洛克威爾自動化 (ROK) 2005 Q2 法說會逐字稿

At this time, I would like to turn the call over to Mr. Tim Oliver, Rockwell Automation's Vice President and Treasurer. Mr. Oliver, please go ahead, sir.

Thanks, Shannon. Good morning and thank you all for joining us for Rockwell Automation second-quarter earnings release conference call. I'm - - I first want to apologize. We're about three minutes late getting started. There's a lot of late call-in volume and we want to make sure that you all get on.

Our results were released this morning have been posted to our web site at www.rockwellautomation.com. A webcast of the audio portion of this call and all the charts that will be referenced during the call are also available on the web site. These posting will remain there for 30 days. With me today are Keith Nosbusch, our Chairman and CEO, and James Gelly our CFO. Our agenda today includes summary remarks by Keith and a review of the both the quarter and outlook by James.

We will, as always, leave plenty of time at the end of the call to take your questions. We 'd like to try again the self-policed two-question limit. We tried it last quarter and despite the fact that some of you used multipart questions or unrelated follow-up questions, I think we did get more people in on the call and we will try that again. Thanks in advance for your help. The call is scheduled to last one hour.

Please note that our comments today will include statements relating to the expected future results of the Company and are, therefore, forward-looking statements as defined by the Private Securities and Litigation Reform Act of 1995. Actual results may differ materially from our forecasts or projections due to a wide range of risks and uncertainties that are described in our earnings release and are detailed in all of our SEC filings. And with that, I will turn the call over to Keith.

Thanks, Tim. Good morning, everyone. Let me start by saying that I'm very pleased with our performance this quarter. It shows once again the evidence of the transformation of Rockwell Automation . The abilities to generate strong organic growth with high incremental margins and very high return on invested capital. While we don't give quarterly guidance, and I don't spend a lot of time looking at consensus estimates, I do know some of you may have had higher expectations for us. So I want to give my views on how you should think of Rockwell Automation's growth pattern.

In general, we are inclined to view our sales as oscillating around the gradual upward trend in demand with -- with above-trend orders and sales followed by below trend intervals. Again, this is why we provide annual guidance not quarterly. The saw -tooth pattern of orders and sales is not readily forecastable, particularly when you consider our short backlog and the high conversion margins many of our products are capable of. So as I said, I am very happy with quarter 2. Another very good quarter for us. For the fourth straight quarter, we demonstrated double-digit organic revenue growth and our second-quarter results very nearly match the tough comparison of the extraordinary strong Q1. As good as it was, after the exceptionally strong first quarter, expectations for the second were even -- were for even more growth. The fact is, that the very strong fourth and first-quarter growth rates were followed in January by a pause in the growth rates of orders and sales. Particularly in the flow goods part of our revenue base.

By the way, this was not true of our Power Systems and segments of our power control business, which are still in a growth spurt. The pause in flow of goods, included both legacy installed-based products, as well as some of our newer products. Both domestic U.S. and European sales were mainly affected. So that's what we know about the so-called air pocket. Having said all that, let me spend just a minute on where we are for the year and going forward.

I am very happy with this year in every way. Our first half was exceptional by any measure. With half of the year now behind us, our organic revenue growth is more than 16%. And our operating earnings are up nearly 70% versus 2004. This strong start puts us about halfway to our full-year guidance, which is a great place to be. It also gives me confidence that we will achieve our guidance and that 2005 will be a remarkable year for Rockwell Automation. Looking beyond 2005, I am also very confident in the strength and growth potential of our business model.

The team here is very focused on taking all the actions required to sustain strong organic growth in 2006 to 2009. This will be done through building domain expertise, accelerating Logix features and functionality, proliferating the integrated architecture, with Logix becoming the factory floor information server. It will be done by expanding our served markets, the batch hybrid process space, safety, and integrated motion, and doing this both domestically and globally. And we will do all of this with differentiated technology, products, and services.

I hope this puts this quarter's result in perspective and helps provide some insight on how we are managing Rockwell Automation to create high return organic growth. Let me now turn the call over to James.

Thanks, Keith. I am going to start with the chart entitled "Q2 results summary." And these really show the key facts to the quarter. Revenue of 1 billion, $218 million, was up 13%, 11% excluding currency. I will be back to this topic. Turning to profitability, looking at the net income lines. Net income from continuing operations was $142.5 million as you can see on the chart, but we had a few unusual items this quarter. First, $19.7 million of tax benefits. And we also got an $11.4 million pretax benefit in the quarter, and this relates to the recovery from some of our insurance companies litigation costs we incurred over the past several years. So excluding both of those, income from continuing ops was about $115 million, up 54% year-over-year.

Diluted EPS, as you can see on the chart, from continuing operations was $.75. But again we had $.10 of tax benefits and $.04 from the insurance recovery. So excluding those benefits, EPS were about $.61, up 56% year-over-year. And looking at discontinued ops as you can see, $.04 in the quarter which gives us to reported EPS this second quarter of $.79. And just for the record, discontinued Ops last year with our former first-point contact business and this year the $.04 reflects the resolution of certain income tax matters. Let me go to the next chart entitled "Q2 results Rockwell Automation." Which gives you revenue and op income for Rockwell as a whole. As you can see sales were 1 billion, 218. Operating earnings $218.7 million for the record with the caveats I just made. But let me give you a little more detail on slide 3, which is "second quarter results for Control Systems." On the left, revenue this quarter was $998.6 million representing organic growth of about 11% year-over-year, about 9% minus currency.

We had good International sales, particularly in Latin America, Canada and Asia, and our Logix business was up 25% year-over-year. Sequential growth was about 1% in the quarter. And as you heard Keith say, we experienced a pause or an air pocket in the early part of the quarter, followed by a pretty strong March, and you can see it in the modest sequential growth recorded. Over on the right, looking at operating earnings, this quarter's result was $186.8 million, margins expanded about four points to 18.7, but 17.6% when you exclude the amounts that we discussed earlier for the insurance settlement. The level of profitability was the result of higher volume, favorable price, strong productivity, and not a lot of additional overhead needed to enable the higher volume. With or without the favorable insurance settlement, our margins were down sequentially from the 19%-plus seen in the first quarter which we viewed, and viewed at the time as exceptional. Excluding anything unusual, our year-over-year conversion on incremental sales are about 43%. Admittedly down from the past quarter or two, but certainly in line with prior guidance and in line with our current outlook.

Let me go now to the second-quarter chart for Power Systems. Sales on the left, $219.8 million, up 20% year-over-year and up 10% sequentially. Our end markets, like aggregates, mining, energy, are displaying some very favorable conditions. Over on the right, on the margin side, operating earnings were up as you can see, more than 100% year-over-year to $31.9 million. That's a 14.5% margin, up 7 percentage points year-over-year. Here you can really see the benefits of volume, productivity, price increases, which offset higher raw material costs. And keep in mind that the year-ago results were net of about $4 million in restructuring charges, but a terrific Result at Power Systems, both in the revenue and profitability front.

If I could, I would like to go to the chart entitled "Q2 results Regional Sales," and provide some details on our results around the world. As I have already said, good International growth on far right-hand-side of the chart , we show revenue growth excluding the impact of currency. Good growth in Canada, the U.S., Latin America, Asia Pacific, looking at Europe, down about 1% year-over-year, excluding currency. Really reflects some slower growth rates across the EU in 2005. Germany, in particular, appears to be wrestling with slow growth in unemployment.

Looking at Asia Pacific, we continue to benefit from strong local demand, led by China, India, Taiwan, and Southeast Asia. And for the record, greater China sales were up 33% year-over-year. Go now to chart 6 , "cash flow." And as you can see, we have included both the quarter and year to date. We generated on the left, lower left, $131.7 million of free cash flow in the quarter and year to date we are at $222.1 million. Conversion in the second quarter was about 92% of income from continuing operations and for the year we expect free cash flow to be about equal to net income. We repurchased in the quarter over 2.5 million shares, and have reached a 5.2 million shares cumulative repurchase in the first half.

My last chart is 2005 guidance, and it reiterates without change the prior guidance of the year, that is organic revenue growth of 10% to 11% , margins should be up 3 to 4 points this year , to reach the 17% range, and as Keith said what is so great about our full year guidance of $2.55 to $2.65 and we're targeting cash flow for about net income for the year. Keith said the first half was a very strong result, we feel good about the momentum that we've got as we enter the second half and hopefully, this information will be helpful as you think about the balance of 2005.

