Timken Co (TKR) 2006 Q2 法說會逐字稿

Good morning. My name is Michelle and I will be your conference operator today. At this time, I would like to welcome everyone to the Timken second quarter 2006 earnings release conference call. [OPERATOR INSTRUCTIONS]

Mr. Tschiegg, you may begin your conference.

Thank you and welcome to our second quarter conference call. I'm Steve Tschiegg,Manager of Investor Relations. Thank you for joining us today, after our call should you have further questions, please feel free to contact me at 330-471-7446.

With me today are: Jim Griffith, President and CEO, Glenn Eisenberg; Executive Vice President of Finance and Administration and CFO; Mike Arnold, President of our Industrial Group; Jacqueline Dedo, President of our Automotive Group; and Sal Miraglia, President of our Steel Group. We've remarks this morning from Jim and Glenn, and will then all be available for Q&A. At that time, I would ask that you please limit your questions to one question and one follow-up at a time, to allow an opportunity for everyone to participate.

Before we begin, I'd like to remind that, you during our conversation today, you may hear forward-looking statements related to future financial results, plans and business operations. Actual results may differ materially from those projected or implied due to a variety of factors, Those factors are described in greater detail in today's press release and in our reports filed with the SEC, which are available under our website, www.timken.com. This call is copyrighted by the Timken Company. Any use, recording or transmission of am I portion without express written consent of the Company is prohibited.

With that, I'll turn the call over to Jim.

Thanks, Steve, and good morning. I'm pleased to report Timken has achieved another record quarter of profitable growth. This was the best second quarter in terms of both sales and earnings in our Company's history.

You've seen the press release and you know it was a good quarter in terms of the numbers. I'd like to review some of the strategic accomplishments for the quarter and spend a few minutes on the story behind the numbers. Then Glenn will take you through the financials. We summarize our strategy with a simple equation; innovation plus execution equals profitable growth. Let me share with you the progress on major initiatives of the Company, using this framework.

First, innovation. When we talk about innovation at Timken, we use the term broadly, focusing on how we're changing the Company to create more value for customers and shareholders. Our innovation program is driven by three major initiatives: First, strategic portfolio management; second, growth in industrial markets; and third, Asian growth. Let me review them in turn. Strategic portfolio management activities impact all parts of the Company. In steel we recently announced the launch of new capabilities. We increased the size of large bearing bars available to the market to 13 inches in diameter, a unique capability in North America.

We also announced an investment to increase our capacity to provide special heat treating, expanding our capability to serve the hot energy market. In automotive markets the key is expanding the diversity of our customer base. Over the course of the year, we'll launch 25 new automotive programs, and more than half of them will be to non-North American-based customers. Just as importantly, we are exiting segments where we do not have differentiated capabilities. The announcement of the sale of our precision steel components business in Europe is an example of an area we've decided is no longer strategic to us. In addition, we are on track to exit $40 million of non-strategic low-margin automotive business this year.

We are growing in targeted industrial markets. In aerospace, we acquired assets from a small aerospace specialist that expands our range of aftermarket capabilities this quarter. This builds on the foundation of the 2004 acquisition of Alcore and last year's acquisition of BII. Sales in aerospace are up 50% from the same period last year. We are growing in heavy industry, where we have a uniquely strong position in bearing applications in mining, and metal production. We have investment programs underway to total over $185 million to increase large-bearing capacity in Romania, China and the United States. And we are growing in Asia. Our investments in large bearing capacity in China will form our fifth plant in that country.

We've added a new plant in each of the last four years, and that pace is accelerated. Our growth in China is not limited to local manufacturing. We are now exporting steel from the United States to China to serve the energy market. We announced a contract this quarter with Julong Petrochemical Industries, and we expect that total exports to China will exceed 10,000 tons of steel in 2006. Our sales in China for the corporation should be up 20% in 2006. As you can see, while growth -- excuse me. As you can, while our growth is benefiting from the current strong market for our products, we are also fundamentally improving the nature of our Company to allow us to sustain and improve that profitability.

