Kadant Inc (KAI) 2004 Q2 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to the Kadant Incorporated second quarter earnings conference call. At this time all parties have been placed in a listen-only mode and the floor will be open to your questions following the presentation.

It is now my pleasure to introduction your host, Mr. Thomas O’Brien, Chief Financial Officer of Kadant. Please go ahead, sir.

Thomas O’Brien: Thank you, operator. Good morning, everyone, and welcome to Kadant’s second quarter 2004 earnings call. With us on the call today are Bill Rainville, our Chairman and Chief Executive Officer, and John Painter, an Executive Vice President of Kadant and the head of our Composite and Fiber-based products segment.

Before we begin, let me read the Safe Harbor statement. Various remarks that we may make today about Kadant’s future expectations, plans and prospects are forward-looking statements for purposes of the Safe Harbor provision under the Private Securities Litigation Reform Act of 1995. Our actual results may differ materially from these forward-looking statements as a result of various important factors, including those discussed in our quarterly report on Form 10-Q for the fiscal quarter ended April 3, 2004, which is on file with the SEC and is also available in the Investors section of our website at www.Kadant.com under the heading SEC Filings.

In addition, any forward-looking statements we may make on this call represent our views only as of today. While we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so, even if our estimates change and you should not rely on these forward-looking statements as representing our views on any date after today.

During this call we may refer to some non-GAAP financial measures. These non-GAAP measures are not prepared in accordance with generally accepted accounting principles. A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures is contained in our second quarter earnings press release issued yesterday, which is available in the Investor’s section of our website at www.Kadant.com under the heading News Releases.

With that, I will turn the call over to Bill Rainville, who give you an update on Kadant’s business and future prospects. Following Bill’s remarks, I will give an overview of our financial results for the quarter and we will then have a Q&A session. Bill?

Thank you, Tom. Good morning, everyone. Thank you for joining us today. We were pleased to report solid performance in the second quarter. Our adjusted EPS was at the high end of our guidance range at $0.23. That’s without the $0.03 tax benefit. Our revenues came in slightly better than we expected, at nearly $58m. Our total bookings increased 29% and our quarter ending backlog stands at $40m, up 24% from last year.

We continued to have strong quarterly cash flow from operations at $7.8m, nearly double that of last year. We bought back more $6m worth of our stock during the quarter and still ended up with a cash balance of nearly $82m.

These results, which followed an equally positive Q1, contributed to strong first half of the year. While a number of positive trends in our industry will continue through the balance of 2004 and beyond, we are also experiencing uncertainties in some of our markets that cause us to temper our outlook for the second half.

Let me give you a sense of the mix of dynamics that we’re seeing. First, in our papermaking equipment segment. We tend to look at this side of our business geographically, since the market drivers vary significantly in different parts of the world.

First, China. Few global businesses can be successful today without a presence in China, one of the world’s fastest growing markets. Our efforts over many years to build our market position have been paying off. In Q2 we again saw strong sales from China, primarily for our stock preparations systems used for production of recycled paper. This resulted in a record $10.4m in revenues for the quarter and reinforces our position as China’s leading supplier of stock prep systems.

As we mention every quarter, the challenge of our business in China is predicting the timing of these orders, most of which are for large capital systems that meet the country’s needs for capacity expansion. What has changed is the recent deliberate slow down in China’s banking system, which is extending the length of time it takes our customers to obtain project financing. In turn, this is causing us to delay revenue recognition on a number of contracts we’ve received.

For example, we have received signed contracts totaling $10m, for which financing has been delayed, causing us to defer revenues on these contracts until later in 2004 or into 2005. As the result of these delays, China bookings in the first half of 2004 were less than expected, at approximately $13m, versus a strong $17m of bookings in 2003.

We’re confident that the financing for these contracts is going to be approved. This is further reinforced in an article that appeared in today’s Wall Street Journal, basically commenting that China is going to turn over the financing of these private and foreign investments back to normal conditions, as opposed the real control is going to be on trying to control the financing on some of the government financed projects. So this is encouraging to us as our business is primarily with private and foreign investors.

We are also working to mitigate the timing affect of these large capital orders by increasing after market sales in spare parts and services. This will not only meet the more favorable product mix, but will also generate long term revenues derived from our expanding base of installations there.

Now on to North America. Our large installed base of equipment in North America continues to drive sales of our papermachine accessories, which are for the most part after market products. As the performance of paper producers here gradually improves and operating [range] show a steady increase, we stand to benefit. Again, it's a question of timing.

We continue to see steady sales of our doctor blades, which helps producers improve quality with relatively little investment. The tissue industry, which is driven by the need to constantly improve quality to protect brand equity, remain the [bright spot] to our blade business. We’ve won blade contracts from several customers who are installing new equipment in North America, and have received contracts from mills where we previously were not the primary blade suppliers.

The new creping blade holder that we introduced is selling well, both here and overseas. It is now the preferred holder for the big three tissue producers in the US. Orders for our ProCrepe blade continues to rise steadily in the US, and have grown dramatically in Mexico due to quality and production improvements. In fact, we’re seeing an increase in sales of all our creping blades, which were up more than 46% over the last year’s quarter. Our growing presence in the tissue market in North America continues to be fueled by a competitive edge in technology and process expertise.

European markets, which showed sporadic improvement earlier in the year, now appear to be sluggish at best, with continued economic uncertainty in many regions. This will likely result in a challenging sales environment in all of our paper making equipment product lines for the rest of the year. We are currently looking at different options for streamlining our European locations to improve operating results there in light of these conditions. Our goal is to optimize profitability by structuring these businesses in line with our other Kadant operations.

Now I’ll switch gears to update you on our composites business, where we continue to see revenue growth, but face ongoing issues that are affecting profitability. For the second quarter, our revenues increased 52%, to $5.1m. Our bookings rose 84% during the quarter and for the first half were nearly double those of last year. We generated $1.7m in cash flow from operations in the quarter, for a total of $200,000 in the first six-months.

Clearly the market for composite decking is growing and ongoing efforts to expand distribution of these products are producing positive results in terms of sales. Demand remains strong as we continue to increase the number of dealers who stock our products. In the July issue of Consumer Reports magazine, our GeoDeck product was listed as a best buy in their rating of all types of decking materials, including a number of composites brands. We achieved the highest rating in all major categories; maintenance, strength and appearance.

The challenge in this business continues to be profitability, with two factors affecting our bottom line performance. First, our warranty expenses in Q2 were higher than we expected, causing us to increase our warranty provision. The claims are tied to the board contraction issue on material we shipped prior to mid-August last year. We have since corrected this problem and expect these claims to taper off during the year.

Second, the cost of plastic use in the composite mixes recently increased, which will affect Q3 and possibly the rest of the year. We have taken a number of steps to lessen the effect of this raw material cost on our operating expenses, such as installing equipment to blend different grades of plastic. Although our $370,000 operating loss in Q2 was slightly less than the $500,000 to $700,000 we had forecasted, the ongoing effects of the warranty and plastic costs may cause us to miss our target of profitability in Q3.

At this point, we believe that our third quarter performance could range from a loss of $200,000 to an operating profit of $100,000, on revenues of $4m to $4.5m. This would result in an operating loss for the year of $1.3m to $1.9m on revenues of $16m to $17m.

The effect of the composite business on our profitability is one of the reasons we have tempered our outlook for the year. This, along with deferred revenues due to financing delays in China contracts, as well as the softness in European markets, should lead to GAAP diluted EPS of $0.17 to $0.20 for the third quarter of 2004. For the full year we expect to report GAAP earnings of $0.85 to $0.90, down from our original estimate of $0.90 to $1.00.

On the revenue side we plan to generate $46m to $48m in Q3, with annual revenues of $205m to $210m. We are very disappointed with the negative effects the composite business continues to have on our earnings and are taking steps to improve the value of the business. However, it’s important to note that composites is not having a detrimental effect on our cash.

Kadant generated $7.8m of operating cash in the quarter, a significant increase over last year. We continue to maintain a strong balance sheet, with nearly $82m in cash at quarter end, even after buying back a little more than $6m worth of stock in Q2.

Let me remind you that our cash balance is equivalent to approximately $5.60 per diluted share, based on the number of diluted shares outstanding at the end of the second quarter. Our strong financial resources give us several options for creating long term shareholder value going forward. First, investment in internal technology development. We continue to design products that meet our customers’ needs for improved quality and productivity and help them keep the edge in an increasingly competitive marketplace.

Second, additional stock buybacks. As I mentioned, we repurchased more than $6m worth of our shares during the quarter, and with the remaining authorization to buy up to $25m of shares until May 2005. Divesting our own stock will continue to be a viable option for the use of our cash.

Third, making strategic acquisitions. We have been actively evaluating several candidates for acquisition, with the objective of broadening our product offerings in markets we already serve and penetrating new markets that could benefit from our technological or process expertise.

