史丹利百得 (SWK) 2007 Q3 法說會逐字稿

Good morning. My name is Valerie and I will be your conference operator today. At this time, I would like to welcome everyone to The Stanley Works third quarter conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (OPERATOR INSTRUCTIONS) At the customers' request, please limit your questions to one question and a follow-up. Thank you. Mr. Gould, you may begin your conference.

Thank you, Valerie, and good morning, everybody. On the call with me this morning are John Lundgren, our Chairman and CEO; and Jim Loree, our Executive VP and CFO. We've issued a few press releases in the last few days, our fourth quarter dividend last Friday, the announcement of a new director on Monday, and this morning our third quarter results and fourth quarter and full-year guidance early this morning. They're all on our website, StanleyWorks.com, in the Investor Relations segment. There's a presentation also on our website, some PowerPoint and PDF charts that we'll refer to during the call. They went up about 60 minutes ago, so please refer to those. John and Jim will review the quarter's results and then we'll have a question-and-answer period following that. The call should last about an hour. Beginning at 1:00 P.M. this afternoon, we'll have a replay available through next Wednesday, the end of Wednesday, the 31st. The replay number is 800-642-1687. This quarter, the code that you need for the replay is 20199629. After that comes down next Wednesday, both the replay and presentation will remain on our website. Any questions, call me at 860-827-3833. And we just have two brief announcements and we're ready to start. First, in accordance with Reg G, we issue our earnings guidance at the beginning of the quarter, as we did today, and we cannot comment on it thereafter. If it were to change materially, we would issue a press release and conduct a conference call. Finally, certain statements contained in this discussion by the various Stanley participants are forward-looking statements. As such, they involve risks. Actual results may differ materially from those expected or implied, so we direct you to the cautionary statements in Form 8-K, which we filed with today's press release this morning. With that, I would like to turn the call over to John Lundgren.

Thank you, Gerry. I will provide an overview and ask Jim Loree to look a little deeper into some of the individual segment performance as well as our fourth quarter guidance, which I will remind everybody will be the last quarterly guidance that we will issue consistent with our first quarter call 2007, where beginning in January of '08 we will provide annual guidance and update that in the event of a material change. This quarter, in a large way, validates the portfolio diversification strategy that we initiated almost four years ago. Obviously, we continue to pursue it today. Looking at the quarter in summary, our CDIY business and segment performed fairly well in a challenging domestic market and the consequence of less dependence on some large U.S. retailers didn't have as large an adverse impact as it might have, had our portfolio looked the way it looked four or five years ago. Strong CDIY performance in Europe as well as our industrial tool group and our security segment across the board contributed to the good results in the quarter, which does enable to us reaffirm our full-year 2007 sales EPS and free cash flow guidance that Jim's going to take you through in a lot more detail.

Quickly, on the numbers, because you have them, it was a record sales quarter for The Stanley Works, exceeding $1.1 billion. Pretax income was up 11%, operating margins surpassed 15%, and free cash flow of $119 million was 130% of net income. Strong performance in our industrial tool sector across the board, Hydraulics, Proto, Vidmar, Facom, all with very strong high single or low double digit growth. Our mechanical security business had an extraordinarily strong quarter. Bostitch continues to recover despite about 50% of its end markets being quite weak. Obviously, the North American residential sector, about 50% of what Bostitch does is industrial and less impacted by market conditions. But that profit improvement program that we've discussed on many occasions remains on track.

The HSM merger is also on track. The legacy systems integration business at Stanley -- still not performing at our expectations, but clearly benefiting from the reverse integration into the Facom -- excuse me, into the HSM business model, which was one of the prime strategic drivers behind that important acquisition. We grew across the board, all three regions of the world showed growth and the combination of price and productivity more than offset the high inflation that we experienced during the quarter. And this is the fifth consecutive quarter where that's taken place, which has an obvious positive impact on our margin achievement.

Numbers in general, you see the $1.09. It was flat, in-line with our guidance of approximately $1.10. Operating margin, as I mentioned, up 100 basis points, 15.4% versus 14.4 a year ago. 700 basis points of increased tax versus third quarter '06, which accounted for about $0.10 a share. The 27.2% tax rate was only slightly or marginally above the midpoint of the range we provided in our guidance, but nonetheless 700 basis points higher than a year ago. Share count, not too different. It crept up 1.1 million shares as the performance of the stock over time has put more options in the money and the anticipated exercise of those options. So EPS growth constrained by $0.10 in taxes, but all in all from an operating margin perspective, good quarter. Let's come on to that.

