terms of our priorities for cash flow, it's to continue to invest in profitable opportunities that earn above the cost of capital, and then it is to maintain a consistent dividend and then to pay down debt. We certainly expect to pay down a material amount of debt by year end as we go down the season,but we do not have specific future debt targets.

Okay. And one quick one, if I could, are there any other businesses you would like to move kind of up the scale, perhaps more towards framing, or doing trusses, anything along those lines, or strictly distribution at this point?

Our strategy, Rick -- or Steve, I'm sorry -- is to stay with the distribution space. Even though we grew our market share and expanded our growth this year we still have 88% of the market available to us, and that's our target.

Got it. Thank you.

Our next question is from the line of Adam Hershey (ph) with NuBerger Herman (ph). Please go ahead with your your question, Adam. There's no response from Adam's line. The next question will come from the line of Michael Gazner (ph) with Buckingham Research.

Thank you. You mentioned you weren't expecting a huge further decline in plywood prices, you said about OSB having a little bit more room to fall. At what point do you get a little bit more aggressive in terms of getting -- moving less business out of the direct channels and -- you know, in OSB in particular, how much further would you -- would think market have to go down for you to make such a move?

In -- in OSB the natural flow of that product is the direct channel. So we would not expect a shift to the warehouse channel. It's just that the quantity that's used and -- and when I think about OSB, I'm think about 4x8 sheets of 7/16, that is generally purchased in truckload quantities by our customers, so we would not be changing the flow of that product. On the other products, we have a range at which we operate our inventory. Today, because we expect pricing declines, we're operating at the low end of that. When we hit bottoms, we might increase our inventories a little in those products, but we do not expect to earn our living speculating on products, and we -- what we're doing when we shift to the direct channel, that is also how the market is going, and we are just going along with what the market is doing there. We are still supplying our out of warehouse business at levels that the customers demand it. So if it will be a change in customer preference that would drive over out-of-warehouse. I'll ask George if he has anything to add to that.

Thanks, Chuck. Michael, I would like to add that on OSB where we can add a lot of of value with your sales team, and our logistics footprint, is on the value-added new generations of flooring products, which we have taken to market for companies like Huber and Louisiana Pacific that are coming out with next generation of flooring products. We are growing that business through our warehouses, and we are adding new skews and new generations of that products to our warehouses across the country, so that is a warehouse channel product, but as a total of OSB sales, still the majority are 7/16th, 4x8 sheets and most of that would flow through the direct channel.

Thank you.

Our next question is from the line of Adam Hershey (ph) with NuBerger Herman (ph.)

Hi, it's Laura Sloate. Can you hear me.

Hi, yes, Laura.

I'm a bit confused. When you were on the road show in previous, you talked about some volatility from pricing. With operating income down 61%, your stock price down 45%, and it just seems to me that you don't have any control, either on your profitability or your gross margins if you have high volatility in -- in your products. Is there any offsetting kind of mechanism that you can use to slow down, or the impact, the volatility if the future is volatile? And number two, how much of the 20% volume increase in OSB was forced volume that you had to put through your channel because of your relationship at Georgia-Pacific?

We'll start with the easy one, second. The volume of OSB from Georgia-Pacific we're happy to have it. We'll be glad to have more. We're negotiating with other vendors to add more, so there were no ill effects of having that product availability.

Laura, this is George, really with the spiraling markets downward, and managing our business, the strategy has to be for us to grow our specialty products, the less cyclical products, and the less price sensitive products to our breadth of product. We are focused on doing that, it takes a little longer for those to add revenue to the bottom line and gross margins to the bottom line than -- than trading OSB. So we have a lot of new programs. We have a lot of new products that are beginning to take place for BlueLinx, and that is -- that will help us manage the -- the -- the price sensitive items. Specialty products growth is imperative for our Company.

But, George, isn't that a multi-year program? Isn't that going to take you three, five years to get any kind of real percentage differential between specialty and structural? Given that structural is so dominant in your mix.

Structural is dominant in our mix, more dominant than historic for two reasons. One, because prices were higher and it shifted our revenues, and, two, because have added some capacity and that comes first. And when we were on the road show we did explain that as being part of Georgia-Pacific, we sold Georgia-Pacific structural products. Many of the other structural product producers did not look at us as a viable outlay for their product. So the first thing that came to the table and the first thing that drives revenue growth was the addition of those structural products from companies like Huber (ph) and Louisiana Pacific and Weyerhauser, companies that viewed us as Georgia-Pacific ,as their chief competitor. Today, we have added those first, and those did add revenue first. But we do have in queue many specialty products we are rolling out across the country and we are aggressively working with large national producers to be able to add their products to our -- our inventories and our sales force revenue stream, and I think that that will come quicker. That's not a multi-year project. We are working very hard to see that happen right now, as we speak.

And -- and in terms of customized products, is that also going to be true?

Yes, we have -- as I announced and it's really the first time we mentioned it. We have a maintenance free exterior trim that we are bringing out under the BlueLinx name. That's the first product that will be introduced under our name. And in response to customer demand and our customers want us to have that product. We're bringing it out. We're rolling it out as we speak. Right now in the northeast is the first market to get that product.

And what was your penetration of your top -- what do you feel your penetration of your top -- I think 1 -- 1,200 or 1,500 accounts in the quarter? Did you increase it year-over-year and quarter-to-quarter?

Yes. We actually track our market share market share of those targeted accounts, and in those targeted accounts our market share grew as they grew their business by about 4%. So it's almost the same as our revenue growth with those targeted accounts. They are growing at the same pace that we are, and we are adding specialty products to those -- those specialty -- or those targeted accounts.

Thank you.

Our next question is a followup question from the line of Edings Thibault with Morgan Stanley.

Thanks very much. Just a question question. Chuck, I wanted to follow up with you on replacement margins. How would you characterize replacement margins? Are they comparable to trend margins?

Right now they are a little bit weak -- weaker, maybe in the 50-basis point range. We -- we believe that's driven by more than normal availability, and more -- and a view that prices are going down, so I think we'll being impacted on replacement somewhere in the 50-basis point range.

Okay. And then final question is -- you know, on the accounts -- working capital. It looks like one of the things you did was reduce your accounts payable. I was wondering if you could talk about the changes in that line item?

Yes, this is David. Eddings, I'm going to the slide to just take a look here. The -- as we worked on reducing inventory, which we are steadily doing, and continue to do, that does have an impact on accounts payable. I would also like to come back to the debt target question for a moment. It is a very high priority of ours to manage working capital and get better and better and better at that. So there's no -- there's no thought that we don't pay very careful attention to debt. We just have a specific dollar target. But the payables is due to reducing purchases.

So there's no -- you're not financing any of that on -- off balance sheet, if you will?

No, definitely not.

Okay. And just your thought process behind renegotiating the revolving credit agreement. You said it gave you more liquidity, but liquidity isn't a concern. How should we read that?

More liquidity is always good. And what I would characterize the change was in tweaks and some advance formulas that give us $15 million to $30 million more of availability. It's just good to have cushion. We also upsized it for future potential, although we don't have plans to use those higher amounts at this time. We just did it all together.

So what -- was any of it driven by the LSV transaction? Because I think that closes here in the third quarter, right?

It did close in the third quarter, and again, cushion is helpful when one is executing a transaction like that.

Got it. Thank very much. Good luck in the quarter.

Thank you.

There are no further questions at this time. Please proceed with your presentation, or any closing remarks.

Thank you for joining us today. We look forward to speaking with you again next quarter.

Ladies and gentlemen, that concludes your conference call for today. We thank you for your participation and ask that you please disconnect your line.