Now, let me shift gears and give you an insight into the execution side of our performance equation. This was a great quarter for execution, especially in our steel business where we set records for both shipments and productivity, reducing the number of man-hours necessary to produce a ton of steel to all-time record lows. Our efforts to improve our execution are also driven by three primary initiatives: Improving customer service; restructuring programs to improve our operating performance; and Project 1, our global business reengineering program.

Again, let me take them in order. We have seen dramatic improvements in our customer service levels. Selected capacity adds, careful demand management and improvements in our supply chain capabilities have improved service levels by five percentage points over a year ago. This performance improvement is crucial to our ability to grow and enter new markets. We are about halfway to our goal as a corporation. We have restructuring programs underway in both our automotive and industrial businesses, with an objective to dramatically reduce costs.

The downsizing of our Canton, Ohio, industrial facility is proceeding well with, most of the small product transferred and our remaining employees focused on maximizing the output of crucial large-bearing components. Our automotive restructuring program, in both the United States and Europe, is on schedule to deliver the $40 million in cost savings by the end of 2007. In August, we will celebrate the grand opening of our new automotive engineering center at Clemson University, a crucial milestone in our efforts to consolidate sites and streamline overhead in this segment. Finally, Project 1, our business process improvement and global ERP implementation, is proceeding well. On July 1st, we passed a critical milestone, as we successfully converted our Canadian operations, which was our pilot installation, over to SAP.

In closing, these initiatives reinforce why we consider the second quarter of 2006 to be so powerful. It is the combination of record sales and profitability, plus these achievements, that position a Company for continued profitable growth. We are pleased with the quarter and we've increased our full-year guidance accordingly. Our core markets are strong, and we expect that to continue.

Now, I'll turn it over to Glenn for a more detailed review of Timken's performance.

Thanks, Jim. For the quarter, Timken generated record sales of $1.4 billion and fully-diluted earnings per share of $0.79. Excluding special items, earning per share came in the $0.90. The quarter included $21 million of pre-tax expenses related to restructuring and manufacturing rationalization, and a charge for asset dispositions. In the second quarter of 2005, special items totaled a pre-tax expense of $4 million. The rest of my comments will exclude the impact of these special items.

Sales for the second quarter were $1.4 billion, a record for the Company, and 5% over 2005, driven primarily by industrial demand and improved pricing. Key growth markets continue to be in the aerospace, energy, distribution, mining and rail sectors. Gross profit margin for the quarter was 22.9%, an improvement of 150 basis points from last year, reflecting favorable pricing and mix, primarily from our Steel Group which I'll speak to in a moment when I cover our segment performance. Gross profit was also favorably impacted by lower pension and retiree medical expenses of $7 million. Similarly, we expect to have a $7 million benefit in the second half of this year. SG&A, as a percent of sales was 12.6%, 40 basis points higher than last year, due to increased investments in our Project 1 and Asian growth initiatives, and higher growth for incentive compensation tied for the Company's improved performance and outlook.

As Jim mentioned, we remain on track on our key growth initiatives. As a result, EBIT for the quarter came in at $138 million or 10% of sales, 110 basis points better than 2005. The effective tax rate for the quarter was 33%, which we expect to maintain going forward. And net income for the quarter was $85 million, or $0.90 per diluted share. EPS was up 17% over last year's result and compared favorably to our previous estimate.

Now, I'll review the results of each of our businesses. The Industrial Group continued to perform well, driven by strong end markets, which has enabled the Group to make investments in key growth areas. Industrial sales for the quarter were $529 million, up 6% from a year ago, benefiting from strong demand across its broad industrial markets, with the highest growth coming from the aerospace, industrial distribution, off-highway and rail sectors. Industrial EBIT was $63 million or 12% of sales. Earnings for the quarter were in line with last year. Favorable pricing and higher volumes were offset by higher manufacturing costs, including those related to capacity additions, and investments in our Project 1 and Asia growth initiative.

