Sypris Solutions Inc (SYPR) 2008 Q2 法說會逐字稿

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  • Operator

  • Good day and welcome to the Sypris Solutions Inc.

  • conference call.

  • This call is being recorded.

  • At this time for opening remarks, I would like to turn the call over to the President and Chief Executive Officer, Mr.

  • Jeffrey Gill.

  • Please go ahead, Sir.

  • Jeffrey Gill - President and CEO

  • Thank you, Matt, and good morning.

  • Tony Allen and I would like to welcome you to this call, the purpose of which is to review the trends reflected in the Company's financial results for the second quarter of 2008.

  • For those of you who have access to our PowerPoint presentation this morning, please advance to slide 1 now.

  • We always begin these calls on the note that some of what we might discuss your today may include projections and other forward-looking statements.

  • No assurance can be given that these projections and statements will be achieved and actual results could differ materially from those projected as a result of several factors.

  • These factors are included in the Company's filings with the Securities and Exchange Commission including our most recently filed Form 10-K and the Form 8-K filed earlier today.

  • And in compliance with Regulation G you can access our Web site at Sypris.com to review the definitions and the non-GAAP financial measures that may be discussed during this call.

  • With these qualifications in mind we would like now like to proceed with the business discussion.

  • Please advance to slide 2.

  • I will lead you through the first half of our presentation this morning, starting with a brief overview of the second quarter to be followed by a look at several of our key markets; a review of our 2008 priorities and the short mention of the strategic review we are conducting before concluding with a brief wrap up.

  • Tony will then provide you with a more detailed dive into the Company's financial results in the outlook for the balance of 2008.

  • Please advance to slide 3.

  • The results for the second quarter were generally in line with our expectations and prior guidance, with earnings per share within the lower end of our guidance with a loss of $0.05 per share while revenues came in $6 million below the midpoint of our guidance at $110 million.

  • Our Electronics Group revenue increased 13% sequentially driven by a 15% increase in Aerospace and Defense and a 9% increase in Test & Measurement.

  • On a year-over-year basis, our Electronics Group was flat with the second quarter of 2007 reflecting a downturn, a slight downturn in our Aerospace & Defense segment driven by a decrease in Data Systems Shipments offset somewhat by a 6% year-over-year increase in our Test & Measurement Group.

  • Our Industrial Group revenue remained steady at $69 million for the quarter, but was fully $5 million below our internal expectations therefore accounting for the majority of the miss.

  • Within the Industrial Group, the demand for light truck components and trailer components comprised the majority of this miss.

  • Excuse me.

  • Our Test & Measurement gross profit increased 18% year-over-year with gross margin expanding to 26.5% for the quarter and our Electronics Group's orders remains strong at $33 million with high expectations for second half growth and the fact we are targeting in excess of $50 million of orders for Q3.

  • Our free cash flow reflected a usage of $13 million, which was $2 million better than our guidance, and included a tax payment of close $10 million associated with the Dana settlement.

  • All in all, for the quarter, our earnings per share and free cash flow were achieved despite the revenue shortfall.

  • Obviously we were hoping to do better than that and had we not come up short in the Industrial Group, the earnings per share target would have been exceeded in a far more positive fashion.

  • Now let's take a moment to review the outlook for each of our key markets.

  • As you'll see from the next slide, the market for commercial vehicles remains mixed at best.

  • The top half of the chart shows the change in forecast -- that is boxed -- for the market for heavy-duty vehicles.

  • The most recent forecast by ACT for July is down roughly 4% from ACT's March forecast, reflecting the impact of the rising crude oil prices, tight credit and reduced levels of freight, among other issues.

  • For the full year, the current [view], forecast shows a 2% increase over 2007 to roughly 216,000 units for the year.

  • But quite frankly some of our customers are forecasting a full year outlook that is closer to 205,000 units.

  • ACT is forecasting a 34% growth in this market for 2009.

  • But when we look at customer demand, internal forecast for 2009, the range is in the area of 27 to 40%.

  • So for the heavy-duty outlook at this point for 2009 it's really anybody's guess at this point from our standpoint, but it is -- in any event, it is still looking strong, not quite as strong as it was before.

  • In the area of medium-duty vehicles, this is somewhat of a different story.

  • The July forecast is down from March by 7% to 188,000 units.

  • The revised outlook is fully 9% lower than when we look at it at 205,000 units for the year.

  • The original forecast, by the way, going into this year for medium was 220,000 units.

  • [For] outlook by ACT for 2009 is forecasting 7% growth in this segment of the business.

  • But at that level it would still be below 2007 output.

  • From the beginning of the year, our outlook for Class 8 is down about 6% while the outlook for Class 5 through 7 is down almost 20% from the original forecast.

  • So as we look at this part of our market, the real story lies with the medium-duty truck market.

  • Now let's take a quick look at the balance of the year.

  • On the next slide you'll see that the third quarter outlook for heavy-duty vehicle production is 9% higher on a year-over-year basis, but is 9% lower on a sequential basis with the forecast for Q3 coming in at 51,000 units versus 56,250 units for the second quarter of this year.

  • For Q4, ACT is forecasting a 26% increase from the prior year period and [up] 15% sequentially at roughly 58,750 units.

  • In the medium-duty market the outlook remains bearish with Q3 being down 6% lower than Q3 of '07 and 10% lower on a sequential basis at 45,000 units.

  • Recreational vehicle demand is forecast to decline 34% and school and urban bus demand is forecasted to decline by 14%.

  • As we have looked at these numbers, quite frankly in preparation for making our forecast for the balance of the year, we have taken into account more of a risk-adjusted approach to the fourth quarter in the belief that there's risk in the ACT forecast which is increasing a 7,000 unit sequential increase in output in Q3 to Q4, while also recognizing that the fourth quarter has far fewer production days, if you will, than does the third quarter.

  • So we taken that into account.

  • And we are not banking on a 26% increase in the fourth quarter for this type of production.

  • On page 6, you'll note that the outlook for the production of trailers continues to weaken with 2008 volume now expected to decline 30% from the 2007 levels, falling to 151,000 units from 216,000 units in 2007.

  • The road to recovery in Class 5-7 production has slowed considerably, driven largely by the economy, high energy prices, reduced construction and tight state and local government budgets.

  • Light truck production has fallen significantly, resulting in a 25% reduction and outlook for this segment.

  • This is in part what has flattened our outlook or reduced our outlook for the second half of 2008.

  • And at these levels, the light truck segment of our business will represent just over 7% of our consolidated revenue for 2008.

  • Our Electronics Group is a completely different story altogether.

  • Aerospace & Defense is expected to show continued topline growth through 2008 on a year-over-year and on a sequential basis.

  • This growth is being driven by secure communication products that we've discussed over the past 12 to 18 months, as well as the award of new programs.

  • Our markets for intelligence and secure communications are expected to remain positive for years.

  • The only exception that we've seen in this market recently has been there have been some funding issues that appear to be impacting our telemetry portion of the business, which is primarily focused on missile ranges and testing.

  • And, therefore, our DataSystems shipments have been down this year.

  • Our Test & Measurement outlook remains positive for the year.

  • Our team there is doing an absolutely excellent job.

  • We have an expanded R&D budget that is expected to feed demand for additional new products in 2009.

  • This is important for us, both in terms of driving future margin expansion as well as continuing to increase our Electronics Group percentage of our overall portfolio.

  • Orders for Q3 of 2008 are expected to reach a multiyear high with a target of $50 million for the quarter compared with $33 million in our most recent period.

  • Switching gears for a moment, as many of you will recall, we embarked upon some initiatives to improve our overall performance roughly 12 to 18 months ago.

  • And these efforts were focused on realigning our restructuring part of our Industrial Group; investing to achieve double-digit growth in our Electronics Group; and then investing not insignificant amounts of funds in continuous improvement and looking for ways to drive business process improvement.

  • On the following page I would like to give you an update on where we stand with these things.

  • With regard to the SIG restructuring, the transfers that were moving between our plants are on track.

  • And we've actually exited our non-core lines of business on schedule and that is just about done.

  • Our new leadership team is being populated, is quite frankly doing a wonderful job of not only dealing with the current market conditions that we have, but quite frankly, driving improvements in a number of areas in this business that we believe will pay dividends for years to come.

  • The productivity results are beginning to show on a businesswide basis in this area.

  • Quite frankly, the rate of progress has been significant.

  • It is just unfortunate that the decline in expected volume that we were looking at this year is masking some of the short-term impact.

  • The silver lining to that, of course, is that when the volumes do return, we expect to achieve substantial operational and financial leverage with the return of volume.

  • With regard to our second area which was achieving double-digit growth in our Electronics Group, John Walsh is the new President there, is doing a nice job.

  • And we are making substantial progress in reconfiguring the cost profile of that business as well as investing in -- beginning the process of investing in additional products that will spur the growth of this business for quite some time.

  • We have a new magnetic product offering that will be coming to market in 2009 that we are very excited about.

  • This is from our Test & Measurement Group and we are seeing some positive signs of receptivity for our receiver offerings at DataSystems.

  • In short, we are now very confident that we expect to have our Electronics Group meet or exceed our target of achieving 40% of our overall portfolio for 2008, which would be up from 36% in 2007 and on a path that is consistent with our overall long-term objectives.

  • And that is to have our Electronics Group equal 50% or more of our total portfolio.

  • With regard to the third objective, improving business processes, quite frankly we are starting to show some really excellent results in this area with some great improvements in efficiency, reductions of cycle times, more efficient allocation of direct labor.

  • And it seems like we are only on the front side of this.

  • Our group that's leading this throughout the Company would tell you that we are on first base rather than second or third base.

  • But when we look at the kind of progress that they are making, we are very, very optimistic.

  • And in fact, as we looked towards some simple things in working capital for 2008, then we expect to reduce inventory days by 47% by year-end.

  • And we expect to fully double our working capital terms during this period of time which, as you guys know, will generate lasting free cash flow for us and reduce our cost over time.

  • So with regard to what we set out to do a year to 18 months ago with regard to these priorities, we are on track.

  • We are making real progress and we are very pleased with the results.

  • Please advance to slide 8.

  • Having said this, what we would say is that the economy, the outlook of the industry has changed rather significantly over the past 18 months.

  • And so as we look at 2008, it really is turning out to be a year of unprecedented issues.

  • And I know everyone on this call is familiar with those issues, but quite frankly, the combination of the declining economy and widespread credit issues, or tightness, when combined with soaring inflation and energy, steel and food is really [creating] a dynamic that I think that not many of us would have predicted 12 or 18 months ago.

  • And as a result, obviously, the environment in NAFTA is very challenging whether it is housing and industrial production falling, or energy prices soaring but perhaps on the front end of really rolling through the overall economy.

  • And so as we look at this and it just says to us that even though we embarked upon a plan 12 or 18 months ago to improve some operating items and we are making progress in that area, that we can't just stick to that plan.

  • So we've made the decision to revisit our original assumptions with regard to that plan.

  • And as a result, we have initiated actions to review all of our operations once again with the intent to eliminate any remaining wastes to go after fixed overhead in a much more aggressive passion, to accelerate where possible the integration of efficiencies during these periods of reduced demand and really to challenge the existence of any major program if it inhibits our ability to consolidate and to drive a material improvement in overall operating efficiency.

  • Our objective, I think, is fairly clear.

  • It is to generate significant improvement in our operating earnings to offset the economic risk that we believe all of us are facing today.

  • It is our intent to complete this analysis sometime during the next three months or so.

  • And it would be our intent to report back to you on the results of that analysis some time during the fourth quarter.

  • Please advance to the next slide for a brief wrap up.

  • In conclusion, the second quarter results a net guidance for earnings per share in free cash flow despite a material shortfall in revenue from our Industrial Group.

  • The outlooks for our Electronics Group remains positive.

  • Our Industrial Group continues to [fight] short-term reductions in demand especially for light, medium and trailer components.

  • Our 2008 priorities remain on track, with major progress being made in productivity, working capital turns, and inventory days.

  • Increased efficiencies, growing electronic shipments and a recovering commercial vehicle sales are expected to combine it to drive a vast improvement in 2009 financial performance.

  • But having said this, our view is that the outlook for 2009 is not without risk.

  • As we mentioned a moment ago, commercial vehicle production's forecast increased 15 to 20% next year which would result in significant operational and financial leverage for Sypris.

  • But it is our sense that energy prices, credit availability and industrial production could have an impact on this performance if we don't see some abatement in these areas in the next two or three months.

  • As a result, though, we are conducting a strategic review with the intent of driving significant costs out of the business to buffer this risk -- the analysis of which is expected to be completed during the fourth quarter.

  • This concludes my portion of today's presentation.

  • And I'd now like to reduce Tony Allen to you.

  • Tony will carry you through the balance of our presentation here this morning.

  • Tony Allen - Acting CFO

  • Thank you, Jeff, and good morning, everyone.

  • By advancing forward two slides to slide 11 you can see the details of our Q2 performance compared to guidance.

  • Revenue was $110 million in the second quarter, down 8% from the prior year and below our guidance range of $115 million to $118 million.

  • During the back half of the quarter, we experienced a major drop in orders for light truck following Ford's announced production cuts.

  • And this was followed by reductions in orders for our Class 5 through 8 components.

  • As a result the Industrial Group's revenue closed at $69 million in Q2 which was below our expectations and represented a 6% decline from Q2 2007.

  • Electronics Group revenues also came in short of expectations at $41 million, which was a decrease of 4% from the prior year.

  • Orders for our DataSystems products declined further in Q2 as government funding for certain programs wasn't released as expected.

  • We also continued to complete our certification testing for our next-generation link encryption product, which delayed shipments on this important program.

  • Our top five customers represented 72% of our total revenue in Q2 which included Dana at 38%, US Government and Agencies at 15%, Arven [Meritor] at 11%, Ford at 5% and Honeywell at 3%.

  • Electronic orders for Q2 were $[33] million which was consistent with the prior year order rate, but below our expectation as the timing of certain orders was pushed into this second half of the year.

  • Our PVT in Q2 was a loss of just over $1 million resulting in a net loss of $900,000 and a $0.05 loss for the quarter.

  • This was at the low end of our guidance of a zero to $0.05 loss.

  • Gross profit for the Industrial Group was short of forecasted 7.7%, as the volume declines more than offset our ongoing productivity improvements and the favorable year-over-year impact of customer settlements, related to both pricing and volume including the Dana settlement in Q3 2007.

  • The Electronics Group's gross profit was $5.7 million or 13.9%.

  • The production delays associated with the certification testing and the lack of government funding reduced sales from our higher margin products portfolio, and resulted in a sequential drop in our gross margin rate.

  • SG&A and R&D spin were below our expectations for the quarter.

  • And interest was also favorable as borrowings during the quarter were down on favorable cash flow.

  • We also benefited from the favorable currency translation adjustment as the peso strengthened against the dollar during Q2.

  • Our cash flow usage for Q2 was $13 million which was favorable as compared to our guidance range of $14 million to $16 million of cash usage.

  • Q2 usage included a disbursement of $9.5 million to fund our 2007 income tax liability in Mexico.

  • On our working capital equation, we were able to improve our AR collections beyond projected levels.

  • In addition, our response to the declining market conditions for our Industrial Group resulted in lower inventory levels, with a more significant impact to occur in the second half of 2008 as we focus on minimizing inventory in this volatile market.

  • Certain capital expenditures were pushed out of Q2.

  • And we will continue to monitor those expenditures, based on our revised outlook.

  • By turning to slide 12, we can now discuss the outlook for our third quarter.

  • Q3 revenues expected to be $100 million to $110 million.

  • At the midpoint of the range, revenue will be flat with the prior Q3 of $105 million.

  • We expect the Industrial Group's revenue to be down 12% in the quarter as volumes are off in all segments of the truck market, as well as the trailer market.

  • On the other hand, Electronics Group revenues is expected to grow 20% compared to last year due to increased revenue from new product launches and strength in our Test & Measurement markets.

  • We expect our quarterly order intake will reach its highest level of the year at $58 million which will represent a 20% increase over the prior year for the Electronics Group.

  • Our EPS in Q3 2007 included the favorable impact of the Dana settlement which totaled $7.5 million of PVT, or $0.29 of EPS.

  • Excluding the impact of this non-recurring event in 2007, our Q3 2008 PVT is expected to improve slightly over the prior year quarter.

  • The Industrial Group's gross profit is expected to decrease from the prior year, reflecting the reduction in volume and the 2007 impact of the Dana settlement.

  • And our gross profit rate is expected to fall below 6% in Q3.

  • Our gross profit percentages for the Industrial Group in 2008 are also impacted by the annual material revaluation that occurred beginning in Q1, with a separate revaluation on a specific component planned for Q3.

  • The Electronics Group is expecting an increase in gross profit over the prior year, driven by the revenue growth and a rebound in its gross profit rate to over 15%, which will be consistent with the prior year and up nearly 2 points sequentially.

  • We expect an increase in SG&A and R&D spin over the prior year quarter, with investments to drive productivity improvements and system enhancements, and increase spin to meet the product development milestones for a new secure communication product that will be key to our business plan for 2009.

  • Our interest expense is expected to increase slightly over the prior year due to a higher average debt balance, partly offset by lower rates.

  • We have also revised the outlook for our effective income tax rate for 2008, based upon the updated forecast.

  • Our income tax provision assumes that a valuation allowance will be required on the deferred tax assets being generated by our domestic operating losses in 2008.

  • As a result, we anticipate a negative effective income tax rate of approximately 5% for 2008 comprised of a tax expense on our Mexican operation, partially offset by an immaterial tax benefit coming from our domestic operations.

  • An ongoing priority for Sypris in the second half will be to continue our aggressive working capital management practices in this rapidly changing environment.

  • We are expecting to generate free cash flow of $3 million to $5 million in Q3, as compared to cash flow usage of $9 million in the year earlier quarter.

  • This will primarily be accomplished through an emphasis on improving AR Collections and reducing inventory across our business.

  • The Industrial Group is driving inventory down to stay ahead of the declining market; and our new management team at Sypris Electronics has completed a [base sign] review of their operations and planned a series of initiative during the balance of the year to reduce inventory and improve our systems, policies and operations.

  • Capital expenditures will be above the relatively low amount for the prior year.

  • And we will control this spin rate, based on our updated outlook.

  • By advancing to slide 13, we can now review our outlook for the full year 2008.

  • We have dropped our revenue guidance to a range of $425 million to $445 million from $460 million to $480 million.

  • This decline is attributable to the Industrial Group and the impact of lower production in the light-, medium- and heavy-duty markets.

  • The trailer market which is at historical lows is also not expected to rebound in the second half of 2008.

  • On a comparable year-over-year view, consolidated revenue will be flat with 2007 at the midpoint of our 2008 guidance.

  • In this comparison it is important to note that the declining volumes in the truck market are partially offset by the impact of material revaluation in our 2008 revenue.

  • The increase in our pass-through of steel prices will count for nearly $22 million of revenue and cost of sales in 2008, which flows through at basically zero margin.

  • The Electronics Group is expected to fare better in this challenging market, as deliveries on our latest products ramp up in the second half.

  • However, we are taking a more conservative view of our DataSystems product sales, due to the trend of reduced government funding and increased competition during the first half of the year.

  • We are also expecting a different mix of revenue in our Aerospace and Defense segment as new program wins are replacing certain of the follow-on contracts previously targeted.

  • Our forecast for the Test & Measurement business is unchanged.

  • And our longer-term outlook received an assist from the previously announced award of the FAA contract.

  • The year-over-year revenue comparisons for our three business segments has the Aerospace and Defense segment growing at a 10% rate, the Test & Measurement segment growing at a 7% rate; and the Industrial Group following by 5%, due to the depressed market conditions.

  • Orders will be up 3% in the Electronics Group on the year; and the anticipated mix of business in the backlog should provide the foundation for improve performance in 2009.

  • In our prior guidance, we expected the trough in market conditions would occur in the second quarter followed by a strengthening second half.

  • However, as discussed in our Q3 outlook, our updated view is that this trough will now occur in the third quarter.

  • And we expect to see sequential improvement in earnings beyond the third quarter.

  • Our prior outlook for earnings of $0.05 to $0.10 per share has been revised to a loss of 40.33 to $0.43 per share for the full year 2008.

  • While the Industrial Group expects to realize benefits from the restructuring activities and productivity measures undertaken in the first half of the year, the steep volume decline will be difficult to offset through variable cost reduction.

  • Our current guidance assumes our gross margin rate for the Industrial Group will drop sequentially to below 6% in Q3 before rebounding to over 8% in Q4, with a return to the 9% level targeted for early 2009.

  • As previously discussed, we are actively reviewing our realignment initiatives with the goal to accelerate activities that will contribute to improving profitability beyond these targeted levels.

  • We have a different set of challenges facing our Electronics Group as we hold to our revenue guidance for the year.

  • But our earnings outlook is down from the prior guidance due to lower DataSystems product sales and a changing mix of business.

  • These conditions are expected to result in gross margin rates in Q3 and Q4 that are consistent with the comparable prior year periods.

  • Although SG&A spend for the Electronics Group increases over 2007 to fund our strategic initiatives, SG&A as a percent of revenue will decline in the second half of 2008.

  • And the Electronics Group will improve its contribution to operating income as compared to the prior year and sequential periods.

  • We expect to continue to drive our investment in working capital down to generate an additional $5 million to $8 million of free cash flow during the second half of the year, which will result in positive free cash flow of $7 million to $10 million for the full year.

  • In addition, we will be controlling our spend on capital expenditures and targeting continuous improvement initiatives to ensure we meet or exceed our cash flow goals.

  • Our current forecast includes a reduction in capital expenditures of over 10% from our previous guidance, and also results in about a 4% spend rate based on the lower revenue outlook.

  • If you could please advance to slide 14, we would like to provide a few final comments before taking your questions.

  • In summary, although our revenue for Q2 fell below our guidance by $6 million we were able to deliver EPS within our target range.

  • We have updated our guidance for the second half of 2008, based upon our most recent view of market conditions, giving consideration to customer forecasts and industry forecasts.

  • We are facing strong headwinds in all market segments on the industrial side of our business.

  • And we are reviewing initiatives to diversify our product offering with existing customers, to diversify our customer base, and to diversify globally to offset the volatility in our current portfolio.

  • Operationally, we are realizing the productivity gains and cost reductions from the initiative taken by new management teams on both sides of our business.

  • But these results are being overshadowed by the revenue decline from the truck markets.

  • We expect to see the benefit from our continuous improvement and lean initiatives as we enter 2009 with these activities delivering value at higher run rates as the programs mature in the back half of 2008.

  • We also hope to see continued double-digit growth from our Electronics Group and the recovery of the truck and trailer markets in 2009.

  • And, finally, we intend to implement significant actions to respond to our current outlook and are taking a much deeper dive into the strategic initiatives previously outlined for our business, and to accelerate the pace and depth of the actions to restore profitability.

  • With that, we conclude our formal remarks and welcome your questions.

  • Operator

  • (Operator Instructions) Tom Carpenter with Hilliard Lyons.

  • Tom Carpenter - Analyst

  • Can you walk us through what you are seeing in the DataSystems business and give us some more insight or color on the changes in the funding, and I guess, how this is different from your outlook the last quarter to -- it seems like this has been kind of up and down business as far as funding and timing over the past year.

  • And if you can give us and insight into next year -- or I'm sorry -- over the next year and what you are looking for, that would help us a lot with modeling.

  • Jeffrey Gill - President and CEO

  • I would be happy to.

  • What we have concluded is that, during times of conflict, that it appears that the Defense Department redirects money away from call it research testing and analysis, to bombs and bullets and fighting the war.

  • And so what we have been running into is forecast from places like the missile ranges and others that due primarily testing and analysis, saying, "We have a tremendous need for product.

  • Here is what we have on budget for the coming year." And then when it comes to the execution of it, what our people are told is we still have the need but we are not getting the funds.

  • So our kind of take-away on that is that until such time as the conflicts in Iraq and in Afghanistan wind down, places such as the missile ranges will not be receiving the funds that they anticipate, but that once we do end those conflicts or substantially wind down those conflicts that the research testing and analysis work, which is what the ranges do, will resume if you will.

  • So from our standpoint, we are taking the approach that there won't be an near-term return in funding for this part of our business, at least through 2009.

  • Tom Carpenter - Analyst

  • Now I just want to make sure we are clear.

  • You are talking about missiles and I was talking more about some of the product, the DataSystems (multiple speakers) is that the same (multiple speakers) issue?

  • Jeffrey Gill - President and CEO

  • Right.

  • A lot of products that we have in DataSystems are sold to the missile ranges.

  • Tom Carpenter - Analyst

  • Okay.

  • I guess, the issue looking from the outside, you guys experience a fair amount of ramp costs for these.

  • And I don't if how you price it, based on kind of a normalized order flow.

  • But it seems like you guys -- I don't know if you guys have to eat some of the cost because of the timing delays or if you guys get to recoup them in the pricing.

  • Can you help us understand that better?

  • Jeffrey Gill - President and CEO

  • The pricing for these products typically has attractive gross margins (multiple speakers) and so, but you are correct, is that when you go through a development cycle you eat those costs as you go.

  • And then you expect to reap the benefits when you sell the product.

  • And so to the extent that our product sales in this area had been lower than we expected, we had not been generating the returns that we would otherwise expected on those initial expenditures.

  • Tom Carpenter - Analyst

  • Right.

  • So looking out over the next year -- and I know you guys are talking about looking at identifying some inefficiencies in the business that you guys can attack costs and working capital and manage inventory better -- is something you guys have definitely looked at over the last couple of years.

  • Did those get you to where you needed to be?

  • I know we've got another truck EPA change a year from January.

  • And that seems like that could possibly put a damper on things again.

  • Jeffrey Gill - President and CEO

  • Let me give you a couple of data points.

  • First of all, the current outlook for 2010 -- which is the year that would follow the EPA change for heavy -- is 233,000 units.

  • And so at least as we sit here today, the outlook is for 2010 to be higher than 2008.

  • That is primarily because the anticipated prebuy which was to take place over a two-year period is now obviously not taking place.

  • And so, as we look at next year, we do expect there to be some increase year-over-year in heavy-duty production, whether it ends up being at the low end of our customer ranges, which is somewhere in the 20% increase year-over-year or the high-end with some customers are predicting 40%.

  • It is anybody's guess.

  • And quite frankly, our sense of it is that it will probably be towards the lower end rather than the higher end.

  • And -- but that would still represent an increased year-over-year of 40,000 units plus for our business, which would be positive.

  • From a structural standpoint, Tom, what we're looking at this time -- in addition to the normal working capital initiatives that everyone would expect -- is we are simply looking at how do we fundamentally change the fixed cost structure of our business?

  • And that is a much bigger program.

  • If the results of the analysis are consistent with initial expectations, the results would be very, very meaningful.

  • But is too early for us to talk about it.

  • We expect to complete it sometime in the next 60 to 90 days.

  • And once we have that, we will be in a much better position to talk specifically.

  • Tom Carpenter - Analyst

  • Okay.

  • And can you guys -- it looks like you guys are carrying the Dana investment as a long-term asset?

  • Well, Dana securities.

  • Jeffrey Gill - President and CEO

  • Yes, it's carried in a couple of different places on the balance sheet.

  • The majority of it as called out as an investment in marketable securities actually is a non-current asset.

  • Tom Carpenter - Analyst

  • Okay.

  • Even though it is a long-term current asset, and with that stock price down quite a bit since they went public again, do you have any changes on the balance sheet or revaluations?

  • Jeffrey Gill - President and CEO

  • Yes.

  • Tom Carpenter - Analyst

  • That you have to take in the coming quarters?

  • Jeffrey Gill - President and CEO

  • We have taken in changes in Q1 and Q2 based upon the decline in the market value.

  • And we will continue to face that issue as we move through Q3 and Q4.

  • And, additionally, I think as we move through the end of the year, before we get through the end of the year subject to where the Dana stock is trading, we will certainly face issues that if it doesn't return to the levels at which we believe it should be valued, we could be facing charges that roll out of other comprehensive income into earnings.

  • Tom Carpenter - Analyst

  • Right.

  • That's what I was getting at into earnings and equity -- okay, great.

  • Two questions and I will jump back in the queue.

  • Jeff, can you give us an update on the CFO search?

  • Jeffrey Gill - President and CEO

  • Yes.

  • We are making some good progress.

  • We've seen a number of very qualified candidates that give us confidence sometime in the next 60 to 75 days that we will have secured a successor.

  • Tom Carpenter - Analyst

  • Excellent.

  • Do you think it -- I don't want to tip your hand.

  • Do you think it will be someone that has some experience in the businesses that you have?

  • Jeffrey Gill - President and CEO

  • Yes.

  • Well, clearly -- and a number of the leading candidates have backgrounds that come out of large corporations that are very process-oriented, and we feel could be a very strong addition.

  • Tom Carpenter - Analyst

  • One final question.

  • This isn't at all to beat you guys up, but I will reiterate again you are a large shareholder, you obviously are frustrated with the results and stock prices.

  • When you look out at some of your options over the next year or two, you know ones that continue to be a public company and just take cost out of system, how can we make each and every business better.

  • Two is to go private.

  • Three is to break up the businesses.

  • You guys have commented before that you think your two major businesses (inaudible) worth at least 5 dollars a share which is more than the current stock price in your book values.

  • Also more than double the current price.

  • Being public I know you like talking to analysts a couple times a year, but what are the benefits that you say been public versus going private or breaking up the businesses and unlocking what I'm sure you and what we believe is unrealized -- significant unrealized value?

  • Jeffrey Gill - President and CEO

  • Let me answer your question this way.

  • Outside of enjoying the conversations we're able to have together is that as we go forward into 2009, and if we are not generating substantially different valuation for the Company in terms of our share price, we will look at any options that appear to be logical for unlocking the value for shareholders.

  • Tom Carpenter - Analyst

  • Fair enough.

  • Good answer.

  • Thanks.

  • Operator

  • (Operator Instructions).

  • Jim Ricchiuti with Needham & Company.

  • Jim Ricchiuti - Analyst

  • The question I have is just with regard to your gross margins that you're forecasting for the Electronics business.

  • It's a pretty big, pretty good sequential increase.

  • And I wonder if you could just kind of walk me through that because it sounds like you are taking a little bit more conservative view of the data system products line, but still a pretty decent increase.

  • So do you see that in the backlog?

  • Do you see that in the shipment schedule for some of the products that are going out in Q3, Q4?

  • Jeffrey Gill - President and CEO

  • Yes.

  • We do.

  • And, sequentially, you know when you look at the change from Q2 to Q3 it does look material on the surface.

  • But with the backlog that we have coming out of Q2, not necessarily on the data system side, but more on our products and EMS services that we do out of Tampa, we feel that the revenue projections that we have and the mix of businesses we have will drive that type of sequential improvement.

  • Jim Ricchiuti - Analyst

  • And Tony, you got called out in the press release I guess about $1 million in expenses for efficiency initiatives.

  • Tony Allen - Acting CFO

  • Right.

  • Jim Ricchiuti - Analyst

  • That -- can you give -- I guess that's combined Q3, Q4.

  • Can you give us any flavor how that falls and is that mostly in the Industrial Group?

  • Tony Allen - Acting CFO

  • It is mostly on the Electronics Group actually.

  • (multiple speakers) and it falls pretty evenly between Q3 and Q4.

  • It's probably a little bit more weighted between with Q3.

  • But it's -- I would just forecast it pretty evenly.

  • Jim Ricchiuti - Analyst

  • Okay.

  • And the comment that you made about troughing in Q3, I just want to understand that a little better.

  • Are you -- what specifically, I may have been a little confused by the comment, are you referring to the industry environment in Industrial or are you referring to -- what specifically is troughing in Q3?

  • Tony Allen - Acting CFO

  • The industrial set and it ties back in into the charts Jeff presented earlier on production.

  • So that was aimed at the Industrial Group.

  • Jim Ricchiuti - Analyst

  • Yes.

  • And I'm trying to also understand how the tone of business with your larger customers in the industrial business -- we'll put Ford aside, we know their issues.

  • But how the tone of business with, say, Dana and Arven Meritor has changed as you have gone through Q2?

  • How dramatically has it been more recent in the quarter and what's your sense in talking to them in the last few weeks?

  • Jeffrey Gill - President and CEO

  • Our sense with regard to what, in particular?

  • Jim Ricchiuti - Analyst

  • I guess, how much more cautious, Jeff, have they gotten in the last, say, month or so?

  • Just in light of the (inaudible) prices for diesel, prices -- the overall outlook for the economy?

  • I'm just trying to get a sense -- do we feel that there are potentially other shoes that could be dropping as they began to reset lower?

  • Or do you feel they are taking a pretty good cut?

  • Jeffrey Gill - President and CEO

  • I think in both cases for both of those major customers that their change in outlook has been pretty aggressive in terms of reduction.

  • For example both customers [says] outlook is below that of ACT.

  • And so, typically, they've either been on the mark with ACT, sometimes above it.

  • But in this case they are below it.

  • So our sense is that both management teams there are trying to drive a very realistic approach toward the balance of the year rather than call it stretch goals.

  • Jim Ricchiuti - Analyst

  • And then, a final question on the -- it sounds like you are anticipating a fairly healthy increase in orders in the Electronics business.

  • I think you called out $[50] million or so in Q3.

  • Maybe you could elaborate on what drives that.

  • And there's always the potential for orders to get pushed out yet it sounds like you seem pretty confident.

  • So does that order flow?

  • Do you expect to convert that over fairly soon into revenues?

  • Is that something we should look out into '09?

  • Jeffrey Gill - President and CEO

  • First of all, the source of the flow is tied to the release in large part, the release of certification, some products that have been going through some extensive rounds of testing.

  • And in fact, the testing as I think you know has taken much longer than we expected and so, once the testing is completed, then, our teams expectation is that those pent-up orders will be released.

  • These products will convert into revenue fairly quickly.

  • And so that's why when we talk about having a sequential increase in Electronics Group revenue going forward, it is going to be supported by the conversion of these orders into shipments during the latter part of this year and then continue on into next year.

  • Jim Ricchiuti - Analyst

  • Any kind of time line as to when we see these -- the testing reaching final stages?

  • Because it has been drawn out.

  • Jeffrey Gill - President and CEO

  • Did I say last April?

  • To our knowledge, we are in the last round of tests currently.

  • And to our knowledge, the release or passing of those tests -- assuming that there are no final issues -- should be anywhere between now and the next 30 days.

  • But quite frankly, I thought we were through before only to find that we have yet another round of testing and so by a different agency.

  • But our belief is that we're done.

  • Jim Ricchiuti - Analyst

  • Okay.

  • Thanks very much.

  • Operator

  • David Shapiro with Aegis Financial.

  • David Shapiro - Analyst

  • I just want a start off with a few bookkeeping questions.

  • On the balance sheet, what isn't on -- specifically in other assets, long-term other assets and the liability side, what are the numbers embedded with the data settlement that are in those balance sheet items?

  • Jeffrey Gill - President and CEO

  • On the other -- you are talking specifically about the other asset line that, at the end of June, is roughly $29 million?

  • David Shapiro - Analyst

  • Right.

  • Tony Allen - Acting CFO

  • In that number there is a little over $11 million related to the Dana investment.

  • David Shapiro - Analyst

  • And then on the accrued liabilities and long-term liabilities lines?

  • Tony Allen - Acting CFO

  • On the accrued liabilities and long-term liabilities, there you are looking at the deferred revenue that would be remaining on those -- in those accounts.

  • David Shapiro - Analyst

  • Right.

  • Tony Allen - Acting CFO

  • And I don't have those numbers in front of me.

  • We could follow up offline on that.

  • David Shapiro - Analyst

  • Okay.

  • Thank you.

  • Tony Allen - Acting CFO

  • I just don't have that data in front of me.

  • David Shapiro - Analyst

  • Okay and then the gross profit flow through on the Industrial Group.

  • What from the Dana settlement went through on the gross profit?

  • Jeffrey Gill - President and CEO

  • Which period are you looking at?

  • David Shapiro - Analyst

  • Second quarter.

  • Jeffrey Gill - President and CEO

  • Second quarter.

  • It was the gross profit flow-through for the second quarter accounted for what I would say about 1% of our gross profit.

  • David Shapiro - Analyst

  • Okay.

  • Is that around -- previously I thought it was going to be about $2 million?

  • Maybe a little less?

  • Jeffrey Gill - President and CEO

  • It's less than that yes.

  • Less (multiple speakers).

  • David Shapiro - Analyst

  • Okay.

  • You know as we take a look at the [Harris Basin] defense group, was encryption delay sort of this testing that you are talking about it?

  • Is -- that would be the encryption product that is getting delayed?

  • Jeffrey Gill - President and CEO

  • Yes.

  • The answer to your question is yes.

  • David Shapiro - Analyst

  • And when that comes out -- hopefully next quarter and beyond -- you know as we get take a look back at '04, '05 and '06 you are running about 15% or so plus gross margins in that group.

  • And is there any way you get back to those levels as a more normalized run rate, once those products start flowing through on the Aerospace & Defense unit?

  • Because at that time of course you have Afghanistan and Iraq and those issues as well still going on during that time.

  • Jeffrey Gill - President and CEO

  • Yes and we believe that we will be at that level once we have the composition of our sales mix represented by more products.

  • If you go back in the time frame that you're talking about, we actually were selling quite a bit of the previous generation encryption product.

  • And the one that we are releasing through testing now is expected to have similar margins.

  • David Shapiro - Analyst

  • What type of time horizon do you have for the -- I guess, for the sustainability of those margins on a product like this before you start having to go through the new round of testing again?

  • Jeffrey Gill - President and CEO

  • We expect the life cycle for this product to be four to five years.

  • The current one.

  • David Shapiro - Analyst

  • So maybe you have one to two years of down time and then maybe another three to four or so of higher margins on these types of products?

  • Jeffrey Gill - President and CEO

  • We would expect 2008 to cover the burn rate if you will of recapturing a major part of the investment.

  • And so, as we look at 2009, we would expect margins to normalize at a higher level.

  • David Shapiro - Analyst

  • Okay.

  • That's helpful.

  • And then in the press release, you were talking about strategic initiatives and taking advantage of your balance sheet.

  • Is that meant to mean you are going to be making some external acquisitions?

  • Or are you more talking about organic growth in your electronic side?

  • And then maybe some rationalizing of your Industrial Group or will you talk more on the external acquisition side?

  • Jeffrey Gill - President and CEO

  • Well, it's basically supporting growth in our Electronics Group so that it will represent a larger percentage of the overall portfolio.

  • It's looking at rebalancing our configuration in the Industrial Group.

  • We are working on joint ventures in India and China as we speak.

  • And we believe that as we rebalance our platform on that side it will be important to be able to participate in those two fast-growing markets.

  • And if you look at some of the companies in our industry that are weathering the current economic environment better than others, it tends to be because they have a good balance of business on a global scale rather than being tied solely to the NAFTA environment.

  • So part of our effort on this side is going to be to over the next two to three years drive a better balance of our earnings from -- let's call it faster growing markets and consolidate on a he cost profile in our NAFTA-oriented markets.

  • David Shapiro - Analyst

  • So being maybe devoting capital to JV but not really doing outright external acquisitions for either group?

  • Jeffrey Gill - President and CEO

  • That's correct.

  • David Shapiro - Analyst

  • Thank you.

  • Operator

  • With no other questions, I'd like to turn the call back to management for any additional comments or closing remarks.

  • Jeffrey Gill - President and CEO

  • Tony and I would like to thank you for joining us on this call.

  • We welcome your continued interest and, of course, your questions about our business.

  • So we want to thank you and have a good day.

  • Operator

  • That does conclude today's call.

  • Again thank you for your participation.

  • Have a good day.