Pretax income and operating margin both expanded. Pretax income up 11%, operating margin up 20% with a 15.4% operating margin. So double digit growth in both of those key metrics were achieved. Looking at revenues on the next chart and some of the various components, 12% total increase in revenue. The biggest single contributor -- about half of that was the HSM acquisition. But $1.131 billion -- record revenues for Stanley. Looking at the sources of growth, as most of you know, we do not include currency in our organic growth figures. It did add 2% to the total top line. But growth across the board -- volume contributing 2% positive price, which is a good thing, 1% for 3% organic, then 2% currency. So the split between our core activities or activities that have been with Stanley for more than 12 months and acquisitions was about equal leading to 12% growth in total. Looking at the segments, I won't detract from what Jim is going to talk to you about in just a minute, but again growth across the board -- Construction & DIY being flat organically, 3% in total. That's the positive impact, of course, of currency outside the U.S. -- industrial segment strong by all measures. Again, the difference between organic, very strong at 8% and total -- a large Facom business in Europe that's benefiting from positive exchange rates, and security way up, with a combination of strong mechanical, great performance at HSM, slightly offset by a modest decline in the legacy systems integration business. So record revenues achieved for Stanley in the quarter despite the challenging North American or U.S. retail markets.

Most of the numbers in the financial highlights we have discussed, either in the press release or I've touched on. But just very quickly, in total acquisitions added almost $70 million. A clear theme where extraordinary strength outside the U.S., market-driven weakness in the U.S., strong industrial across the board, and I've already touched on security. Margins grew nicely. Again, up 100 basis points. Price, productivity, and a higher margin HSM business included in the mix all contributed to that improvement. Pretax income, as previously said, double-digit growth. Good margins and security. Higher tax rate and positive cash flow and Jim's going to give you some more granularity on that in just a minute.

This is an important chart. It's something we look at on a regular basis in terms of the differentiation among at least Stanley and some of its peers. Again, we look at this pretty regularly to ensure that we're on the right path, but it reaffirms again that the weak American, certainly residential construction markets, not necessarily industrial, continue to impact about 25% of our revenues. Specifically at the top of the chart, the Construction & DIY segment in the Americas -- our tools and storage business is down 11%, Stanley Bostitch down 4%, the weighted average of those two combined to about 25% of our sales down about 9%. And the other 75% of the portfolio, up 7% organically with good performance industrial across the board, security across the board, and CDIY outside of North America. So despite two large businesses in North America having some very serious market headwinds that we won't dwell on that we're reading about every day and we anticipate will be not much different until midway through the second quarter of next year. Nonetheless, organic sales grew 7% and the remainder of the portfolio contributing to some positive growth overall. Let me turn it over to Jim who's going to take you through some of the segment detail and outlook for '07.

As we said in the release, it really was a story of industrial insecurity, really strong performances, but we had to hold our own in the CDIY segment to put it all together and that's exactly with what they did with revenues up 3% to $457 million. That included 3 points of currency benefit. And we did that with minus 8% organic growth in the Americas, which was very, very difficult market conditions, as John mentioned, and I think a very good performance and certainly some share gain going on there to achieve that in the U.S. with the strong new product introductions we have and the strong execution. But the real story in CDIY this quarter was international with double digit growth in Europe, Australia, Latin America, Asia, virtually everywhere we are in. Markets around the world, we had strong growth -- we had good growth in Canada and it wasn't all currency. There was definitely some new product introduction gains in those major markets that we participate in. That revenue performance allowed us to basically hold our own with a modest decrease in segment profit, down 5%, and a slight decline in the segment profit rate, down to what I would consider a more normalized level of about 16.8%. So all in all, excellent performance for this segment in a very difficult market. Hand tools and storage was up 7%. Again, the story was the strength internationally, in particular Europe offsetting the weak Americas. The European folks in our Construction & DIY hand tools and storage business were up 25% and that truly was an extraordinary performance driven by new product introductions and increased brand support. The margin decrease was also affected by -- in the overall segment, was affected by some mix towards mechanics, tools, and storage that we mentioned.

Point of sale performance in the U.S. was down 5%, so sell-through of the product down 5%. So actually, inventories came down a little bit for the customers in the quarter and we note that FatMax and the FatMax Xtreme point of sale sell-through was up 7% at the North American retailers. That's a sample of the largest customers -- the seven largest customers that we do business with here in the Americas. The rest of the world, as I mentioned, the sales were very strong, up 23% and Bostitch sales were down slightly, nominally, down 1%. Again, the story was international with Europe up 12% and the U.S. was down about 4% in Bostitch. And the profit improvement initiatives in that business remain on track. We said a couple quarters ago that we expected some sequential improvement, about 1 point a quarter, and they're holding to that improvement. So the team up there in East Greenwich are continuing to move that business in the right direction.

So moving on now to industrial, a truly great story here. A strong, strong performance. Revenues up 13% to $300 million, segment profit up 46% to $42 million, and 320 basis points of expansion in the segment profit rate to almost 14%. Industrial and automotive repair tools, which consists, for this purpose, of Proto, Mac, and Facom was up 8%, including 5% organic growth performance. We had terrific strength in the Proto industrial business in the Americas, up 11%, and Facom was up 7% organically on strong new product introductions and a solid integration continuing in that business. As John mentioned, the engineered solutions businesses also benefited from exchange, but had some really solid organic growth, up 16%, in total were up almost 30%. And we had double digit growth in these small businesses, the Vidmar high-end storage business, assembly, technologies, and the hydraulics business. We had a good story on price realization, where favorable pricing more than offset our cost inflation in this segment and certainly productivity added to profits as well. As I mentioned, the folks at Facom are doing a great job on the integration, and not only are the revenues coming in as we expected, if not a little bit better, but the synergy realization continues to be in-line with expectations.

Moving on now to security, another great story here with revenues up 24% to $374 million. Segment profit up 34% to $69 million, and another expansion in segment profit rate up to -- up a 130 basis points to 18.4%. The story here was two-fold. First, an excellent performance by the mechanical access business, which as you know tends to be North American centric. We had 7% sales growth in that business with strong orders and productivity in the automatic doors business, but also good, solid performances across the board in mechanical access solutions, including the old best access commercial lock and lockset business. Again, the order book is strong in that business, the operating margin is now north of 20%, the price realization and productivity gains are strong as well there and the nonferrous metal inflation, while evading somewhat is still with us, but the price is more than offsetting that right now and the productivity is actually additive to the margins. Then the other story in security is the convergent security business, where we had 62% sales growth, all of that driven by HSM, a modest decrease in the remaining part of the business, excluding HSM. That modest decrease was driven by a sales decline in the United States systems integration business, which is as we expected, as we wean ourselves off the unprofitable types of business that we were working on previously there and integrating that business into the HSM business model. The team is in place to manage that integration, it's going well, and the good news there in the U.S. systems integration business is the operating margin was up $6 million on a sequential basis, which is moving in the right direction.

Now turning to cash flow. Another good story here. Solid, solid quarter, $130 million in operating cash flow, $119 in free cash flow. Brings us to a year-to-date figure of $326 million for operating and $271 million for free cash flow. And that puts us solidly in position to achieve our forecast of $400 million to $450 million for the year and we will expect to see some working capital improvements in the fourth quarter that are built into our thought process there.

Then turning to the full year and fourth quarter guidance, really nothing different here. We expect the fourth quarter to be in-line with previous expectations and thus the full year. 2% organic sales in the fourth quarter, which is in-line with what we've accomplished each quarter this year. Acquisitions contributing 6 points total, 8 points of sales growth, earnings per share of $1.10 to $1.15. That will give us a 6 to 11% earnings per share growth with some significant tax headwind, which you can see on the chart there. Looks like about $0.15 to $0.18 headwind still to deliver this earnings growth with those headwinds that we're confronting. The free cash flow, $130 million to $180 million, will get us to the $400 million to $450 million. And when you step back and look at the year in light of the very difficult United States Construction & DIY market, we expect to register 15 to 17% earnings growth, and that goes to the strength of the portfolio that we started this conversation at the beginning, talking about how that portfolio had shifted. And if we go to the next chart here, the portfolio shift, you can see back in 2002 when we were $2.6 billion, we had $1.7 million of Construction & DIY. So the majority of the portfolio revenue base coming from that Construction & DIY segment back in '02, now today a very similar number, $1.8 billion coming from Construction & DIY. But we've grown the security business from $300 million to $1.4 billion during that timeframe and the industrial $600 million to $1.3 billion and as consequence, we have a much more balanced portfolio.

The other point I would make here is because the Construction & DIY segment is our most geographically diverse segment, and you saw that in the results today, that we only have $1.1 billion of exposure to the United States Construction & DIY market and $700 million in the rest of the world. So that geographic diversification within the Construction & DIY segment has helped thus quarter and we think will continue to help us as we go forward here. So we have a larger, more diverse revenue base and that really did help us drive performance throughout the year. And we'll expect to continue to see that in the fourth quarter.

Moving to the next chart, you can see pretty good year when we step back and look at some of the key variables, such as free cash flow. Looks like about 11 to 25% increase there. Pretax income, about a 25% increase there. Operating cash flow, consistent increases as well there. And then EBITDA should grow about 25% this year. So on pretty much all fronts including earnings per share, with that 15 to 17% growth expectation, it looks like it's going to be a pretty good year. And it looks like despite the difficulties in the United States Construction & DIY housing-related markets that our portfolio's withstanding them very well and will continue to do so as we go forward. With that we'll open it up for questions.

(OPERATOR INSTRUCTIONS) Your first question comes from Michael Rehaut.

Hey, guys. This is actually Ray Huang on for Mike. How's it going?

Good.

Just a couple questions. First on the price realization, you guys expect that to continue going forward to the fourth quarter into the next year and by how much?

It will definitely go forward into the fourth quarter and will help the fourth quarter. We are looking at inflation in the total year of around $70 million now and we'll recover around 80% of that in terms of our price realization. Price realization has grown to be a fairly good competency of the company over the past few years and certainly this year has been a pretty good year in that respect. Part of it, though -- part of the higher percentage than what we typically -- we typically have been in the 60 to 65% realization range in the last couple of years and I think the reason we're doing a little bit better this year is that we're gaining some positive effect from the nonferrous inflation subsiding a bit as we kind of go throughout the year and price increases lag the inflation, so we're having a little bit of benefit from -- of that lag effect, which we thought would come sooner or later, and looks like it's coming. Nothing really significant there. But I think in the fourth quarter, we should be -- maybe the first quarter where we're very close to 100% price realization, vis-a-vis our inflation. When you look at it on a segment basis, it's interesting because we continue to -- that lag affect is clearly occurring in the security business and in the industrial business, where we are recovering a little bit more than 100% of our inflation, but really just catching up for inflation that we experienced in the past. And in the CDIY segment, unfortunately due to the structural characteristics and difficulties in achieving price increases in that segment, the price realization percentage is much lower. We would be -- without that segment kind of weighting the mix down, we would probably be right at or around 100, maybe slightly above 100% as we sit here today.

So you are still tracking that $70 million in raw material inflation that you guys had previously given?

Yep. No change on that based on the last three months' worth of data.

Just a follow up on Bostitch, seems like you're on track there, but where are you guys versus where your initial expectations were a couple of quarters ago and how do you see that progressing over the next 12 months or so?

No, that's fair. As Jim said, we're at -- we're in fact, slightly ahead, and it's not going to be perfectly linear. I think we were pretty clear starting a year ago, we said 100 basis points a quarter for eight quarters. That gives you 800 basis points and takes margins from very low single digits up to low double digits. We are slightly ahead of it, it's not perfectly linear, as mentioned. In terms of the key products, we can talk about some things that weren't public at the time, but the key projects are what's driving a lot of the improvement. Specifically, our plant in Chihuahua, Mexico, is closed. That's been a very good thing. Faceting production has primarily been relocated -- well, it's been relocated to three difficult facilities. As you know, nails don't travel very well, they're heavy, and we've moved that production primarily to East Greenwich, Rhode Island, secondarily to Poland and Langfang, China. Concurrent with that move, we're making good progress on our tool transfer from East Greenwich, Rhode Island, to both Taiwan and China with our recent Besco acquisition. Again, a very important element in the tool -- profit improvement program was the transfer of some less proprietary tools to lower-cost markets. Importantly, we own the company, we own the facility, it is not outsourced. It is a Stanley Works production facility, primarily in Taiwan, secondarily in China. Specific models at the beginning of that curve have been transferred. The product's working and the products are moving back to the various domestic markets. So simply said, on track. It's three quarters in a row where we've achieved what we said we would, and as Jim suggested and we would suggest from our most recent reviews of the Bostitch business, we continue to track it very closely and our plan and what's baked into the fourth quarter guidance and our plans for next year will continue at that pace.

Okay, great. Thanks, guys.

Your next question comes from Ken Zener with Merrill Lynch.

Good morning.

Good morning.

I am interested in the industrial margins, while up year over year, I'm just trying to understand the kind of sequential decline. I'm trying to see about the mix for industrial this quarter, which is 13.9 versus 15.2 in the second quarter '07. Is that just kind of normal seasonality, or can you kind of explain that a little bit?

Sure. It's primarily one driver, and Jim, who's got business-specific detail in front of him. I'm not sure how much detail we want to go to. The biggest single element is August is never a very high productivity month in France. You know how important Facom has become. It's a third of the revenue and more than a third of the profit from that business. Last August, of course, we had tremendous synergies going on and hitting the early synergies, hitting the bottom line. So while the business at Facom remains extraordinarily healthy and wouldn't want to suggest anything to the contrary, August with vacation periods, etc., Europe in general, France in particular, is a relatively low productivity month, usually results in underrecovery of some fixed costs. Simply said, it didn't show up last year because the improvements due to the synergies at Facom overwhelmed the -- I'll say lack of efficiency or reduced efficiency. Importantly, we still have eight French plants and major (inaudible) all we need to do is plan it a little better and forecast it a little better. It's always existed, it just didn't show up last year because synergies overwhelmed the historical lack of fixed cost recovery in French plants in August.

Okay. Then I guess on the security integration, I believe last quarter you said the business was down 8% in the second quarter and it sounds like it's kind of down in low single digits this quarter; is that correct?

That's correct. That's on the electronic -- the convergent piece, Ken. Mechanical continues to do nicely with low single digit organic growth that improved margins. We'd love to with all three businesses on the mechanical side hitting on most if not all cylinders, but what we're speaking to is, yes -- on the electronic and convergent side.

But you also said profit was up $6 million. Was that quarter to quarter?

That was sequential that Jim referred to, second to third. And that's primarily -- you'll recall we had a -- within the legacy SI business, we had a tremendous backlog of less than profitable installation projects, particularly in some corrections facilities around the world where we didn't do as good a job as we should have in both estimating cost to install, and secondarily bringing it in at the cost we estimated once we provided an estimate that arguably was not competitive to begin with. We are -- Stanley, we're in this business for the long haul. We are going to honor those commitments to our customers. That backlog at the end of the second quarter was dramatically reduced. We still have a few more -- and what we said on our second quarter call is they would be reduced. We're not finished with them until this end of this year, but that's the primary sequential driver. Quite frankly, continued strong performance at HSM and fewer bad projects in the backlog to work through at legacy systems integration.

Your next question comes from Nigel Coe with Deutsche Bank.

Thanks. Good morning. Nice quarter, by the way. I think you had met some good numbers here in a very challenging environment. Just want to focus on industrial, particularly with engineered solutions, 16, 17% growth. Can you talk about the drivers of that performance? A lot of my industrials are talking about 4Q and 2008 being a bit more challenging. Can you maybe address that question as well?

Sure. Engineered solutions is a mixture of several small businesses, anywhere from $60 million to $150 million each. Within those businesses, each one participates in a niche market. So, for instance, Vidmar is in the high end storage business for industrial customers, military customers, and most recently now hospitals in the healthcare industry, with the acquisition of InnerSpace. And assembly is in the automotive OEM business, and hydraulics happens to be in the scrap recovery and demolition segments of the markets. So to extrapolate anything dramatic about the state of the overall industrial economy would be very dangerous and difficult. However, fortunately for us, the markets that we happen to be in are vibrant right now and the value propositions that we have within these businesses are very good and strong and I think in all cases, we're either maintaining or growing share within those businesses. So it's a combination of industrial strength within certain niches that we're in and on top of that, some good performance. Now, the one notable exception to that in terms of market strength would be the assembly, the automotive business. There's a couple things going on. Number one, European performance was very strong during the quarter, so despite the U.S. woes in the automotive industry, they did very well in that regard. They had a relatively easy comp on top of that, because it's been down for a while. And basically the combination of those two factors and some good new products have helped propel them into a positive performance as well. So no one story there, but having said that, we don't see any significant weakness at all in the industrial economy across the board. I'm talking more in a general sense now. I think the exports in the U.S. are certainly robust. That's helping drive the industrial economy and the international aspects of the industrial business are very strong as well.

Nigel, let me just add one thing to Jim's point, because the segmentation is relatively new to the investment community. We've only been reporting this way -- this is our third quarter. And within industrial, the largest distinction between what we call industrial and automotive repair versus engineered solutions -- engineered solutions represents about 20% of our industrial portfolio. That is a made-to-order versus a made-to-stock business model. Of all the businesses that Jim discussed, they tend to be larger ticket items, longer lead times -- and in the interest of simplification, more often than not it's going to come from the customer's capital budget as opposed to his expense budget. Thus, we have a little longer look into the future in terms of open orders and things of that nature in that business. So fundamental business model difference, made to order versus made-to-stock and beyond that, obviously, they all compete in the same general environment. It's more an internal than an external thing is why the engineered solution segment showed more robust growth than industrial in total.

Got it. Thanks for the color there. And just a quick follow-on, HSM. I know it's not part of organic growth, but can you talk about the organic growth for the quarter?

It's very consistent with what it has been. The trend is in the right direction, it's in the 8 to 10% kind of a range. And the good news about that business, it has so much recurring revenue that forecasting the revenues is a lot easier than say the CDIY segment next week. So in any event, business continues to be strong and trending in the right direction in HSM.

Your next question comes from Eric Bosshard with Cleveland Research.

Good morning.

Eric.

Two questions, first of all, on the Facom business, the 7% organic growth ex FX seems like heck of a number. What's going on in those markets and within market share that's driving that, and is that sustainable over what period of time?

Well, the market itself, Eric, is not on fire. It's certainly strong, stronger than usual, so you get probably 2.5% economic growth going on in Europe right now and these markets tend to track the economy fairly closely, but compared to how Europe has been -- continental Europe in particular has been performing over the past few years, that's a slightly stronger pulse than before. The real story at Facom is largely one of new product introductions. Facom prior to Stanley's ownership was owned by a financial -- in effect a financial portfolio company, a company that owned Fitch and an Italian commercial furniture company. So they are now part of a global tool company, a global, industrial, and automotive tools platform. We didn't really bank on any revenue synergies or anything else when we put the deal together, nor do we really count on those. But we are definitely getting some. In addition to that, we're getting some geographic expansion into central and eastern Europe. So a combination of factors. The question about sustainability, who knows. Certainly, new product introduction doesn't turn on one quarter in the industrial business and turn off the next. I think we should have some sustained performance for a period of time. Whether it will be at the levels that we have this quarter will be another question, but certainly we see no reason to become pessimistic about organic growth at Facom at this time.

Eric, before you ask your second question, because we know how it works, you get cut off in the queue, just to expand -- historically, Facom's been outstanding at production. I think the internal improvements at Facom are simply a robust new product pipeline replaced all the attrition from the core business. Thus the business was able to stay flat. What's happened with the Facom team, and I think just improvements that Jim talked about in their rhythms, in their metrics, in how they're managing the business is -- simply said, the new product introduction's not 100% cannibalization or replacing lost business. So they're maintaining a larger percentage of the core business and as a consequence some of the new product introduction becomes net incremental. And that's really helping. Can we keep doing that forever? It's a long putt, but we like the way the business is going, we like the way it's managed, and at Equip Auto which is the largest automotive and industrial show in Europe just took place. We were very pleased with the interest, the results with our position at Equip Auto in Paris in late October. So for the short-term future, things look good at Facom.

Lastly, seeing how this is your last quarter of quarterly guidance, within the 4Q guidance, my numbers suggest that you probably need to have some profit growth out of the CDIY segment, which is different than what you showed in 3Q. Can you give a little sense of what you expect the profit comparison to be in that segment in 4Q year over year and why?

I'll tell you what, Eric, we're not in the business of giving guidance by segment, anyway, even though we still give quarterly guidance. What I will say is that we expect the fourth quarter to look an awful lot like the third quarter in the sense that CDIY will be a strong base and not particularly strong in terms of growth, but solid in terms of not eroding and in industrial and security, we're expecting very strong quarters out of them as well in the fourth quarter.

Your next question comes from Peter Lisnic with Robert W. Baird.

Good morning, gentleman.

Hey, Peter.

I guess first question would be on security. The -- if you look at the legacy conversion portfolio, you mentioned the sequential profitability improvement, but can you give us a sense as to what that would mean on a year-over-year basis or where we're at in terms of just the underlying margin in that business right now?

As Jim just said, Pete, in all fairness, not only aren't we going to forecast or talk revenue and margin by segment, we're certainly not going to talk to it by subsegment. We have no intention on an open conference call of talking legacy convergent security margins versus HSM versus anything else. What we've said and we've been very clear about, HSM is obviously mixing up security in a meaningful way. A business that was certainly a drag on profitability -- round numbers, it's $350 million of the $600 million segment, so you can do the math on what $6 million in one quarter did. Going forward, we see the reverse integration of the legacy SI business into the HSM model continuing to affect performance and that's what's built into our guidance. Importantly, the change was simply, we have a better -- with the help and one of the strategic justifications of HSM, a far better cost estimating tool, far better project management capabilities, and the elimination of the backlog. All of those, as we said in the second quarter, impacted the third quarter positively, will continue to impact the fourth quarter. That's why we bought HSM and right now we've got a 15% plus operating margin business and we continue to believe it's there and can go up from there. But we just -- we just aren't in a position and it's not in our best interest to provide any more granularity than that.

I understand that. I was just trying to get a ballpark of whether or not you're saying improvement and how much. So thanks for that answer. Second question, in terms of the mechanical access business, I think I have the same question that Eric just asked on Facom, and that is -- looks like plus 7% in the first half or first three quarters of the year, and Jim, you mentioned strength in all three of the businesses. Can you give us a bit more color on how that's happening and do you expect that to continue and how?

Well, we don't expect it to continue at 7% for the intermediate term, that's for sure, because it's a 3 to 4% market growth story and if we can get mechanical to grow 3 to 4%, the real growth in the future for this segment above line average will come from the convergent business and mechanical's job is to grow 3 to 4% and create a -- generate a lot of profit and a lot of cash and help us fund the expansion of the platform into other geographies and so forth. That said, there's a lot of good things going on in the organic growth area in mechanical. We are -- we are very strong in the education and healthcare markets. They both happen to be good markets to be in right now. We're gaining some share in the construction, commercial construction market because of the fact that we have more specifiers than we used to and that's gradually starting to have a positive impact. And we also have a full product line. You'll recall that in the last few years, we purchased a few companies that have enabled us to round out our product line in mechanical access and some of the competition prior to the fact that when we had this -- now have the full product line, but prior to that, some of the competition was taking advantage in their pricing strategies by lowballing us where we were competing with them and then making their money on areas where we didn't have products and then winning bids that way. That is not happening to the extent that it did before and that certainly is helping.

The other factor there is the automatic door business, which has just been a tremendous growth story over the past five to seven years, started out a long time ago. Five to seven years ago it was a $100 million business, today it's between $200 million and $300 million. And most of that has been organic growth and they've had enormous share gain. And that has to do, we believe, with the superior products they have and they continue to develop new products in that particular business and also has to do with our distribution strategy, which is a go-direct strategy and enables us to serve the national accounts extremely well. And we have gained share as a result. So all those factors, I think, are combining to give us a strong performance. The other thing, which it's an intangible, but I believe it has something to do with this, is that we split these businesses from a management perspective about a year ago. And as it turns out the mechanical folks are now able to focus much more on the nuts and bolts of organic share gain and productivity and other things in their business, and they don't have to worry about estimating costs in the electronic business and project management and the electronic business and trying to figure out how to grow the recurring revenue base in the electronic business and the technology change in the electronic business and everything else that was potentially a bit of a distraction before. So I think increased focus has also contributed to the strong performance in mechanical access.

Pete, let me just add, because you didn't get everything you were looking for, I know, in convergent. But in fairness, the third leg, of course, of our mechanical securities solution business is builder's hardware. We talked about it in February, talked about it again in May. We lost a meaningful piece of business there. It is what clouds the outlook and makes Jim or me hesitant to say, yes, of course it will continue with the rate. The good news is we lost the business, we started to plan for it. That business has in fact wound down a little slower than we thought and we've done a better job replacing the lost business and we gave ranges of what we thought that might mean in terms of revenue and income. And quite frankly we've lost the revenue and income a little bit slower than we'd anticipated in our outlook and we're replacing it with business that we know we can count on in the future a little bit faster. Still a lot of open books there, with the speed at which line reviews work and as Jim already talked about, the architectural bidding process and it's a little less than straightforward. That too has contributed to great performance of late and it's a little more difficult to predict the short to intermediate term future of that piece of the business. But all in we're pleased with our decision to have split those businesses, fundamentally different business models despite the great synergies between the two in terms of installed base.

Your next question comes from Stephen Kim with Citigroup.

Mark [Montin] on behalf of Stephen. Regarding your recent acquisitions, it seems like your lineup of products on the mechanical access side is fairly complete. Wondering if you're expecting to further add to your portfolio on the mechanical side or should we expect more acquisitions coming on the convergent side going forward? And in particular, are you still expecting to expand these future convergent acquisitions internationally?

I guess it was March 8 when we talked specifically about some of the different strategies and the growth platforms that we have in security and industrial and automotive tools. But we have three growth platforms, of which two are security, and each of those, one is mechanical and one is convergent. And the growth strategies are somewhat different, especially as it relates to the M&A growth. You're right, we have a relatively complete, now, product line in mechanical and North America. Certainly, there's no burning platform need to buy anything else that's product related. It doesn't mean that there won't be possible niche opportunities that come up from time to time within mechanical in North America. But the real opportunity and the management team is well aware of it and strongly pursuing it for growth -- for merger and acquisition growth in mechanical is outside the borders of the United States. And that's where they're focused on. I suspect you probably will see some deals there in all likelihood over the coming years. When you think about the strength of this business and the profitability and the growth profile, etc., it's a nice business and it's equally as nice in Europe as it is in the U.S., but the products in the U.S. don't just translate like the tool business translates into Europe. You have to have -- they're subject to different standards and you have to have local products. So it makes it more challenging and it really does require an M&A approach to the non-U.S. growth strategy. So that's mechanical.

Convergent, convergent has the opportunity to grow through acquisition as well, but I would say their growth strategy will likely be more focused on organic, not to say that we won't acquire -- there are certainly a lot of commercial monitoring companies that we could consolidate into our business in a very successful and cost-effective manner and it's likely that we'll do that. And it's also possible that over time there may be some businesses outside the borders of the United States that are attractive to us. That will to a large extent depend on how well the team is executing in North America, making sure that the U.S. systems integration business is stabilized. Before we go venturing too far beyond our borders, we're going to make sure we are totally certain we have the equation right in the United States. And the only way you can be totally certain is to get some quarters under your belt and make sure the performance is there. Clearly, we're moving in the right direction and we would expect to continue to do that.

Okay, great. Then a follow-up on a previous question about the implications for fourth quarter guidance and margins holding up fairly well. I'm just wondering if this is particularly due to the strong pricing that you mentioned earlier on the industrial and securities segments? I know you said that CDIY was going to continue to be an anchor there. Are you expecting margins to really hold in place mainly due to the pricing issues, or is it something particular due to the timing of the year?

We're looking at about a 2% organic growth, we're looking at strong productivity, we're looking at price and inflation roughly offsetting each other, a combination of factors such as that are really driving the outlook for continued positive performance. Certainly the market conditions -- we're not betting on any improvement in any market conditions, I can assure you of that.

Your next question comes from Seth Weber with Banc of America.

Good morning. My questions have all been asked and answered, thank you.

Thanks, Seth.

Your next question comes from David MacGregor with Longbow Research.

Yes, good morning. Just on the topic of organic growth at HSM, can you talk about your plans for 2008 with respect to opening new offices and how that could contribute to organic growth?

Yeah. There are, David, three to six regions where we feel we're not -- cities, quite frankly, where we feel we're not perfectly suited to compete. The best way to not make money or lose money in this business, as I'm sure you understand, is to have folks driving 300 or 400 miles to service a commercial account. So I won't name the cities, but three to six are on the radar screen for having enough critical mass between the legacy Stanley systems, integration business, and HSM to open an office there, and as a consequence, to staff it with two to four field techs. And that is quite frankly to eliminate -- to cut drive time from four hours to an hour or two to allow to us grow organically in that market. It probably, overall, would come with the -- we still have some redundancy in our field operations, as you might expect, combining the HSM locations with the Stanley locations. We've done a really good job so far. Brett Bontrager, Tim Whall, and the team have done a very good job in terms of choosing the right locations -- and the tough decisions, the best of the best in terms of the people, where if you've got two ten-person offices in a city, that becomes a 15-person office. So long answer to a simple question, look for three to six new cities next year, which we think will help contribute to the organic growth. We think it's necessary. We continue -- the biggest help to organic growth, of course, is keeping attrition at or below industry standard levels. Where we are with HSM, that's what Tim Whall and the team wake up every morning, not just trying to -- not just looking for new business, but working real hard to ensure that they retain every existing customer that's a profitable customer. And if there's any chance of losing it for whatever reason, we work extra hard to keep that from happening, which is why attrition is well below industry standards in that business and we're working hard to drive it even lower.

And as impressive as 8 to 10% growth is, is it possible with these three to six openings on the screen for '08, that we could see organic growth moving higher from 8 to 10% next year?

Anything's possible. Is that built into our guidance? the answer is no. As much as we would like to, we don't compete -- we don't operate in a vacuum. There are people actually out there after those same commercial accounts we are, some of whom are a lot bigger than we are. So the simple answer is that's just part of our ongoing practice. We think we need to do that to keep up with the kind of growth that we've experienced in the past. It would be naive for us or anyone else to think that for whatever reason consolidations at the customer base, that there won't be some attrition. Remember, when there is, whether it's 3 or 5 or 8%, even if you're on the low end of that, 3 to 5% attrition means you need some new business in existing markets or you need some new cities to backfill that before you break even. The best part of the HSM model, as Jim suggested earlier, is the high base and increasingly high percentage of the revenue that's recurring. When you get more than 50% of your revenue base occurring, that is an annuity and you know at least a year in advance that business will be with you and that's where our focus is on HSM. But we will take any upside that the team can deliver. They've done nothing but please us with the connectivity and their performance so far, but it would not be prudent for us to expect any more from them. They've got a lot of things going on and they're operating in an intensely competitive market.

There are no further questions. I'll turn it over to John Lundgren for final comments.

Listen, I want to thank -- just nothing else to say in terms of the numbers. They are out. As always, Gerry's available for follow up if somebody didn't get it. There's a lot going on in the market this morning and a lot of calls coming out, so thanks to all of you who took the time to listen in. And for those of you who didn't get to, you know it's available starting at 1:00 this afternoon. Thanks a lot.

This concludes today's conference call. You may now disconnect.