On that note, I’ll turn the call over to Tom, to give you the detailed financial overview. Tom?

Thomas O’Brien: Thank you, Bill. I’ll start with the second quarter revenue results. Consolidated revenues were $57.8m in the second quarter of 2004, up 4% from last year. Included in these results is a favorable foreign currency translation effect of $1.7m, or 3% in the quarter. Revenues in the second quarter slightly exceeded our guidance, which was $55m to $57m, due to stronger than expected revenues in our composite and fiber based products segment.

Now let’s look at the revenues in those two reporting segments. Revenues in the papermaking equipment segment were $50.9m, essentially flat with last year’s quarter and included a 3% favorable effect from foreign exchange.

On the positive side, stock-prep revenues from China set a quarterly record of $10.4m, up 9% over a very strong second quarter last year. This solid performance is probably the result of higher bookings from China at the end of 2003.

Our stock-prep results in the rest of the world, however, were quite weak, with a decline of 22% in North America compared to last year, and an increase of 4% in Europe, which included a 10% favorable effect from foreign exchange.

Our water management product line also reported weaker results in the second quarter, both in North America, down 5%, and in Europe, which was flat compared to last year, but included a favorable currency impact of 10%.

Aside from China, the other positive note in our revenue performance in the second quarter was in our accessories product line, where revenues were up 8% compared to last year, including 5% from foreign currency. The results were mixed by region, however, as our North American accessories revenues were up 5% compared to last year, while our revenues in Europe were up 11%, including a 13% favorable effect from foreign currency.

Now let’s turn to our other operating segment, composites and fiber based products. Revenues in this segment reached a quarterly high of $6.8m in Q2 ’04, a 34% increase over last year’s $5.1m. This increase was entirely due to higher sales in our composites building products business, which achieved record quarterly revenues of $5.1m in Q2 ’04, up 52% over last year.

The increase over last year reflects the success we’ve had in broadening our wholesale and dealer sales networks, as well as weaker sales last year, due to the weather induced late start to the building season. Revenues in our fiber based granular products business were $1.7m, flat with last year.

Turning to our product gross margins, consolidated product gross margins were 36.6% in the second quarter of 2004, down 50 basis points from last year. This decrease is entirely due to lower product gross margins in our composites and fiber based product segment, where margins declined from 37.4% last year, to 21.9% this year. The lower margins in this segment were largely due to higher warranty provisions in the composite building products business this year over last year, along with higher natural gas costs, which affected our fiber based products business.

With regard to the warranty provisions, warranty expense was approximately $800,000 in the second quarter of 2004, compared with $300,000 last year.

Looking at the papermaking equipment segment, product gross margins were 38.0%, up 90 basis points compared to the second quarter of 2003. Most of this increase was due to higher margins from sales of capital equipment, mainly in China.

Now let’s look at our SG&A expenses for a moment. SG&A expenses were $15.6m in the second quarter of 2004, an increase of $2.2m, or 16% over last year. Approximately $500,000 of this increase is due to the unfavorable impact of foreign currency translation, compared to the second quarter of ’03.

The remaining increase includes approximately $400,000 of severance cost associated with one of our European operations and over $200,000 in Sarbanes-Oxley implementation costs. I should note that we now anticipate the total outside costs we will incur in 2004, to comply with the internal control requirements of the Sarbanes-Oxley Act will be approximately $800,000, roughly double the amount we had originally anticipated. This amount excludes the significant amount of time being incurred internally by our employees.

Turning to operating income and our EPS results. Consolidated operating income was $4.9m in the second quarter of 2004, down from $6.2m last year. Operating income in our papermaking equipment segment was $6.2m, down approximately $500,000 from last year, largely due to lower results in our European businesses. Q2 ’04 operating income was also $500,000 lower than last year in our composite and fiber based products segment, primarily due to a $370,000 operating loss in the composite building products business, compared to a small operating profit last year.

Finally, our corporate expenses were approximately $300,000 higher than last year, partly due to the Sarbanes-Oxley costs I noted earlier. Our EPS. We reported GAAP diluted EPS of $0.26 in the second quarter of 2004, compared to $0.28 last year. Included in the 2004 results is income of $0.03, which is due to a reduction in our tax reserves, primarily associated with the expected utilization of our foreign tax credits. The 2003 period includes a net unusual gain of $0.01. Now if I exclude these items from both periods, we can compare adjusted diluted EPS of $0.23 in 2004 to $0.27 in 2003.

Now let’s look at the $0.04 decline in adjusted EPS compared to last year. First, EPS increased by $0.01 in 2004 due to the favorable effects of foreign currency and by an additional $0.01 due to a lower effective tax rate. These combined increases of $0.02 were offset by decreases totaling $0.06 due to the following; $0.02 due to after tax losses on our composite building products business, $0.01 due to the higher number of outstanding shares in 2004 compared to 2003, and finally, $0.03 due to lower operating results, of course excluding deposits in the 2004 period.

I’ll conclude with a few remarks on our operating cash flows and the balance sheet. Cash flows from operating activities was $7.8m in the second quarter of 2004, almost doubling from last year’s $4.1m. Both reporting segments contributed to these strong results in the quarter.

For the total company, operating cash flows in the first six-months of 2004 were $8.9m, up 190% over last year’s period. Operating cash flows in the last 12-months were a little under $29m. We ended the second quarter with $81.6m in cash, which increased approximately $700,000 from the first quarter of 2004, in spite of having purchased $6.2m in Kadant stock in the quarter and having paid off our small outstanding debt balance of $400,000.

This cash position represents approximately $5.60 per share, as Bill noted, based on the number of diluted shares outstanding at the end of the second quarter. Now our net cash position, that is cash minus debt, has increased by approximately $87m since our spin-off from Thermo Electron, three years ago next month.

On the working capital side, where the lower the percentage the better, we ended the second quarter of 2004, with working capital as a percentage of the last 12-months revenues, of 15.7%, down 330 basis points from last year’s 19.0%. And the definition of working capital here excludes both cash and debt.

That concludes my review of the financials and I will now turn the conference back to the operator for our Q&A session. Operator?

Thank you. The floor is now open for questions. (Caller instructions.)

Thank you, your first question is coming from Claudia Shank, of J.P. Morgan.

Hi, guys. Just a couple of questions. One was if you could maybe give a little bit more color on what you’re seeing in Europe? Because I guess what I’ve been hearing from some of the paper producers there is that things are getting a little bit better and they all seemed a bit better in contract, I guess what you all are seeing.

Yes, thank you, Claudia. What we are seeing over there, it depends, some of the big corporations are doing better, because they’re international in scope and they have operations spread around now through North America and other regions of the world and they’re starting to see some pick up. But pockets where we normally have very strong presence, for example in France, Germany, Italy and a number of those countries, there has been a slowdown certainly in CapEx and some of the operating rates. Scandinavia tends to be doing fairly well yet at this point. So we’ve got a mix and depending upon – some of the projects that we were really chasing were in some of the areas that all of the sudden slowed down.

Is it more regional or are there sort of grade differences in terms of--?

It's regional, but it also impacts some of the grades. Tissue continues to remain fairly constant throughout the region that we look at. We do see some of the liner board activity in what I’d say Central Europe have slowed down to some extent. I think that’s tied more to the GDP efforts that they have.

Okay, thanks. And just also on the Sarbanes-Oxley payments, is there some guidance you can give on the payment of those, I mean should that be pretty balanced over the next couple of quarters?

Thomas O’Brien: I think Claudia that we – yes, I think it will be pretty much balanced over the remainder of the year. Part of the reason why it’s increased is the fact that we’ve had to outsource more of the work, simply because of the volume of the work that’s required under the Act. So that’s one of the reasons why it’s costing more than we originally anticipated.

Okay. And then just the other questions I had were on the composites business. One is just maybe a little bit more color on the trends you’re seeing sort of now in warranties, versus maybe the beginning of the quarter or the beginning of the year? And then also I just wondered about pricing in the composites business as well, if you’re able to sort of offset any of these cost increases with higher prices yet?

Sure, in terms of the trends on the warranty, the summer months are what triggers the contraction problem. So, you might remember, we fixed this problem last August essentially. And essentially most of the decks that were put down last summer really weren’t treated. We’re seeing those decks are now seeing their first summer of heat, or their third month of heat, if you will. So, you’d expect that in the summer months we are going to get a bit more. And then it should roll in as the year progresses, because again, we should roll into the newer stock, if you will.

In terms of pricing, we have not put any, or really heard of surcharges related to the plastic, if you will. I do think that there is opportunities to raise prices generally speaking, but most of our customers really want to have you raise the prices at the beginning of the year. And then they can kind of live with those price increases, as opposed to mid-year prices has changes. And I do think there’s some pricing opportunities in the market generally speaking.

Thank you. Our next question is coming from David Diamond, of High Rock Capital.

Good morning. Can you just talk a little bit about – you talked about deployment of cash, which is obviously a low return asset. Is stock price, given the cash value on an adjusted PE share repurchase is obviously accretive. But frame for us, you talked about evaluating acquisitions, if you were to make acquisitions, give us a sense of criteria, neutral accretion dilutive in terms of earnings, because it does sound like you’re moderating the full year earnings modestly, but if you deploy cash in share repurchase or acquisitions, we could just as easily see the numbers go right back up.

Yes, thank you, David, that’s a good question. In fact, we tend to look at it, certainly just on our core business for a moment, as one more of timing than really changing the fundamentals of what we look at as opportunity. But concerning the investment, you’re right. I mean, we do have competing needs or opportunities for cash. We intend on putting it to work.

And we are, right at this time, looking seriously at a couple of candidates on acquisition and I could tell you that they certainly would be accretive. And that we have a criteria where certainly over the next – within a three to five year period we’d like to achieve an order of magnitude of 25% return on invested capital. And we’re not going to be compromising that objective.

So any acquisition we would make would certainly have a positive impact on our business. Does that answer your question, David?

Yes, actually it does. Thank you.

Thank you. Our next question is coming from Alan Fournier, of Pennant Capital Management. Mr. Fournier, your line is live.

Hi, can you hear me now? Good morning, sorry. In terms of cash flow from operations in the quarter, how much was from working capital reduction?

Thomas O’Brien: About 2.8m, Alan, somewhere in that range.

Is there anything else in that number, option exercises or other things?

Thomas O’Brien: Option exercises would be in that number, on operating. But just in general, just to give you a sense of the flow, we had net income of $3.7m, depreciation and amortization was $1.2m, and then we had working capital for the balance. So that nets cash flow from operation.

Thank you. The $800,000 in Sarbanes-Oxley expenses you mentioned, is that a year or is that the second half? I didn’t get the timeframe there.

Thomas O’Brien: Okay, that’s for the whole year.

Okay. And that goes away next year?

Thomas O’Brien: Well, that’s the $64,000 question that everybody’s debating. It will certainly not be as high as this year, but it won’t go away to zero, no. I don’t really – I couldn’t hazard to guess at the moment, but it will be less than this year.

Why wouldn’t 75% of it go away?

Thomas O’Brien: I don't think 75% of it will go away. Maybe 50% will go away, but it’s an enormous paperwork effort that you have to go through to basically update your internal controls and then also do the testing of the controls. And then you have to pay your auditors after you do your testing to test the controls again. So we will have – we’ll certainly have to conduct our own testing. Maybe we can do more of that internally, which will save some money. But we’ll have to pay our auditors to do their external testing, such that they can render us their certification and opinion. So it will go down, but it’s not going to go down to zero. That’s kind of been a debate amongst people as to how much that will go down.

Okay. When you say, Bill, that an acquisition will be accretive, relative to what?

Certainly if you look at what we’re earning in our cash that would be an easy one today, because we’re not getting very much on our cash.

Right. And that’s my fear, that [some companies] look at that as accretion, and obviously relative to buying stock net of cash, that wouldn’t be a good trade in my opinion.

No, we have a higher hurdle on that and this is why we look back in saying that we want to do it. And certainly if we were to get – if we get anything, it’s going to be one that we’re very comfortable that we can get a good return on that investment. And again, that’s why we’re looking at return on invested capital, because certainly anything is accretive to this day. We could almost buy anything it would be accretive to what we’re getting on the cash in terms of earnings. So we have much higher hurdles than that.

And this is one of the reasons, by the way, that it has taken us some time to really find the ideal candidates to select, because we’ve turned on a number of companies that certainly could have been accretive [compared] to what we get off our cash, and they just did not fit what we want to do. We want to take companies that can have certainly a good return on invested capital and our target, again, is something like 25% over a five-year period. And also one that is going to provide us with some growth opportunities.

Okay. And let me say that I applaud you for initiating a share repurchase and having this discipline. It's important in terms of adding value long term.

We believe so as well. Thank you.

Touching upon China for a minute, my understanding is that the concern in China was related to specific industries and I thought there was an issue in terms of paper shortages in China and that wasn’t an industry where – well I guess there’s a need to recycle a lot of paper in China, was my understanding. Can you help me understand that?

Sure. In fact, paper just got caught up [in the net]. There really is a need for paper. There’s a high demand for paper. In fact, with their relatively weak currency, it’s very expensive for them to import paper to be used in shipping out products. So it’s one that they – they just got caught up in a net, because when they tried to throttle I guess the growth engine a little bit to get some control over it, they put everything into the same basket.

And this is why this article in the Journal today gives us a lot of comfort as well. Because this is what our people there have been saying, is that paper is not going to be impacted by it. It's just a question that some of that’s been caught up delay process. But according to this article in the Wall Street Journal today, they comment that really their focus was on throttling some government projects, that some localities were doing to generate employment as opposed to real needs and demands of business. So this is reform back. They’re going to try to make it much easier for investments concerning ongoing businesses. Which is really what we go after. So that’s encouraging from that point.

Plus the customers that we deal with there, by the way, as well Alan, a number of them are international customers that do have – some have capital. Others found other ways to raise capital such as going on the Hong Kong exchange to finance projects and so forth. So it’s just this delay that got caught up that really set us back, like three or four months, which really impacted us for the second half of the year.

So we’ll actually see deferred revenue line item on the balance sheet?

Thomas O’Brien: No. I think we’re just saying that revenues – basically, we have contracts in hand where we really would have expected that we would have started recognizing revenue on those by a percent complete already, or in an earlier period. Instead, because of the customers’ delays in obtaining financing, we won’t actually start recognizing revenue on those contracts until later that we initially anticipated, some of which will now go into later in 2004 or maybe even into 2005, as Bill noted in his comments. So that’s what we mean by deferred revenue. It's not deferred revenue on the books. It's the revenue itself is being deferred to later periods.

Yes, we really defer that until we secure – all financing is secured.

Okay. And then last question, on the composites business, I must say I’m a big frustrated. You said all the right things, Bill, in the past when we’ve talked about dealing with the problems in this business and we’ve also sort of gone through the worst is over conversation several times in the past and it appears as if these problems are ongoing. Is it time to act on this business now?

Well, Alan, frankly I share the frustration, because I thought we’ve be far further along than we are at this period. On the other hand, looking at it, I do believe that by staying the course otherwise we wouldn’t. But by staying the course that we continue to generate value. We have identified some specific steps that we can take.

And we do expect that certainly the warranty issue will be tailing off. Because again, those are on decks that were installed on product that we shipped before August of last year. So we hope and really believe that it’s going to be tapering off by the end of this year, which would really, I think, change the dynamics of the business. As well as the other factors on the plastic, that we are taking steps to mitigate the impact of the vast fluctuation that we see in plastic prices.

But I think we generated something of value, which is endorsed by certainly that Consumer Report and certainly our customers. And the fact that we continue to increase revenue is encouraging. But we watch it very carefully. And I just believe that we’re going to generate value out of that business at this point.

We had talked about sort of competing in a land of giants and you had said a joint venture with a marketing partner would be something you’d look closely at. Is it just that nothing appealing has come along or are you actively pursuing arrangements, so that you can compete with these very large marketing organizations?

I’ll put it this way, it’s nothing that we can discuss at this point. But I mean, we’re looking at all types of options to generate value.

(Caller instructions.) Thank you. Our next question is coming from Rick Lane, of Broadview Advisors.

Good morning, guys. A couple of questions here. One, with respect to China, let’s see, most of your stock-prep was headed towards liner board and box plants. I’m just curious, one, has there been any change in dynamics, just the interplay between China at some point having ability to collect their own waste paper as opposed to importing it from the US? And the pricing that that creates here in the US, obviously they’ve driven up waste paper prices considerably here in the US. Is that impacting any of the demand for equipment over there?

Well, that’s a good question, Rick. They’ve been really the leader in absorbing waste paper, not only from North America, but also is Europe. They have had a huge appetite for it. And you’re right, the first thrust has been the brown grades and liner board for packages and boxes that they ship products out on. And that continues to remain very strong.

And they also, however, are now starting to focus on the finer grades of paper, white grades of paper as well as tissue. And they’re starting – they’re very concerned about generating or picking up their own waste paper. I mean, I think their collection, because they’ve placed such a value on the fibers, is very high on recovered fiber that they do use. That will pick up in time. And they are starting to gain on that. So I think that eventually that may take some of the pricing pressure off waste paper as well in the US and in Europe, which would certainly help our customer base in both Europe and in North America. The trend seems to be going that way.

Okay. When you look at the opportunity in China and the fact that you still have an issue getting some of the stocks up – equipment financed, how do you look at this, the backlog in opportunity? How short is that country with respect to its ability to produce liner board and boxes?

Well, they’re basically pretty well satisfying their need right now, because their industry has grown at such a pace that every time you put up a new facility that product is absorbed very quickly. And the trend is going to be over the next eight years that they’re going to be putting on another 30-35m tons of capacity to feed that ever growing appetite for paper.

And on the liner board side, I think that’s going to continue to grow. As far as the financing of that, these are projects that primarily go through an approval process in their banking systems on the individual mills. And when we refer to getting a contract, sometimes we get a contract, but we don’t get the letter of credit. And without the letter of credit we’re not really going to be doing much on it or taking any recognition on it. So we’re very cautious on that. But I think the encouraging thing is that the banks are going to start relieving that time delay for projects such as this, because the needs there really exist.

And some of the same producers that are producing liner board are now considering going into other grades of paper – white grades of paper and tissue as well. So we see that as an ever ongoing opportunity for us to participate in.

The 10m that you did in the second quarter, was that largely a couple of 4m type stock-prep deals there?

Thomas O’Brien: I think it was pretty much spread, Rick, because again, we take [this in] complete on the contracts, so there were a number of different jobs in that number.

Yes, probably half a dozen or more.

Okay. The financing issue not withstanding, have you seen any diminution of demand coming from China?

No, we haven’t. We continue to see a tremendous amount of activity over there. And I think what’s encouraging is the need. And again, the need that they have, there’s so many international companies that are there that are shipping products back from mainland China back to Europe and back to North America. And so there’s a constant need. In fact, every time a mill goes up, they operate pretty well right to capacity and all their product is being used internally at this point.

As a whole, is the country actually importing liner board or even boxes themselves?

From time to time they have in the past, but right now they’re really trying to satisfy their own need. And they’ve pretty well taken everything that they produce internally at this time. Which does, on the other hand, it does have – has had some impact on for example North America, where in the past we did ship paper products into Asia and into China. And now they’re pretty much taking care of their own needs.

Well then the implication would be that if their own economic growth continues at the pace it has, that if putting up some of these plants slow down a little bit because of the financing, they will have to start to import.

That they would do as well. And that would benefit us. That’s the advantage of being global. That would benefit us in our other markets at that point if that’s the case. But the sense that we’re getting is I think the slow down on certainly the impact on the paper industry has been a temporary one and hopefully we’re going to get some relief on it very quickly, because they sense that too. And again, with their weak currency, the import finished product is expensive, they pay a premium for that.

Well then, I guess if the financing thing got cleared up, how quickly could you go back to your original expectations for the year, understanding that the longer it gets delayed on its percent to complete, obviously that has a timing issue.

Yes, in fact some of that timing has already been affecting us. Because as we’ve been waiting for the delays, instead of putting our work in process, we’ve basically curtailed it until we get the financing. So we don’t get a lot of expense ahead of ourselves. So some of that and ordering materials and bringing materials in and so forth and the castings we need, I mean. So to really fire that back up again, I think we would never recover what we thought we would have throughout the rest of the year. We’re going to get a spill off into the end of the year, going into 2005.

But given the fact that you have been doing 10m – let’s see, what did you do in China in the first quarter?

Thomas O’Brien: It was around 7m.

Around 7, okay, so about 17 to 18 year to date. What would you consider, if financing weren’t really an issue, how do you size the market opportunity? Can that eventually be a $100m market as you expand into other grades?

Well, I tell you what, if they go ahead as anticipated on developing a paper industry that’s eventually going to have 60m to 80m ton production capacity, that’s going to be at the level just about of the US today. And we would see that with all of our product lines in there, varying asset for the market to address, yes, would be very close to that.

Do you worry about your competitors, perhaps providing financing?

No, not really, because in our business we have more financial strength than our competitors do at this point. We certainly outperform them in terms of income and cash generation. We’re in a better position than they are.

And the other thing that we have is we have a longer term of history within the Chinese market and a much larger install base, and more importantly, some very very very loyal customers that have been dedicated to us. And I think there’s opportunity for us to even make more income out of the Chinese business once our facility gets up and running in 2005, because then we can take advantage of some lower cost sourcing.

Okay. And the last thing I was going to quickly ask you was, the source of the share count creep, how many shares have you actually bought back year to date?

Thomas O’Brien: We bought back a little under 300,000. It was about 297,000.

Year to date, okay. And then on a year over year basis, the fully diluted share count has gone from 13.9 to 14.5. Over that period then, how many shares would you have repurchased over that period?

Thomas O’Brien: Over that period it would have been the same number, because we just started purchasing in the second quarter. So the reason for the increase, which is what you’re getting at, right?

Yes.

Thomas O’Brien: Two things, one would be option exercises during that period and second would be [indecipherable] increase in the dilutive effect of the outstanding options, the share price is higher you’re going to have larger dilutive effect. And also remember that all of this is weighted as well, so when you’re looking at one quarter, the impact – let’s say of the 300,000 shares that we bought back, we didn’t actually reduce the diluted outstanding by 300,000 in the second quarter, because it’s weighted. But that 300,000 will come in in the third quarter obviously.

Well, unfortunately, you’ll also have the effect of a lower stock price here.

Thomas O’Brien: Yes. Although there will be lower dilution in that respect.

Thank you. Our next question is a follow up coming from David Diamond, of High Rock Capital.

Just a quick follow up on the cash flow question from earlier, just so I got it right. Let’s call it 15m shares at $0.80, 12 net, you ran 1.2m on D&A in the quarter, call that 5 annualized, that’s 17, what’s the CapEx look like?

Thomas O’Brien: CapEx for the year, we said last quarter the CapEx for the year would be around 4.5m. And that included 1.7m for China, about 300,000 for composites and the balance, which would be 2.5m for the core papermaking side. Now I would say, if you look at our press release, you’ll see in the first six-months we only had CapEx at a little over 1m. I think it’s 1.1m in the press release. So I would expect that the 4.5m is going to come down. We will disclose this in our Q, but I would suspect it will come down at least $0.5m.

Okay. And then to the extent you deploy capital in acquisitions as one of the uses, can you give us the framework for the size? Would you be willing to use all the cash on the balance sheet and borrow 20, 30m or are we talking about 10s, 20s, 30s in terms of size?

It really depends upon the type of acquisition that we would look at. And I think that if we were to look at something in a different – say an industrial filtration company in another industry, we would probably tend to be more on a smaller size, around the $20m to $30m range. If we had got something that was a product addition to our core business, that would even be a smaller one. But if we were to find a company that was very attractive and fit our primary core business in the paper industry and has a good after market value as well and fit our criteria for it, we would be prepared to go higher in that case.

Okay. And are these the types of business, are we talking somewhere around six to seven multiples on an EBITDA basis pre-synergies, these types of businesses?

Probably around that range, yes. And you know – yes.

Thomas O’Brien: Hey David, this is Tom. I’m glad you asked that follow up question, because I did want to respond to something you had asked earlier, which I think is kind of getting to the point you’re at. One of the issues we have, obviously, one of the strengths we have, is the power of the balance sheet. And obviously with $82m in cash, no debt, we could – I’m just saying theoretically here, not suggesting we would, but we could do an acquisition of $120m and still have debt to total capital of 15%.

And we’ve said that over the longer term, in terms of our capital structure, we’d like to keep debt to total capital in and around or less than 20%. So we could do one of 120m and we would still be at 15%, which is very healthy debt to total capital ratio. So I think that was kind of the point that you were trying to get back in your earlier question.

Yes. And for these types of businesses, I assume they would be sort of consistent with – you’re running CapEx, I think you said 5m on 200m in sales, call it 2% of sales. So if we just sort of played around with theoretical math here, 120m, a six multiple of EBITDA would get us 20 if it was, let’s call it, 5 or 10% is CapEx, we could obviously play around with scenarios in terms of coming up with a net after-tax--?

Thomas O’Brien: Right. The only other thing I would say is our normal CapEx, I would say runs for the paper side, between 1.5m and 2.5m a year, so call it – it’s a little over 1% of revenues. It's a little big higher this year, because we’re putting that facility in China. So our CapEx normally runs I’d say a little over 1% of sales, which is also very healthy.

Thank you. There appear to be no further questions at this time. I will now turn the call back over to the speakers for any further or closing remarks.

Okay. In summary, I would say that we’re pleased with our performance in the first half of 2004 and we are disappointed in the effect that these timing delays will have on our second half. And we believe that this is a short term issue.

Kadant remains well positioned in the marketplace with the technology and global presence that allow us to take advantage of market improvements as the occur. We’re also armed, as we just discussed, with a strong balance sheet, which gives us a number of options for generating long term shareholder value. Thank you for your interest in Kadant.

Thank you. This does conclude this morning’s teleconference. You may disconnect your lines and enjoy your day.