Shannon, we're ready to take questions.

Thank you.

[OPERATOR INSTRUCTIONS] . Our first question will come from Bob Cornell.

Yeah, good morning, everybody.

Good morning, Bob.

So now we know what the air pocket meant, right? So -- I wonder if you could just sort of calibrate us now about what really was going on in January. How much of a air pocket you saw in February. And you talked about March being good. Can you calibrate us on what the rates of gain were in March and what the outlook is currently is in April.

Well, Bob, first of all, as we said, the January slow start really related to, as Keith touched on, both U.S. and European demand for flow goods. As you know, that's a pretty good margin, part of our revenue base, not including Power Systems, not including as Keith said, sections of the power control part of our portfolio, which are doing very, very well. We -- I would -- I would characterize it as kind of a -- a pause followed by, what I would call January -- February normally a short month, nothing out the ordinary there, but as soon as we saw the combination of January, February, we, alerted people to the change in momentum. Now we talk about March. March is always a pretty strong month for us, and this one is no exception, approaching -- well, approaching record revenue growth, revenue and income, but I think what we've learned is it's probably not a great idea to take a single month. We try to put March in context with January and February and look at a whole quarter, and as Keith said, kind of look at the whole year at once and adjusting for the sawtooth nature of demand.

Got it. You know how about a calibration on the comments you made about, the bid quote activity and some the comments back from the sales force, distributors, about the, the pipeline type of thing.

Sure, Bob. Let me just follow up with one point on James' comment about the -- about the quarter and January. January, while it was soft, was still up on a year-over-year basis. So , you know, it -- it had that positive to it, but it just did not achieve what -- what our expectations were, but still year-over-year growth. So, positive in that regard.

Yeah.

With respect to the pipeline, I think we are continuing to see the evolution of the recovery, and in particular, what we are now seeing is in the U.S., we are now seeing more activity around capacity expansion, and the need for capacity expansion, particularly in the heavy resource , natural resource types of industries. The supply chain is pretty tight, as you can imagine, given what's been going on, particularly in some of those industries for many years, and so we're seeing an uptick -- in project-related activities, quotations, and in our power centric portion of our business, we feel very good about the outlook over the next couple of quarters .

Generally because of the short cycle projects that we have on the books between -- between productivity and what I would call "cost reduction activities" that indirectly get you capacity expansion, but now we are seeing a number of segments, the request, the desire to look at capacity expansion. Once more, I would not classify it as Greenfield, but I think where- - because of what they've been doing to lean out their operations, it's -- it's what I would call more of the Brownfield expansion, but true capacity as opposed to productivity and cost.

Final question is, how much of $.15 to $.20 of strategic spending did you make in the quarter?

Bob, we said we would spend kind of at a ramping-up rate and you may say $.03, $.05, $.07, and we did a little less than $.03 in the quarter

Okay. Thanks.

Thanks.

Our next question will come from Mark Koznarek of FTN Midwest Securities. Hi, good morning.

Good morning, Mark.

I might have missed it. Did you comment, Keith or James on how April is trending so far?

We didn't comment on it, and what I would say, again, as Keith mentioned year-over-year, we're still seeing good growth, that hasn't changed in more than a year now. It's -- it's a good momentum as we left March and into April. I would characterize April as good.

Okay. My question is, really just laying the second quarter next to the first quarter for Control Systems and observing that, revenues are up 13 million, but income, once we take out the insurance gain is down about $15 million. And I am just wondering if you can help bridge between first quarter and second quarter?

Sure Mark. I think there's a couple of things and it goes back to what we talked about at -- in the first quarter conference call where it was an exceptional quarter from a number of reasons. One, the product mix continued -- I would say expansion of the MRO, spending and growth, and in our Systems Solutions businesses, unabsorbed overhead cost, people, we were able to accelerate and expand that growth without adding any costs in a people business.

So now let's transfer into Q2. Quarter 2, based upon what we characterize as the air pocket at the start of it, that certainly reduced the MRO flow goods business for the quarter , and because -- and really when you missed the flow goods, it is not like you can recover it in a project business. You don't see, a step change quickly in MRO spending that says, that -- that will all be recoverable. So -- so we miss out on good MRO which is obviously rich mix for us.

Secondly, We continue to see great growth in our Power Systems business as evidenced by the performance, and you can see the year over -- the quarter over quarter comparisons there, which is the strong growth that they have throughout the quarter, and then finally, we did increase -- we did increase spending -- spending in some of our growth initiatives , and so I view it as mix. The lack of strength in some of -- in the early quarter with MRO that was not recoverable, and then actually strong growth in our project solutions types of businesses and our power components in -- in -- in motors and mechanical.

Keith, did raw material cost pressure change between the first quarter and the second-quarter results? Because I understand you recently increased price on some automation equipment, but it was late in the quarter, March 1, I believe. So was there price versus cost pressure changing quarter over quarter?

No, I mean there is always pressure. I don't want to underestimate that, but that had nothing to do with -- with the performance from quarter 1 to quarter 2, other than it was probably a -- a slight positive in Power Systems, because we've been behind in the recovery of the cost side of it, and we had a price increase in January in our Power Systems business that as -- as we walk through the quarter, we're getting closer to a full recovery of all of our cost increases. So -- so I think it was a -- a slight positive to -- to Power Systems as the quarter progressed.

Yeah, on the subject of pricing. You know we -- first of all, we've gotten considerably better at tracking and doing price analysis and Power Systems, as Keith said, had gotten behind the price cost relationship and spent some time in the quarter beginning to catch up. Control Systems, we are not that affected by raw materials. It is much more of a people intellectual asset business, and we got about a half a point to a point of price and Control Systems both in the quarter and year to date. So as Keith said, certainly no margin impact due to price costs at Control Systems really at all and probably a mild positive at Power Systems in the quarter.

Yeah, and I would only add to your question, Mark, was that you referenced a -- a price increase in Control Systems in March 1, and we did not have a price increase March 1. Our price increase in Control Systems was in the first quarter of our fiscal year.

Okay. Thanks for clarifying that.

Sure.

And next with Fulcrum Global Partners, we have John Baliotti.

Good morning. I was just -- you answered some of questions I had about the different months, but can you give us a little more color on some of the end markets.

Sure.

-- see how they've been trending, maybe just through the quarter and also maybe April relative to what a January looked like?

I would be happy to for the first part of it. I don't think we have what I would call "end market analysis" in April versus January at this point , yet, but I can tell you what our outlook is for the end market going forward and characterize that. If we look across some of the different verticals, certainly food, beverage and brewing and automotive. The quarter growth rate was slightly below the Company average, but in those markets, we are still growing at -- at approximately two times the rate of underlying growth in the industry. And -- and in these industries, we continue to invest in our ability to serve those markets, and certainly we benefited historically in that when we put -- we put money into customer facing types of -- types of relationships, that we are able to accelerate our growth and quite candidly, that's why we're growing at two times the underlying growth rate in those industries. If you look at semiconductor and life sciences, those are two industries that are going through what I would call a state of flux. They're well below -- well below the Company average. Certainly semiconductor being driven by the sharp drop in prices in-- LCD flat-panel glass, which was a real -- a real benefit in the previous 6 to 9 to 12 months.

And life sciences, while it has definitely slowed, there is still a great end market there, and we continue to build our domain expertise and expand our presence in that market, but they've had some tough times with some of the generic issues, the patent issues, and other activities within -- within the segment. I think probably the star of the quarter was in the extraction based and raw materials industry. Some of of the old more traditional heavy industries, they had extremely strong growth rates above -- above the Company average, as referenced by the strength of Power Systems and some of our power control segments throughout -- throughout the Quarter, and certainly water and wastewater is growing very rapidly for us, but -- but once again, from a -- from a small base. So we don't see a lot of change in those segments as we look forward.

Continued steady expenditure and consumer product and above-average spending in the more power centric reaction-based raw material industries and state of flux, a little bit in ongoing for a while to settle out in both life sciences and semiconductor. So that's a little -- a little preview -- a little review of the verticals.

Okay, thanks, Keith.

You bet.

Your next question will come from Jeffrey Sprague of Smith Barney.

Thanks. Good morning.

Good morning, Jeff.

Just a couple of things. A lot of the questions have already been addressed, but the guidance does includes the percent that you took in the quarter, the $2.55 to $2.65 reflects the $.04 benefit from insurance.

Jeff, when he put the guidance of $2.55 to $2.65 we had been expecting some forward recovery of cost, but I wasn't expecting the recovery of past costs. So, it will be a lower -- from our standpoint, there'd be a lower cost going forward, but the $.04 is about several years' worth catching up.

Okay. If we think -- Logix is up 25%. I think part of the rich mix you've enjoyed is kind of PLC5 and Logix in combination the last couple of quarters has probably positive. Did that dynamic still play out in the quarter or did the totality of the two --

We know exactly what you are getting at because -- good memory, Jeff, because that is what we talked about in particular the first quarter. That reversed a little in -- in the second quarter. That was part of the comment around the pause is spending of MRO in both legacy and new, and in particular, there weren't a lot of projects that were, I'll call it PLC centric, SLC centric in the quarter, and in fact -- and in fact, there was a decline, similar to the decline that we had in the first half of '04. And so the combination was still obviously growth, but nowhere near the levels of the combination that we had in the fourth quarter and the first quarter. So that was some of the rich mix comments that we had been making earlier that we saw.

Now going forward, we expect to see that . We expect that to see -- to flatten out again, and it is a little lumpy because of project business quite candidly, but we do not expect continued -- continued decline like we saw in this quarter, and that's what we're looking for the rest of the year to be a little flatter and, therefore, Logix be in a much more net positive when you sum the two together.

Just so I understand what you said, though. So it was -- the combination of the two grew year-over-year but declined sequentially. Is that kind of your comments?

No, no the combination still grew. Still grew sequentially --

but just wasn't --

but it wasn't as high because platforms the previous quarters was basically flat. And it was, high single, maybe 10% decline in the quarter, which was more traditional to what we had been seeing in -- in the early part of '04. So -- so that was from the legacy standpoint was decline. Logix was growing at 25. The net was still a sequential growth on -- on a -- on a go-forward basis.

Okay. Can you give us just a little more color on Europe. You called out Germany, but a lot of kind of signs in general that you're a little wobbly here.

Well, I -- we have nothing to dispute that. It is very wobbly. For the- - for the quarter, German -- Europe was down 1%. And that was highlighted by the decline in Germany, which was much greater than that, and really the region in total, as we have talked a couple of times about, there's no consistent pattern, and it is not by country, and it is not by month, but I would say, right now, we are certainly in the second -- in -- in the second quarter , it was definitely weaker. And we don't have a lot of - - I'll say optimism from the Western Europe part of it for the remainder of the year. We're not counting on a big recovery there as we -- as we look forward.

We continue to do well in Eastern Europe and well in -- and well in the converting at some of the OEMs, but the European OEMs are hurting because the Euro exchange rates. So some of their volume is not as great as one would have expected in a traditional OEM exporting region. So Europe is just our toughest region, plain and simple. And we don't anticipate that changing certainly over the next -- over the next six months.

Is there any sign, though, that they are more aggressively pushing productivity to address some of the costs and currency disadvantages that they have, some of the -- some of your kind of vertical market customers? Or just not really any evidence of that?

I would say not as much evidence. I think they have the -- they have the tougher problem of dealing with their labor situation, the high cost of labor, and being able to remove labor costs with any -- I would say with any consistency. And so it tends to be a much longer term type of activity, and to be real candid with you, Western Europe is -- is very much focused on Eastern Europe for doing that.

Yeah.

And I'll -- it is kind of like, the expansion of the EU is kind like NAFTA, where there was a lot of expansion into Mexico a decade ago. There's a lot of expansion going on in Eastern Europe, and that's where you see the investments being made much more -- much more than Western Europe. And so they're not looking at really doing a lot of modernization that we see anyways, in general.

Now there is always obviously specifics here that -- that continue, but -- but Western Europe is -- is not -- not spending a lot. But it is also very OEM-focused. And I think the exchange rate is what hurts the OEMs much more than the productivity and I think if that exchange rate becomes a little weaker or stronger, depending on which side of the ocean you're on, we'll see a pickup in -- in that part of the business, and that will be independent of -- of the other dimensions that are more appropriate for end users.

Great, thanks a lot.

Yes.

And next with Merrill Lynch we have a question from Mr. John Inch.

Thanks. Question. Just to clarify, James, I know you said this I just didn't understand answer. Does the guidance, the $2.55, and $2.65 does include the $.04 of insurance receivable.

No.

It does not. Okay. With two more quarters to go, should we be thinking higher end of the range or lower end of the range.

You know what, that's what a range is for. I guess you've heard us as best we can, John, as much as I would like to swing at that one, with -- with the sawtooth nature of demand, with the capability that our MRO flow good business has of coming on, coming off, I guess I would just seek sanctuary in the range rather than try to call it one way or the other at this point.

All right. And then -- the other question just is on the $.15 to $.20. It sounds like you've spent what you expected to spend this quarter. Is $.15 to $.20 still a range or are we looking basically at $.15. And asking perhaps a little bit -- if you can talk a little bit about how the spending progression went and how you're feeling about the investment in growth initiatives, that sort of thing.

Well, to start with, before Keith jumps in, we -- as we said in the quarter, we are kind of ramping up. What we're adding is stuff that adds a lot of value to customers, and we are accelerating features and functionality in our core business and integrated architecture, and it takes a while to find the right quality of person in the right resource, so I think we're still looking at 15 to 20, but we will be judicious and get the right people. If it takes a little longer, so be it. Now, I'll let Keith jump in on how he likes the spend.

I like it a lot, John, for the simple reason it is in the areas that we do very well in traditionally, and it is also continuing to reinforce the transformation of our -- of our business model. So we're investing in -- in verticals, the ability to deliver solutions. We are investing to expand our product service portfolio to those verticals. We're adding customer facing resources that are great value providers. And continue to drive the differentiation That our technology brings into quantified business value for our customers. And so we're -- I am -- we went to that -- this model because we went to those initiatives because we felt they were in the best long-term interest of -- of us, as a company and I couldn't be more excited about, quite frankly excited, about what these are going to bring us down the road, and -- and just thrilled that we've been able to accelerate the spending given the performance that we've had over the last couple of quarters, because this is truly a continuation of the game-changing technology that we have. It will continue to make us closer and more customer intimate and -- and be able to deliver business value for those customers in a much more dramatic fashion than we've been able to historically.

So still very positive. It is tough getting good people as James said. I mean the only frustration is we are may be a little slower in the ramp-up quite candidly, but we want good people.

And, Keith, maybe just lastly, Western Europe is weak today. It may be stronger next year. Who knows.

You have a pretty formidable competitor in Western Europe today. But it strikes me that a lot of the products you are offering prospectively, despite the macro trends should be able to gain some penetration. Could you maybe give us a quick update as to -- are the spending initiatives really India, China, Latin America focused or are you thinking of opportunities down the road to pick up business in Europe incrementally?

Really good question, John. The -- the first comment is, this is not just China and India-centric spending. It is -- it is in -- it is also very strongly focussed in Central and Eastern Europe, but in addition to that, and in particular in Europe, including Western Europe, we are really -- really starting to zero in on our differentiation that we have even in the mature market, even in the -- at the -- at the -- at the at a strong indigenous competitor, whether that competitor being Germany or France.

We have some technology, we have differentiation and some innovation in that technology -- that we are going to focus even greater than we are today in, and we will drive that differentiation to do just what you said and that is be able to get incremental share growth over the next couple of years against all of the European competitors. We think we can do that. We think if we stay focused in the areas that -- that we have differentiation, focused on the vertical industries. Focused on the OEM segments, that we can pick up incremental share, and we're going to resource and staff and invest to be able to do that in Western Europe. And that's something that we just started dealing with over the last couple of weeks in particular. And we feel -- we feel good about our ability to do that based upon the position that we enjoy, and that position gets reaffirmed by customer interactions that we have, and so that's why we're very bullish and very optimistic about our ability to compete independent of the economy in Western Europe in the future. Now that's going to be a challenge. I don't want to underestimate how tough that will be, but given our current position, we feel very good about our ability to grow incrementally even in a tough competitive environment and a tough economic environment. So excited about -- about our opportunities there.

Thanks.

Thank you. You bet.

Moving on to Scott Davis of Morgan Stanley.

Thanks, guys. And hate to kick you when you are down, but your free cash flow is tracking a bit below your goal of 100% convergent with net income on a six-month basis free cash flow would be about 322 and net income at 283. Yet in your press release you have in here 100%. Is there a timing issue for the back half of the year, some sort of a catch-up, Cap Ex, working capital, something I am just not seeing.

Before I answer I just want to disagree with your premise of being down. I appreciate you want to ask about cash flow, but I thought it was a pretty good quarter. 56% net income, 11% excluding currency organic growth, return to debt on capital in the high teen, what part of that is down.

I just meant below your guidance.

Never mind. We'll go on to your question. In the quarter we did step up a little bit of our systems spending and frankly we replaced two old airplanes with a new airplane. And we have a working capital seasonality, which generally gets built up a little bit now and as we get into the second half of the year we think we have an opportunity there. Inventory in particular gets built, and if you look at the seasonal pattern, we do pretty well and we are very focused on a couple of working capital opportunities. So it is really systems spending and working capital in the first half of the year and a lot, a lot of good stuff going on for the second half about inventory and less capital at least with respect to some of these long lived access that I described.

100% is still realistic.

We are working it, yep.

A related follow-on. Given the stock price weakness you've seen and you have stepped up and bought back stock the last six months, but does a $50 stock price going to change your view on sharer purchased here?

No. We liked it, frankly we were a buyer when it was in the 60s, and we're a buyer in the 50s, and as you know, we just raised our dividends 36%, and we're on track to do 9 million shares of repurchase. Now those are all default mode, return of cash to shareholders in the event that a right-up-the-middle acquisition doesn't appear, and so no we are -- well, yes and no, we are still a buyer, and we have quite a lot of powder left on the authorized repurchase for the remainder of the fiscal year. And under certain circumstances, if we needed more we would go and ask for more. Okay. Fair enough guys. Thanks a bunch.

And moving on to Nicole Parent of Credit Suisse First Boston.

Good morning guys.

Hello, Nicole.

I just wanted to ask one question, in terms of thinking about Q3 seasonality and is it reasonable to expect kind of April to accelerate and then May to accelerate. Is there -- are there any typical lumpy patterns in the quarter we should be thinking about?

Well this one probably has less than -- than most quarters quite frankly. The only one that gets a little lumpy at -- in June based what is really going to happen in Europe and the impending vacation season of July, and sometimes Euorpe gets a little stronger at the end of the quarter in anticipation of the July-August phenomenon. But really this quarter probably has the least -- variation throughout it compared to the other three.

Great. That's helpful. And I just -- not to beat a dead horse, but James, I just wanted to follow up on Jeff, and then John Inch's question. So the guidance that you have does not include this insurance gain at all? And I guess you alluded to that you had baked in some number for current year settlement. How should we be thinking about that in terms of cents?

Yes, let me reiterate. When we put the guidance together of $2.55 to $2.65, I did not plan on recovering several years of prior costs. So number one, it's not in there. And I would just leave it at that. In other words, I got -- I got -- call it $1.25 excluding excluding the first half and I got $2.55 to $2.65 for the year, so that's $1.30 to $1.40 in the second half.

Okay. Great. And just one last question and you might have said it and I could have missed it. In terms of the purchasing accounting number in the quarter was lower than I thought. What was the driver of that, and how should we think about that for the rest of the year?

I should have pointed that out. I appreciate you bringing that up. The answer is, it will be approximately equal to the second-quarter level for the rest of the year. And the answer for why it's down is -- as I understand it, it is the ten-year anniversary of the Reliance acquisition and the twenty-year anniversary of the Allen-Bradley acquisition both falling in '05. Here you have two long-standing purchase accounting amortization, in some sense winding down or getting smaller.

Great, thank you.

Thank you.

Our next question will come from Blair Bromley of [American Financial Advisors].

Hello.

Good morning.

I just want to make sure I understand the mix for the second half of the year. Essentially what it sounds like is that we had an extraordinary good mix in the first quarter between -- between platform project sort of businesses, if you will, and MRO. And I'll characterize it and you can correct me if I'm wrong, as a more Quote, unquote, normal mix in -- in the second quarter. But the comments that -- that you guys have made have -- have kind of centered around project work becoming more -- more prominent in the mix, more, as you said Brownfield sort of stuff as opposed to the official MRO, which typically carries a higher margin. So if -- if we're going to have a little bit of a shift in -- in the composition of the business in the second half of the year, call it relative to the first half, how do we get up earnings second half versus first?

Well, first of all, the foundation of the guidance is for gradual sequential revenue growth. Secondly, none of the incremental margins are negative. Right. All of the incremental margins are positive. So at their worse we're in the 30% to 40% conversion margin range on incremental revenue. So under no scenario if you have growth and if you have the conversion margins that we've provide as guidance and in fact that we've had in historical turns do we have down EPS. I don't know if that helps you, but no one is talking about margin contraction in the sense that the incremental revenues bear a margin lower than our average. They have it quite a bit above, call it 40% or even better when we blend the two types of revenue for the second half of the year. Does that help?

Well, I am -- no. [ LAUGHTER ] If -- if your mix of business in the second half is more oriented toward project work.

Yep.

Which traditionally and typically carries a lower margin than MRO.

Like in the 30% to 40% conversion range.

Okay, but you already put up a buck and a quarter in earnings in the first half and your guidance shows $1.30 to $1.35 for the second half. That's where I am having trouble squaring up.

Okay. Well, maybe it's helpful to say that we do anticipate revenue growth in the second half, sequentially.

At a rate higher than what you saw at the first?

Yes, growth. Yes, that's right. So revenue will grow sequentially. That certainly is a foundation to our assumption, and if you assume that, and you adjust for what is a mix of both MRO and project business, we're saying -- as you know, over the last couple of quarters where we had unusually rich MRO mix and the conversion was 50, 55 and we sort of called that out and tried to call that out at that time. What we are now saying is with a greater proportion of project business, the conversion in the second half goes to 30 to 40, call it 40 blended, and you're still having sequential growth versus the first half. So I think that -- if you do the model, you'll still find you can get there in terms of second-half EPS.

So the short-hand version is that the rate of top-line growth will be high enough to offset any degree -- degradation and margin that occurs because of mix.

Yes. And I want to say when you use the term "degradation," we're talking about margins that are well higher than the average for the first half, in terms of conversions. So in some sense, you've got the opportunity to grow revenue at margins that are higher than what you delivered in the first half.

I am not trying to disparage the performance at all, I am just trying to understand the second half versus first.

Good.

Thank you very much.

Operator, we have time for one more question

Our final question will come from Martin Sankey of Neuberger Berman.

Okay. Hi.

Hi.

Hello Martin.

Probably most appropriate for a last question would be you speak of -- of seeing higher project activity starting to come through in the -- through the quotation side. How do you see that hitting your order books and revenues? And by the way, did you build backlog in the quarter?

Let's -- let's start with the project work and we also can answer the question on backlog. The project work . We do not -- we do not expect the capacity expansion projects that we are now quoting to hit revenue in this fiscal year, we do expect the ongoing productivity and cost reduction investments, what we historically had qualified and classified as within the four walls as -- as continuing to grow as we go through the second half of year, based upon a very strong order intake in the last couple of quarters. So we -- we've seen that -- we've seen that happen for us. And -- and so, that's why we are talking about a change in a mix, a more traditional mix, with MRO not overweighted anymore, and the ability to, as James mentioned in the earlier comment, the ability to still generate healthy conversions and to be able to grow EPS in the second half of the year.

And Martin, let me address your backlog question. Remember first that our backlog is pretty short and in some sense just gives you a snapshot, but it's not like some of these people with years and years of backlog. Ours is in weeks or months. But our backlog did go up sequentially about -- call it mid-teens year-over-year and -- I'm sorry, mid-teens year-over-year and up high single digits sequentially. So we did, for what it's worth, build backlog in the second quarter.

Okay. But going back to your other question. So If we consider and going back to Blair's question as well, so if we were to start looking into fiscal '06 a little bit , as some of this project expansion stuff starts to come into your revenues. Do we -- should we expect slightly smaller incremental margin going forward?

Well, let me say --

or less -- or a -- or less strong mix.

Let me say that, first of all, I think you understand now from comment the interplay between the MRO,highly profitable MRO flow goods and the project businesses, and as the mix shifts, you will have conversion margins go from the very high levels, which we saw in the last couple of quarters of 50, 55 to -- long-term we've sort of talked of 30% to 40% conversion, so I have answered your question, yes, it would be -- it would be lower, but we still think in the very healthy range.

All right, yeah. Just slightly less healthy would be the best way to put it.

Exactly.

Okay.

Thanks a bunch.

Okay, take care.

Thanks, Martin.

Shannon, we are all done

Okay.