Looking forward, we continue to expect Industrial margins for the year to be higher than last year, due to a continuation of strong industrial markets, improved pricing, and better manufacturing performance. In the Automotive Group, we continue to position ourselves to improve our overall performance. Our Automotive restructuring program remains on track, with the expected annual savings of approximately $40 million to be realized by the end of 2007.

While we fell short of reporting positive earnings for the quarter, we expect to be profitable for the full year. Automotive Group sales for the quarter were $428 million, essentially equal to last year, as the benefits of improved pricing were offset by lower demand from North American original equipment manufacturers, and the impact of our actions to exit low-margin business. For the quarter, the Group reported a loss before interest and taxes of $2 million, compared to a loss of $1 million last year. Favorable pricing and mix were offset by higher manufacturing costs, due to lower volumes, and increased energy costs.

In the Steel Group, strong demand, plant utilization levels, and productivity, again, led to a number of production and shipment records in both the alloy and specialty steel segments. Steel Group sales for the quarter were a record $469 million, up 5% from a year ago. The Group benefited from increased pricing, surcharges, and continued high demand, especially in the service center, aerospace, and energy markets, which more than offset a decline in automotive sales.

Steel Group EBIT in the quarter was a record $75 million, up 33% from $57 million last year. The increased results were due to pricing, surcharges, favorable mix and productivity. Looking forward, we expect aerospace and energy markets to continue to show strength, while automotive demand is expected to be slightly down from last year's level. We now expect the Steel Group's results for the year to exceed last year's record performance.

Looking at our balance sheet, we ended the quarter with net debt of $665 million, $72 million lower than the end of the first quarter, principally due to higher earnings and improved working capital management. The Company's leverage of net debt-to-capital decreased to 28.6%, compared to 31.9% at the end of the first quarter. The Company expects to generate strong free cash flow for the remainder of the year, riven off of expected record earnings and continued working capital improvement. Capital expenditures for the quarter were $64 million, or 4.6% of sales, above depreciation and amortization of $50 million.

This spending level will increase to roughly 5% of sales, as we continue to make investments in support of our growth initiatives and add capacity to meet strong industrial demand. We contributed $57 million to our domestic pension plans during the second quarter. Our full-year 2006 contributions are expected to be approximately $150 million, compared to $226 million last year. As with last year, we will consider making additional contributions, based on our pension funding status and financial leverage.

In summary, our outlook for 2006 is for continued improvement in our businesses. We recently increased our earnings per share estimate, excluding special items, to $3,00 to $3.15 per share for the year. For the third quarter, we expect EPS to be $0.70 to $0.75, compared to $0.58 earned last year. Our Industrial and Automotive Groups are expected to see improved second half results, with all three business groups now projected to exceed last year's performance.

From a cash flow standpoint, we expect to see higher free cash flow in 2006, benefiting from earnings growth, better working capital management, and lower pension contribution, which will be partially offset by higher capital expenditures to support our growth initiatives. We are very encouraged about the prospects for 2006 and the potential to deliver record sales, record earnings and record free cash flow.

This ends our formal remarks and now we'll be glad to answer any questions. Operator?

[OPERATOR INSTRUCTIONS] Your first questions comes from the line of Holden Lewis.

Good morning. Thank you.

Morning.

On the Industrial business, you know, we've seen some deceleration in the industrial bearing rate of growth. Can you comment about is that a function of capacity constraints? And can you discuss sort of when we might see more capacity coming on that might allow us to perhaps spur that growth rate to a little bit higher level, if that's possible?

Yes, Holden, this is Mike Arnold. A couple things going on. One, we saw obviously coming out of the recessionary periods a sort of '01 through '03, very rapid growth in all of our markets across the world, which sent double-digit increases throughout most businesses. Although that growth continues, especially in markets like China, where we would see greater-than-average growth across the world, that we are seeing decelerated growth in many of our markets, except for those markets where we have focused over the last three years strategically. And Jim mentioned it a little bit earlier, but we've talked a lot about the aerospace industry and the market and our efforts there and our growth now in excess of 50% year-on-year in that market for us, both organically and inorganically has been critical.

The mining industry we actually still see accelerating in growth. And that is an area in which we've been making the investments with regards to the large [inaudible] bearing capacity to serve that market not only here with domestic producers but the replacement market for that industry across the westerly. So that's still in an accelerating growth. So you've got aerospace and you've got mining, both accelerating, and then you've got some other markets that are slowing in their growth that are more related to the consumer side. So, in the areas where we've chosen to increase capacity and that we've talked about over the last year that has put somewhat of a drag with regards to our margins on the last three-quarters, are actually exactly those markets that still have accelerating growth.

Okay. And when do you expect all that to be sort of coming onstream so that maybe we can begin to see the growth either be supported here or accelerate a bit?

Well, eventually -- it continues to come onstream on an ongoing basis. Jim mentioned, I think for the first time, our expansion of large core production into China. That will come on board in mid-2007. We have expansion in our largest facility here in the U.S. that will come on board at the end of this year. We have ongoing expansion in our facility in Romania that actually comes onboard each and ever month, as we add new assets, bring people up to speed, et cetera.

Our growth in this end of our business from a capacity standpoint has been in the neighborhood of 12% to 18% per year. And if you break down by industry as to where that growth has been, if you look at the heavy industries, our mining industry growth has been in that area. So, as you compare kind of the 6% year-on-year sales growth for Industrial, it combines with some markets that are in double digits and some markets that are either decelerating their growth or relatively flat.

Okay. And then lastly, can you just comment on how quickly the distribution side of things grew? Does that accelerate? Did that help the margin in terms of mix?

Well, if you look at year-on-year for the second quarter, our Industrial distribution business was up almost double digits. It was up about 9%. So that is on the positive side with regards to both growth on the upside, but also with regards to mix.

Okay. Great. Thank you.

Yes.

Your next question comes from Andrew Obin.

Yes. Can you hear me?

Yes.

Yes, hi, how are you? I have a couple of questions about the restructuring actions in the Automotive business. When you guys are talking about exiting $40 million worth of revenue, does that mean that, A, what is the timing, and does that mean that I should sort of take out $20 million out of my revenue growth in third quarter and fourth quarter and essentially have 5% decline in both quarters? Is that the right way of thinking about it?

Well, we talk about exiting, Andrew, $40 million in programs, we've talked to you about our portfolio management and we're going through our products with our customers and looking at where they see differentiated value. Where they don't, we are looking at exiting programs. That's the $40 million that we've come to successful conclusion with our programs on. You will not see a sales decline.

We are offsetting that with the new program launches that Jim talked about. And the 25 new program launches that Jim talked about add up to about $80 to $85 million of net revenue this year, which will offset those intentional walk-aways, along with other programs from last year that get a full-year of revenue this year.

So we're not going to see the auto business shrink?

You will not see, this year, the auto business shrink based upon the programs we have in the pipeline.

Okay. Are there any plans to shrink the auto business maybe next year, or is the idea just to keep utilizing capacity but to replace low-margin products with hopefully better-margin products? Is the plan -- because I'm sort of been getting, over the past year and a half, I guess something of a mixed message on the auto business. And I'm just wondering, have we decided -- have we committed to shrinking it or have we sort of realized that, if we manage the program better, we can replace low-margin stuff with high-margin stuff?

Very much -- Andrew, this is Jim.

Hi, Jim.

The direction for the Company, if you look at the three business units, is for the auto business to focus on improving profitability, and that means changing the mix of products, the mix of markets to a more attractive mix, and driving costs out. The steel business to continue to focus on improving differentiation and the growth to happen in the industrial markets. That's just fundamentally the direction.

But I guess what I'm trying to get at is on the auto business, have we decided to shrink the business in absolute terms, or as it only in relative terms, as we invest in growth areas where we're profitable, like industrials and steel?

The obvious answer to that question is it will depend on the decisions we make product-by-product with our customers. But as a general sense, when I saw the results this quarter with auto sales effectively even with last year and industrial up 6% or 7%, I'm very comfortable with that mix. If I had -- back to Holden's question, if I waved my magic wand, I'd see industrial growing faster than it's growing would be the change that we'd make.

Can you just give us a little bit of the color, if it wasn't for the restructuring actions in the industrial business, what was the underlying operating performance in that segment? I mean, maybe you can just give me an absolute number for what you spent on capacity additions for this quarter, if you can? And I know it's part of the operating costs. but still just to get a better sense.

Andrew, if you're talking just on capacity relative to the spending that we've done, we're on the capital side.

Oh, okay.

We're spending probably around half of our CapEx that's available, other than just normal maintenance on capacity additions to support the industrial growth initiative.

So were there any expenses associated with industrial growth or was there sort of flat profitability year-over-year, pretty much associated with operating inefficiencies?

No, there was clearly expenses incurred in industrial to support the growth initiatives. When we talk about -- two things, I mean, restructuring per se, which is on the growth side but in fixing the business, we've taken a restructuring charge. For the other growth initiatives, whether we're adding capacity or whether we're focusing on growth in Asia with a lot of new bodies and infrastructure over there, all those would be either capitalized or expensed. And the expenses that we've incurred with the Asia initiative, in particular, which was one of the larger cost increases within the industrial growth relative to last year, came from that initiative.

So as we go to the second half, Andrew, I think what you'll also see is that the margins in industrial will look favorable compared to prior years because those initiatives were kicked off in the second half of last year. As we get to the same periods now of comparable spending, you'll see the leverage that we'll get off the improved volume and mix in the business.

But can you quantify the expenses associated with restructuring and growth? Is that something you can do publicly or --

Well, I don't think we break out the individual pieces. I think it's fair enough to say that, if you look at the margins that we experienced in industrial in the first half, which were down from a year ago -- and again, we had those expenses which were a major factor in the margin decline year-over-year -- we've commented that, for the full year, we'll be up year-over-year, so we're going to make up that cost differential in the second half through leverage.

Okay. Got you. Thank you very much.

Your next question comes from Bob Schenosky.

Morning.

Good morning.

A couple questions. First on the auto business. With the negative $5 million in the first half in operating profit, the model changeover in the third quarter, is it fair to assume that all the potential profitability is going to fall into the fourth quarter to offset that? Or are you going to see some in the third quarter, as well?

We should see continued increase through the third and fourth. The model changeover, other than the downtime in July, which is planned for and a time for us to change with our mix, isn't going to impact the third quarter negatively, as we improve our products through mix.

So we're expected to see a sequential improvement in the operating profit in auto, then?

Yes. And also, if you look structurally, Bob, on the first half this year to the first half last year, last year we lost $6 million in the first half. This year, you've stated we lost five. That included a bad debt loss of $3.5 million, so you can see the impact structurally of our mix in portfolio management.

Right, no I know that included -- did some of the year-over-year gain come from improvement in the European business?

Yes.

Okay, not able to quantify, though?

No.

All right. A couple others. One for Glenn. Glenn, with pension expenses down $14 million and the 150 you're going to be throwing in, do you have a sense of where you'll be positioned at year end relative to the underfunded status?

We always know directionally. I think it's fair to say, Bob, that we're going to contribute the $150 million. We don't know what the ultimate discount rate that we'll use or the total return on the assets that we have, so obviously, we're dealing with variables that we won't know until the end of the year. I think what we're comfortable with is that we ended last year at roughly $525 million-ish of underfunded pensions.

We are going to put in, at a minimum, $150 million that we've committed to. We've said we'll evaluate if we put it more by the end of the year, based on our situation. Return on assets has been performing well. Interest rates look like they were going to be higher than they were last year. So when you stir it all together, I think we feel pretty strongly that we have the opportunity to see the unfunded position lower, or said differently, the percentage of our total funding going higher. I think the number was around 78% funded on our domestic plans last year, so that percentage should go up as well.

So in theory, then, you could potentially see outlay to drop maybe around to the $50 million level?

You broke up on the last number.

I'm sorry, could that effectively, you know, look to be falling down to the $50 million level for next year? Is that a good ballpark range?

No, I wouldn't speculate on what the rates will be. The only thing I can tell you is that we believe we'll be lower than where we are. You can try to model or look at the sensitivity of what rates are doing and so forth, but we are committed to becoming more funded each year. We're clearly putting in more of a contribution than the requirements or the expense, clearly, that we're putting through the P&L, with the objective of getting fully funded over a reasonable period of time.

Okay. Fair enough. And then if I could just ask an earlier question, maybe a different way. In terms of the industrial business, and the margin second quarter, though you're not separating out the costs at all, can you ballpark the percentage rate maybe that was impacted the quarter? Was it 200 basis points to margin, was it greater, was it less? Just to give us a sense of underlying performance in the core operation.

Bob, this is Mike. Let me see if I can answer both your and Andrew's question a little bit. I would go back and look at our third quarter and fourth quarter discussions with regards to what we talked in terms of impacting our bottom-line results that had a combination of both investments in Asia, Project 1 as we talked about, that had the ramp-up of capacity that, in fact, we were putting in, and then there were some end of-year inventory write-offs that we took. We walked through those impacts pretty significantly. I believe that, as we talked about the fourth quarter, we talked about an impact with regards to our manufacturing capacity increases in the neighborhood of short of $5 million. Now, if you go back and just look at third quarter, fourth quarter, and through first quarter and now into second quarter, you can see that, although our capacity continues to increase, that some of that now is turning into actual sales dollars because of the capacity increases and coming to bottom line.

So in ballpark sense, I would say you walk through those numbers, take a look at what we sort of said and the breakdown of the impact on our bottom line financials or EBIT margins through those periods of time, I think you come up with a pretty reasonable number that says it was pretty hard hit in third and fourth quarter, continued on for the first quarter, not accelerating, now decelerating through the second quarter, which has giving us a little bit of a margin kick. And as Glenn pointed out, we expect the second half to be better than the first half because those have settled out. Those cost increases, even though we continue to increase capacity, it's at a level of speed where now we're bringing on brand-new assets and new investments, rather than ramping-up new plants, hiring people and impacting sort of current operations.

Fair enough. But again, just if you're looking at the core operations, take out the capacity additions and restructuring charges and so on, is it fair to assume that the core operating margins in the industrial business would have been up either sequentially or year-over-year? What I'm trying to get to is I don't want to see -- I want to better understand so you're not fully penalized by all these other costs, you know, as the notes go out on the performance.

Yes, if I were to give you the best, I think for from purposes to look at, I would put the manufacturing capacity ramp-up in terms of probably 100 basis points on our margin. And I'm thinking of that in terms of what we actually spend to ramp that capacity up, but you have to remember that as we talk about this capacity, we've got multiple things going on. ,We've got certain things that we're doing in existing facilities to bring on additional people add capacity, that not only disrupts existing operations, but, in fact, brings on new capability.

On the other side of it, we also have expenses that are just towards building new facilities across the world. As we talked about [Marjpor] facility in China, there are, obviously, resources put towards that. But in what you're trying to get at is if you've gotten past this ramp-up of capacity and the drag on earnings, what do you think that impact was? I'd probably put it more in the neighborhood of 100 basis points.

Okay, that's what I was getting after. I appreciate the response. Thanks.

Your next question comes from Mark Parr.

Hey, thanks very much. Good morning, guys.

Morning.

And Jackie.

Good morning, Mark.

My question is, as usual, gets into the steel arena. First of all, congratulations on the great results, particularly on the steel side. I saw your comments, and I think, Glenn, you gave some color about the source of the strength in the second quarter, you know, not emanating from automotive. And it was more service center and industrial, some of the other end markets. I'm curious, there seems to be a disconnect with those comments with your outlook calling for significant seasonal reduction in the steel business. And I guess what I'm curious is, have you seen a major decline in your backlogs recently or are there market-share issues that we should be concerned about here, you know, given this significantly reduced outlook for the third quarter and the second half?

Yes, thanks, Mark. This is Sal Miraglia. Let me maybe add a few words about that. We historically see a softer second half of the year than the first half, and it's almost always associated with outages that come through customers because of holiday seasons and just generally lower operating levels. