Stoneridge Inc (SRI) 2007 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Quarter Two 2007 Stoneridge Earnings Conference Call. My name is Paul and I will be your coordinator for today. At this time, all participants are in listen-only mode. We will be conducting a question-and-answer session towards the end of the conference. (OPERATOR INSTRUCTIONS)

I would now like to turn the call over to Mr. Greg Fritz, Director of Corporate Finance. Please proceed, sir.

Thank you, Paul. Good morning, everyone and thank you for joining us on today's call. By now, you should have received your second quarter earnings release. The release has been filed with the SEC and has been posted on our website at www.stoneridge.com. Joining me on today's call are John Corey, our President and Chief Executive Officer, and George Strickler, our Chief Financial Officer.

Before we begin, I need to inform you that certain statements today may be forward-looking statements. Forward-looking statements include statements that are not historical in nature and include information concerning our future results or plans. Although we believe that such statements are based upon reasonable assumptions, you should understand these statements are subject to risks and uncertainties and actual results may differ materially. Additional information about such factors and uncertainties that could cause actual results to differ may be found in our 10-K filed with the Securities & Exchange Commission under the heading "Forward-looking statements."

During today's call, we will also be referring to certain non-GAAP financial measures. Please see the "Investor Relations" section of our website for a reconciliation of these non-GAAP financial measures to the most directly comparable GAAP measures. John will begin the call with an update on our second quarter results and the outlook for the balance of 2007. George will discuss the financial details of the quarter, along with our guidance for the rest of the year. After John and George have finished their formal remarks, we will then open the call up to questions. With that, I would like to turn the call over to John.

Good morning and thank you for joining us on today's call. I would like to provide you with an update on our second quarter results and discuss our expectations for the remainder of the year.

Our sales declined 1% from the prior year to $183 million. Viewing this decline, in light of the macroeconomic conditions in our served markets provides insight into the organic growth Stoneridge has been able to produce, as well as the global diversification of our business. Our new product launches in the areas of high temperature sensors, speed sensors, and the launch of our second modular instrumentation award substantially mitigated the 38% decline in North American commercial vehicle production and the 8% decline in North America traditional domestic light vehicle production.

In addition, our European revenues continue to grow, as we launch new products and the commercial vehicle production rises in Europe. Our operating income totaled 6.9 million, compared to 12.8 million in the prior year. Diluted earnings per share totaled $0.11 in the second quarter, compared with $0.21 in the prior year. I would now like to turn to the positive activity in Q2 and the challenge, which we still must -- the challenges, which we still must resolve.

During the quarter, our equity earnings increased nearly 50% from the prior year. The main driver behind this increase is our PST Electronica joint venture. PST has grown its revenues 27% in the second quarter. The venture has grown its revenues 20% in local currency over the past four years and is on pace to continue this trend in 2007. PST continues to maintain a leading-market position in electronic safety and security products in Brazil and has expanded its customer base, to include all of the major OE customers in Brazil, in addition to a strong aftermarket distribution.

PST added Honda to its customer portfolio in the second quarter with a new contract award. Given the strong consumer brand PST has established in Brazil, the future of this venture remains bright. We feel we can expand the Company's product offering to include other electronic products and services. We also believe there may be opportunities for the cross selling of SRI and PST products in our respective markets. PST has grown into a significant asset for Stoneridge and its stakeholders. We will continue to explore ways to drive additional value from our joint venture and to expand our business in South America.

In the commercial vehicle segment, our largest customers, International Truck & Engine, awarded incremental new business to support their mine-resistant, ambush-protected vehicles or MRAP. Stoneridge will provide the fully integrated instrument panel assembly, including the wiring and electronic control units. We are enthusiastic about this important program and look forward to supporting the program's aggressive production schedule.

Our hedges in copper mitigated, to a large extent, the escalating price of copper. We are also seeing increases in stainless steel and silver, increasing our material cost. Most have been offset by our purchasing programs but they remain a concern for our future. Operational issues were primarily centered on selective product launch failures and supply chain management of materials. We also saw a reversal in the progress of our UK operations and have changed the leadership of that operation. Management changes were made in a few other operating units during the quarter, based on performance to address the lack of progress and resolving issues with product launch and operating practices.

When we started the year, we anticipated a 25 to 35% decline in North American commercial vehicle production. This outlook implied an incremental improvement in the fourth quarter, as the pre-buy effect from the new emissions standards subsided. The current outlook is for the depressed production levels to continue into the second half of the year and for full-year production rates to fall in the range of the decline of 30 to 40%.

As a result, we have evaluated our cost structure and have taken the difficult actions of reducing our headcount through reductions in force activities. While these decisions are always difficult, we feel they are necessary to ensure Stoneridge generates returns to cover our cost of capital improved shareholder value. Many of these decisions are extensions of the two operating unit structure we implemented. We continue to evaluate the most effective organizational structure to go to market. We have elected to continue to invest in sales and engineering development resources, which are supporting our current and future growth opportunities, as we feel confident, with our other actions, we can support this investment and deliver on our commitments.

We are taking several proactive measures to address our financial performance, as we move into the second half, including further integrations of the business and the resulting reductions in staff. On a more positive note, turning to the outlook, as I previously mentioned, the outlook for the North American medium and heavy truck production remains challenging. The North American light vehicle market has performed largely in line with our expectations at the start of the year. However, we expect the year-over-year production declines to ease in the second half. We continue to monitor this very closely, as the consumer-financing environment evolves and the market shares of our major customers fluctuate.

Second half price slots appear to be the continued strength in our European commercial vehicle production in the North America agricultural production. These markets were robust in the first half of the year and our current outlook is for these markets for remaining robust going forward. The MRAP program award previously mentioned will also add to our performance in the fourth quarter. Our launch of EGT emission sensors are showing good growth and offers additional growth opportunities for the future.

In addition to the cost actions previously discussed, we are focused on our cost structure and control over our discretionary spending, and achieving world-class operating metrics and driving our cash flow through focused working capital management. While progress has been made in working capital management, our inventory program needs to improve and we have programs under way to assist us in bringing inventory levels down without impacting service levels. Overall, our full-year outlook remains unchanged. Our expectation for full-year earnings is in $0.45 to $0.55 per diluted share.

While we have had operational issues and negative implications from volume declines in North American commercial vehicle production during the first half of 2007, the organization has taken actions and remains focused on successfully navigating the North American microeconomic environment and positioning our Company for future growth through innovation and product development.

With that, I'd like to turn the call over to George.

Thank you, John. Before we review the second quarter, I would like to share a few financial highlights in the quarter. Our free cash flow from operations totaled $5 million in the quarter, as we've made progress in our inventory reduction efforts and reduced our accounts receivable days outstanding. Supplementing our operating cash flow were the sales of two closed facilities in Boston and Orwell. Combined, these sales generate an additional $5 million of free cash flow. As a result, we increased our cash balance to $66 million, slightly above our year-end level.

Our hedging programs are allowing us to significantly reduce our exposure to commodity and currency price volatility. We have hedged 35% of our projected copper buy for this year to reduce the volatility of one of our major commodities. In addition, we have hedged our Peso requirements this year to reduce the cost impact during the year, as the dollar continues to weaken. Both of these initiatives have yielded significant reductions in our risk profile.

I would now like to cover the second quarter results in more detail and then we'll open up the call for questions. Revenue decreased 1% to 183.8 million in the second quarter. The year-over-year decline was due to a 38% decline in North American medium and heavy-duty truck production and an 8% decline in traditional domestic light vehicle production. Offsetting these declines were the impact of new program launches, favorable foreign currency exchange and strong production in our European commercial vehicle business.

Light vehicle revenue increased 5% to $76.5 million. The increase was attributable to new program launches in the areas of high temperature sensors and speed sensors. The new business impact was partially offset by an 8% decline in traditional domestic production. Medium and heavy-duty truck sales totaled $84 million in the quarter, down 9% from the prior year.

Strong European commercial vehicle production and favorable foreign currency exchange rates were more than offset by a 40% decline in North America commercial vehicle production, due to the change in emissions regulations. Sales to agricultural and other markets totaled 23.3 million and were $3 million above the prior year. The increase in sales was predominantly due to strong build rates of John Deere.

North American revenue accounted for 72% share of the second quarter revenue, compared with 76.2% for the same period last year. The percentage reflects the strong growth of our European operations and the production declines in our North American markets. In the second quarter, electronics revenues declined approximately 7% to 98.2 million. The decline was more than attributable to the decline in North America commercial vehicle production. This decline was partially offset by strong revenue from our European commercial vehicle operations and favorable currency exchange rates.

Revenues for the control devices increased 7% in the second quarter. New business revenue was the main driver behind the increase, as our new high-temperature sensor and speed sensor products business ramped up during the quarter. Offsetting this increase was a 8% decline in North America light vehicle production.

Second quarter gross profit totaled $38.9 million, yielding a gross margin of 21.2%. Our gross margin was unfavorably impacted by several items: Increased depreciation expense resulting in a 40-basis point year-to-year decline in gross profit. The other significant resulted from operating inefficiencies predominantly associated with new product launches. As our revenue performance reflects, we have launched several new sensor programs in our previously announced modular assembly program. These launches have resulted in high scrap and reduced labor efficiency. Our operations are focused on continuous improvement and anticipated improved efficiency metrics in the third quarter.

Our commodity and foreign currency hedging programs resulted in a slightly favorable offset to the unfavorable variances. As a reminder, we have locked in approximately one-third of our total purchase for 2007 at favorable rates, compared to the current price of copper.

Sales from low-cost manufacturing locations accounted for 40% of total sales in the second quarter, compared to 38% in the prior year. With our China operation ramping up and other corporate-wide initiatives, we expect our sales from low-cost locations to grow as we relocate labor-intensive manufacturing over time, as we expand our presence in the three key low-cost manufacturing locations in Mexico, Estonia and China and build on our growth potential in Brazil and India through our joint ventures.

Selling, general and administrative expenses totaled 33.6 million in the second quarter, compared to 31.2 million in the previous year. The increase in SG&A during the quarter is related to additional design and development and marketing expenses primarily in Europe. The majority of these expenses were due to new product launches in our European operations.

Finally, our operating income totaled 6.9 million in the quarter, compared with 12.8 million in the prior year. In addition to the aforementioned items, we recorded a $1.6 million gain on the sale of our Boston Orwell facilities.

Second quarter income tax expense totaled $700,000, resulting in effective tax rate of 19.8%. The lower effective tax rate is primarily attributable to the benefit of the federal research and development tax credit, the reduction in accrued income taxes and reduced foreign tax expense, due to a more favorable mix of foreign earnings. We expect our 2007 tax rate to fall between 25 and 30%.

Stoneridge recognized second quarter net income of 2.7 million or $0.11 per share, compared with a net income of $0.21 per share in the prior year. Depreciation expense for the second quarter was $7.3 million and amortization expense totaled 400,000. For the full year, we expect depreciation and amortization to approximate $29 million.

Earnings before interest, other income taxes, deprecation, amortization were 14.3 million in the second quarter, compared to 19.3 million in the previous year. Our primary working capital totaled 104.6 million at quarter end, which decreased 8.8 million from the previous quarter. As a percentage of sales, our working capital declined to 14.7%, well above the first quarter level of 15.8% and prior year level of 16.5%.

While we have made good progress towards improving our working capital levels, our working capital balances remain above our targeted range of 12 to 13% of sales. We see significant opportunity to reduce our inventory balances in 2007 and have made this a focus area for operations. Operating cash flow, net of fixed asset additions, was a source of 5.1 million in the second quarter, compared to a use of 600,000 in the previous year. We are pleased with our progress and the second quarter cash flow results and will look to build upon this progress in the second half of the year.

We continue to target primary working capital balance in the range of $0.12 to $0.13 per dollar of sale. Capital investments totaled 2.2 million in the second quarter, mainly reflecting investment in new products and information technology equipment. Some significant components on our investments were in the areas of emissions, sensor products and instrumentation. For the full year, we expect our capital spending to approximate $25 million to $30 million.

Turning to the liquidity, we currently have fully available $100 million on our revolving credit facility. Our cash balance totaled $66 million, compared with 43 million at the end of the second quarter of 2006. Going forward, we expect we will continue to fund our operational growth initiatives through our free cash flow generation and available cash balances. As part of this, we will also continue to evaluate non-strategic assets for sale.

Now, I would like to take a moment to discuss our outlook for 2007. As mentioned by John, for the full year, based on our current industry outlook, our expectations for the full year remain unchanged at $0.45 to $0.55 per share. As you have seen by now, we have decided to postpone our debt offering until market conditions stabilize. While we are looking to resume this activity, we have not included the potential interest savings in our full-year guidance.

At this point, operator, I'd like to open up the call for questions.

(OPERATOR INSTRUCTIONS) And your first question is from the line of David Leiker from Robert W. Baird. Please, proceed, sir.

Hey, everybody, David Leiker.

Good morning, David.

I haven't heard that pronunciation before. When you look at your medium heavy-duty truck business, I think, George, you said you're down 9% for the quarter.

Yes.

Could you just break that out between Europe and North America?

I think of the total, David, our commercial business, just on the medium-to-heavy side, accounted for approximately 45% of sales in the quarter. And of that, about 21% was in Europe.

Okay, and what about the performance, revenue performance in North America versus Europe?

I've got it by percentage, if that's okay.

What I'm trying to get at is what your North America business did, versus the market.

Last year, North America accounted for a third of our total sales. So that was approximately $61 million and this year, it was approximately $46 million. Yeah, if you look at just the implications, Class 8 trucks, if you looked at June sales of Class 8 trucks, they're about 10,600 units, versus last year in June, 25,200 units and the year-to-date, that same number would be for this year 87,300 units, versus 140,200 units last year. In addition, you see the backlog decline for the major truck manufacturers declining from 172,000 last year to about 138,000 this year.

So there is still continued weakness in the North American market and we fully expect that weakness to continue on. The European market, again, is very strong. Their production schedules are booked out through the remainder of this year. So even if you wanted to get into the production schedule, you couldn't do it this year. Whereas, in North America, if you wanted to get in the production schedule, they have ample capacity. Just to give you the math on that, David, it's about 25% decline and the market was down approximately 41% in the quarter.

Okay, all right. And then the tax rate. And George, it hit your guidance of 25 to 30% for the year, means it's a 40% tax rate in the second half to the year. Obviously, you've been running low, below 20% the last four quarters. What's behind that change here, sequentially?

Well, we're looking at some cash movement globally, Dave, which may have some impact on some global taxes and that's what's impacting the second half.

If you didn't do that, where would your tax rate be?

We think it'd be in that lower range, down around the 20%, 20 to 25%.

Okay and if you were to repatriate some cash, is it Q3 or Q4?

What we're looking at is sort of tied to the financing that we have and right now, to have to say that'd be more looking late third quarter or early fourth quarter.

And how much of that cash, 66 million in cash, is in the U.S.?

Probably a little over half of it but we have the ability to really utilize most of it, other than what we have in one of our foreign operations, which would drive the effective tax rate up because there are no taxes there and there's a withholding taxes, if we remit.

Okay and then your operating expenses, the SG&A line, that's running at a percent of revenue at a pace that you really haven't seen in a while. Is this just a little bit of a bump up then and then you start to leverage that again or how should we be looking at that?

Yeah, the bump up is really to support some growth platforms we have in our European commercial truck business. You'll tend to see that start to reduce after probably the third quarter and moving into 2008. And I think that John eluded to the fact that we are taking a hard look at our discretionary expenses and to begin to really take actions to move our SG&A percentage down, excluding the D&D expense.

Are you on target of where you'd like to see that go?

We're not prepared to really give that target date but I think we'll talk about that in future quarters, as we begin to work and develop that.

Yeah, I think one of the things is that we see opportunities to grow our market position, which requires D&D investment. We, so far, have been able to maintain that and still deliver our other commitments. And we have to evaluate those things very carefully because a lot of this money is driven towards our future growth potential in our businesses.

What portion of that line item falls into new product development, R&D-type stuff, as opposed to truly SG&A?

Well, historically, Dave, you know we've been running roughly about 6% to sales and what we, I guess, John and I and we had a discussion on this, is a large percentage of that was really directed more toward product launches and continuation of application engineering. We are trying to change that mix fairly dramatically over the next year-to-two years to switch it where, probably today, about 70, 80% is more in application engineering and existing product launches and we'd like to get it probably down in the 30, 40% range and it would move to 60% for new products. But that's going to take us a couple years to reallocate that.

On a net basis, David, about a third of our SG&A in the second quarter went to D&D.

Okay and then one last question. Your guidance of [$0.45 to $0.55], that's a GAAP number?

Yes, that's a GAAP number.

And that's including an assumption of repatriating some cash to hit the tax rates you're talking about?

No, remitting the cash would not really have any bearing on other than -- well, it would have no bearing because it's all sort of cash, other than the investment rate differentials between North America and Europe.

Well, the effective -- to your question, I think, Dave, the effective tax rate would be implied in the 25 to 30% range.

That's the tax rate you're using to get to that guidance of 45 to 55?

Yes.

Okay, thank you.

(OPERATOR INSTRUCTIONS) And your next question is from the line of Brandon Farrell with KeyBanc Markets. Please, proceed.

Hey, guys.

Good morning, Brandon.

John, I just wanted to ask you a strategic question. Now, that you've been here a little over a year-and-a-half and you guys have kind of brought the business down to two reporting lines, instead of four. Where do you see your progress, in terms of where you've benchmarked it and where you've gotten to today and how that change is going forward?

Well, I think the progress is that we've got the organizations now focused on markets and products that we think have offered good growth possibilities. And if you look at where we're making investments in emissions and sensing products and in instrumentation, and even the [tachograph] products, I think we started to streamline those and make the -- I think that's the biggest plus for the long term is we've now got a clear roadmap of where we want to go with our products. I think the biggest shortfall for us, so far, has been in our ability to improve our operational performance. While we've made some progress, we've also relapsed a little -- stepped back a little bit and now, we're back at it again. And I think, as we look, going forward, I mean, we are committed to restructuring our manufacturing footprint to lower our overhead and to lower our cost of that. And I think that plan is under way now.

We've done some of that restructuring this year. We will continue to do it, as we go forward, to adjust the market conditions. But ultimately, we're going to push forward to lower manufacture -- to the 60% manufacturing footprint and low-cost area 60% or higher. So I think, from a market perspective, we're in the right position in the markets. We've got some good products that are in growth market segments. From an operating perspective, we still have a lot of work to do there. From a working capital perspective, we're making progress on our receivables and bringing those in line. We're working on our inventories to bring those down in line and so I think we're pushing on all fronts.

And then the final thing is on non-productive assets, we're streamlining our operation and getting rid of those, as evidenced by the sale of a couple of facilities there. And we will continue to look at those things, too, as to how to generate cash for the business that could be put to more productive uses.

Okay and then with respect to Asia, are you guys starting to see any initial opportunities to source contracts there that, obviously, you haven't had in the past with potentially existing customers that are there?

Yeah, our -- we're just at the very, I guess, tip of starting to do that. If you looked at our Asian operation, when we first started that manufacturing, we had to demonstrate that we had manufacturing capabilities over there. We've done that by transferring product from our U.S. markets and we still have a few things that we will transfer over there. And we now have started to staff up the business development effort in Asia, so we can go after some of those contracts that come from the local market. But it's, again, in its infancy and I don't expect significant new contract awards out of that, over the next one-or-two years.

Okay, Brett, actually, has a question here.

Yeah, I wanted to ask you guys a little bit about -- George, it sounds like the increased D&D expense that impacted you on the quarter --

Yes?

It sounds like that's going to run up through the third quarter and then drop off after the -- kind of into that fourth quarter, first half of '08 timeframe, correct?

Right because I mean, this is geared to launches that we have in '08 and '09.

And then when you look at the comment about inefficiencies related to new product launches, is that related to the increased D&D or is this a separate issue?

No, it's a separate issue. It goes back to a product that probably was poorly designed a couple years ago and then not only was the product designed poorly for manufacturability but then the way they set up the manufacturing process was not robust enough, so we're having a great deal of difficulty and this is compounded because this is a product line that's growing in the market rather nicely. So we're struggling with that right now. But I think what we'll end up doing is potentially redesigning parts of the product and we are redesigning the manufacturing process, as we go forward.

What kind of a timeframe do you think it will take before you get some resolution there?

Well, we've seen from the beginning of the year till now, we've seen improvement. We've kind of reached a plateau that would suggest that we need to redesign parts of the product. And to get that through customer validation. But I mean, for new customers, I think we could have that done by the end of the year. For existing customers, it will take us longer through new product validation.

We are also looking at, in conjunction with that, as I said, we're looking at the way we manufacture that product and that -- to redesign or maybe change out equipment so we can get better efficiencies and throughput. Part of the problem is that we have a terrible throughput coming on the line. So --

Okay. Okay, thank you very much, gentlemen.

I had some follow-ups, as well, guys. Back to that same question, we saw, basically, you had flat sales, about a 200-basis point decline in gross margins probably due to what we just discussed. Is that going to be -- are we going to see sustainable decreased gross margins going forward because of that issue, potentially?

No, I don't think that will be -- that's not going to be sustainable. I mean, as I said, we're addressing that issue now. You know we only launched this product at the beginning of this year and so we saw -- immediately, in full volume production, we saw some significant problems with the way it was designed. And so we're now going to correct those but I wouldn't expect our product launch metrics -- or, sorry, the metrics off of this line are improving but they're not to the point where we think they're good enough to say that we're finish with what we need to do there.

Okay and then with respect to that MRAP announcement, what -- you said the program begins in the fourth quarter. What is that worth at peak and then when does it peak?

Well, as I understand it -- and I can't give a comment on when the program peaks and all because it is -- the government, as you read in the press, there's a lot of excitement around that program from terms of getting it out but we understand that there are several suppliers who are involved in that and may bid out that award. So when we get the final number, I mean, when we get the final amount for this fourth quarter, we'll know.

What we know now is we've been asked to produce a few units for them to validate their production and go into that and we'll get further indication of what the volume is going to be by the fourth quarter.

And Brandon, because the units are so know, and for competitive reasons, we would prefer not to talk about the size of that program, at this time.

So you'd potentially be limited to just international of the suppliers that are going to be sourced there, correct? Or is there opportunity to potentially produce for some of the other individuals or companies that have been awarded volume there?

Well, there's always opportunities to do that. I mean, right now, we're working closely with international.

Okay. And then I think, historically, we kind of figured that potentially you guys had about 40 million annually in organic growth and maybe 10 million to 15 million rolls off annually. It sounds like, just looking kind of where you guys stand on revenue in the first half of the year, relative to your end markets, we're probably running above that rate, maybe, I don't know, 60 million to 80 million in organic growth. Is that, in fact, the case and has the amount of business that rolls off annually changed at all?

Brandon, we don't give out that number, specifically. I think, some of the programs that you saw in the first half launching are beginning to reach full volume and then as you go through the changeovers in July, if you look at the pace though, I think if our revenues had been roughly flat. While we don't give specific revenue guidance, obviously, save any different market conditions, we think we can maintain a similar level of performance, going forward.

But Brandon, as you know, I mean, our focus has always been to get the top line back, which we, historically, we've not had over the last five years, and to maintain the efficiency and the effectiveness of our organization, so we can retain existing business, so we don't have the loss rates that we had over the last three or four years. So we want to get a more sustainable top line growth that we can build off of and that's -- I think you're starting to see signs of that, even though the market's down dramatically in North America large truck this [year].

And just one last follow-up on SG&A. It has kind of been at an elevated level, roughly, 33 million in the past few quarters. It seems as if we could see that tick down, maybe a little in the third and fourth quarter and into next year. What do you think the quarterly run rate might be? And it sounds as if, potentially, rather than reallocating D&D dollars, we might be seeing an absolute increase in the near term and spending there? Is that fair?

I don't think the level we're anticipating we're increasing. We are working very hard on reallocating and where we're going to invest the D&D dollars but I think we've ultimately said that we're going to maintain sort of the run rate that we have in D&D. We've seen some increase in Europe because of some new platforms that are coming on board '08 trough 2010 that we've made some conscious decisions they're growth platforms that we want to become part of, so we've invested there. And I think, as John eluded to, is we're taking corrective actions in other operations to reduce costs. And I think through time, that you're going to find that we have -- we'll have the ability to reduce what I call the discretionary SG&A and we'll maintain the levels of D&D expense. But we're redistributing where we focus on the spending of those dollars.

Okay, thank you, guys.

You're welcome.

Your next question is from the line of Paul Ross with Westover. Please, proceed, sir.

Hi, George and John -- good morning.

Hi, Paul, how are you?

Would you give us a little color on whether it was the size of your revolver that you were proposing to replace or the cost and the spread that caused you to pull back on your refinancing, at this time?

Well, Paul, it was a combination of both of those. I think the timing and we were renegotiating our revolving credit agreement, which we'll continue to put in place and push the maturities with that. And then our term, we actually -- we saw both the spread and the discount really accelerate over the west two-to-three weeks. It's still our intention to complete that transaction but we're going to do it at more favorable terms to the Company, as opposed to just taking terms that are offered in the market.

So the discount and the spread was something that we felt we didn't want to entertain, plus, the limitations on potentially, some of the covenants. And so it was a combination of all three to those.

Thank you.

You're welcome.

And your next question is a follow-up from the line of David Leiker. Please, proceed, sir.

George, as we look at the quarter and what was on the gross margin side -- and I just want to dig through this a little bit further -- it looks like there's something like a $3 million to $4 million shortfall where we would have expected your gross profit to be, given the revenue number. Can you put that in the buckets of what gets allocated to these launch issues, versus other items?

I think some of these blend together, David and we track what we call our sort of product launch and also, our cost to quality and some of these overlap. But we clearly track what I call premium freight: Scrap, waste and launch costs and then we also did mention that depreciation was an impact and we've taken some additional depreciation on some equipment we have in Europe.

But for the most part, it was sort of split in the product launch versus what I would call and efficiencies in the plants and your number is pretty close and very accurate that we are focused on. In fact, we started weekly meetings around those issues and I would say the split is probably about 60%, in terms of what I call the cost of poor quality, which is premium freight: Scrap, waste and the product launches are about 40% of that. So --

And what drives that cost of poor quality. The biggest issue, as we said earlier, is the material management systems and our supply chain management system. As we need to become much more proficient in those and we're working on those because as we go through those and we see that if we have a shortage of material, then in order to catch up and make sure we keep our customer commitments, we then work overtime and we then ship out on premium freight. So as we bring those conditions under control, we should be able to see that drop.

And indeed in the -- now, it's early but in the weekly meetings that we have, I go to the plants and we look at their premium freight, both inbound and outbound, we look at their scrap percentages, we look at their productivity and efficiencies, we look at their manning and headcount and so we try to have a constructive dialogue on what we're doing to ensure that we brought these processes under control.

And this cost of quality, as you're talking, is that related to these facilities that are launching new business or is that across other parts of the business?

No, it's primarily related to where facilities are launching business. With the exception of the UK operation, I think, which we taken a -- as I said earlier, we've changed the management there. We need to get a different focus on that operation and the new management team, early on, has gotten its hands around the business and have identified some actions that they want to look at, which includes outsourcing, which would reduce overhead cost structures in that business unit.

And David, included in that is also the complexity of our wiring harness business, which adds, you know, you can sort of label that "product launches" but it has a number of change variability from customer demands. And that puts complexity through our three operations and we're really working very hard, one, to try to reduce the complexity of that and also, get a better balance of our supply chain and our materials so that we don't have stock outs, which forces premium freight and some other issues within the organization.

Got it. One last thing, the contribution margin in the first quarter looked all right, so it seems like this is something that got worse in the second quarter -- really hit in the second quarter.

Yeah, I would have to agree very much that it's -- it was more in the second quarter. We did see some impact of it late first quarter but we're working very hard. This is something that happened in the second quarter that we can contain and improve from here.

Okay and the last tie-in of all of this is if you had that kind of a shortfall in Q2, which is, you know, call it $0.10 in earnings, what's the offset on the positive side here on the balance of the year to keep the guidance where it is?

Well, I think part of the thing is -- and still is an unknown -- is when does Class A come back? And we're still forecasting in there that it doesn't really come back in the third quarter, that it's out in the fourth quarter. And then the improvement in the operating efficiencies of the plants are what's really driving the improvement at the gross margin level.

I think if you looked at the product launches that were undertaken in the first half, all of those are now completed, so any difficulties we had associated, expect for one product launch, which I told you has a design problem and a manufacturing problem, except for that, the other product launches are pretty much done and so we shouldn't be having these same types of difficulties with that in the second half of the year.

But doesn't something have to be better by about $0.10 a share to offset this negative that you had in the --?

Well, I think as you look at the cost of premium freight, for instance, as one example, when we start driving that down, as we have started to see happen, that takes what was a negative and starts to make it a positive, from our performance over the second quarter.

No, I understand that, versus the second quarter. I'm talking about second half -- your guidance for the second half the year. It seems to me that you raised that from what it was at the start of the second quarter. I'm trying to understand what is it that was behind the increase in the guidance for the second half to the year.

Well, part of that would be this MRAP program that we think we'll hit in the fourth quarter. Part of that is looking at, again, some volume improvements in the European market that we see continue to be strong there. We continue to see our aftermarket business perform well and so it'd be those types of things that we're looking at. We don't see --

Okay, great. Thank you very much.

And your next question is from the line of Jonathan Steinmetz with Morgan Stanley. Please, proceed, sir.

Great. Thanks, good morning, guys.

Good morning, Jonathan.

Just a few follow-ups. On the -- George, your comments on copper, you said that you had a portion of it hedged. Can you provide any dollar value as to what that could affect you by, when the hedges roll off?

Our benefit in the quarter, Jonathan, on a copper hedge, I believe, was in the range of $300,000 to $400,000.

Okay.

And that, obviously, when it rolls off, we have that same level of hedging for the rest of the year. Those would expire December 31 and we always look at opportunities but right now, it's really going to be market dependent at this point. Copper's trading at around 350 or 360 and we're hedged at about 280.

Okay. On your Class A outlook, you mentioned you expect a recovery by the fourth quarter. I'm just wondering what you're sort of predicating that upon, whether it's stuff your customers are telling you. Because it seems to me, as a freight and so the tonnage has been very weak, which might put that recovery in jeopardy. I'm just wondering if you're hearing anything in the industry that causes you to expect it to bounce back that quickly.

Well, I don't think we're -- I think that our customers are being very cautious about what their outlook is but I think versus what the client was in the first half, I think they're looking at some maybe slight increase going into the second half. And certainly, with the MRAP program going forward, that would be a nice increase for us. But I would say that everybody remains very cautious about the heavy truck forecast, given what the severity of the decline in the first half that they didn't expect but sooner or later, the buying cycle will kick in again and I think people are looking at that. Now, I wouldn't say the third quarter is going to see that. I'd say it's all people are pushing things to the fourth quarter.

Okay. And sort of a strategic question here but your SG&A is pretty high, as a percentage of sales. For the time being, at least, you may have a cost to capital disadvantage, versus some of your competitors. What are your thoughts, in terms of the ability for sort of an independent Stoneridge to not so much survive but flourish and do you think that there's, I mean, do you need a lot more scale here to make this work or do you think that if you can iron out some of these operational issues and win some new business that the companies find independently?

Well, I think we are going to win new business. I think that's where the D&D investment is going and I think that's one of the things that we talked about earlier is that our focus was to start to get the top line to go back into a growth mode. Some of that will leverage, of course, our expenses but on the other side, we've now established -- and George and I will be talking with each of the business unit leaders on targets for their SG&A and where we want -- what we want that to reduce to, over what period of time. And in addition, we're looking at, as I said, manufacturing overhead and the cost structure inherent in those things.

So I think we still have opportunities to drive our costs lower and then with that, and with our strong balance sheet position, we have opportunities to go out and acquire, at some point in time in the future, I think that. So yes, I should think that Stoneridge can survive on its own because remember, we have very, very good gross margins. What we've got to do is drive the cost structure out on some other areas and get non-productive assets sold off and then go in and start growing the business through -- organically and through acquisitions.

Okay and last question. Quick housekeeping -- George, what tax rate should we be using if we want to sort of strip out the property gain?

If you strip out the operating gain?

On the property. In other words, if I wanted to apply a tax rate against that, what would be the right number to sort of apply on the tax line? I think you gave a pre-tax number.

I would say we can get 35% would probably be the safest figures on --

And I would agree with that, Jonathan.

Okay, thank you very much, guys.

You're welcome.

And your next question is a follow-up from David Leiker. Please, proceed.

What are you guys using for Class 8 and Class 5 to 7 build for 2007?

I think for the full year, David -- and we saw the 40% decline on the quarter -- for the full year, we're looking at something, as John mentioned, down 30 to 40% in his comments.

For Class 8 build in North America?

For 5 to 7, it depends really on the mix, David. I think what we've seen in our first half is that one of our largest exposures there, they've actually been declining more in line with the Class 8 market. So it's going to be more of a market share mix question when you get that specific because our exposure's limited to -- it's pretty concentrated to one customer.

Okay. All right, thanks.

And your next question is a follow-up from the line of Brandon Farrell. Please, proceed.

With respect to the asset gain, was that built into the original guidance for the year?

Yes, it was.

And I know you weren't willing to comment on the MRAP contribution from just an aggregate revenue standpoint. How should we think about the content per vehicle then? Does it potentially mirror your existing commercial truck content per vehicle? Is it substantially different than that?

I would say it's at least but we wouldn't want to comment beyond that.

Okay, so at least equal to, we'll say 250?

That's not the number for that particular program but it's at least equal to the current program.

Okay and then any potential other end markets, that's the defense end market, that you guys aren't currently in, that we may be seeing additional announcements from in the near term or just, if it's not a new end market, are we going to see additional potential announcements in the back half of the year, with respect to new contracts?

I would say we're always looking for those opportunities but I don't there'll be any that we see on the horizon. I mean, again, on the government -- on the military side, that would be the greatest possibility right now but we're not counting on that in our projection.

Okay and then George, back to your earlier D&D comments, you had talked about keeping D&D spending flat, at an absolute level. Is that presumably on, even an increase in revenue dollars, if we see revenue growth tick up?

No, we're talking about dollar spend, not percentage spend.

Okay, so even if we see growth accelerate, aggregate spending on D&D could remain flat with discretionary spending coming down?

It may go up a little bit but it's not going to grow in the same percentage that sales would grow.

Okay, fair enough, guys. Thank you.

You're welcome.

And your next question is from the line of [Jeff Scugland] with UBS. Please, proceed, sir.

Hi. I was off the line a little bit, so I apologize if you've already answered this but I just wanted to follow up on the acquisition comment you made earlier and just kind of inquire as to what types of things we might expect over the course of the next 6 to 12 months, both in terms of business wise, and size [unintelligible]?

Well, I think that, probably over the next six months, I don't think, unless something very opportunistic came into our hands, that we would be doing much there. I think, as we look at how we're repositioning our business and our structure, we were looking for companies that have electronic content, have emissions or sensing content. There are some small companies that have come to our attention that we've taken a look at and quite frankly, through the price was too high for them and have passed on them. And we will continue to that. So it's really, right now, there's not a formal acquisition program going forward. We want to still finish with fixing our balance sheet, getting our refinancing done and getting our operations back to where we think they should be. And then we'll be prepared and set to go forward with a more formal acquisition program. But if something opportunistic comes along, we do take a look at it and see if it makes sense for us.

Okay and would the focus be on light side or on heavy-duty vehicles?

Well, actually, it could be -- we like both sides but it could be -- well, it could be either one. And really, again, if it's an emission side, that goes across light and heavy. That could be a very attractive product mix for us. If it goes on the sensing side and some of those things there, that could be a light vehicle and could be a good [sets] for us. And then, again, some of the other things, electronics could be on the heavy-duty side. So it's really more of how it fits into our overall strategy and how it would strengthen our business.

We have no further questions and I'd like to turn the call back over for closing remarks.

Well, thank you. I would say that our performance in the second quarter, again, we don't want to diminish the operating shortfalls that we've seen in our business but I think that the team has responded well in coming back and in a difficult market and with some of our own internally-inflicted problems, that the team has been focused on these things. They have been working well on these things and I think, as we've said many times before, we're turning this business into what we want to be a high-performing business and we're taking a look at every aspect of this business. And you can see different progresses being made, some much faster than others and some not as fast as others. I mean, we've done a good job on receivables. We're starting our focus and our attention on inventories. You've seen our working capital come down. It's not where we want to be. Our focus, now, is on the cost structure. We're looking on that cost structure to how to get that back in line for what we think is reasonable for a company our size. And then we're still focusing on the operating side.

I think, in addition, I think the market, the revenue growth of our business, I think in a market that's down as much as it is, to look at our results in the first half, you should see that -- you should get encouragement from that. So I would say, from our perspective, we're not pleased with what the final performance was but we're pleased with a lot of the elements of that performance.

With that, I'd like to thank you all for dialing in and attending.

Thank you for attending today's conference. This concludes the presentation. Have a great day.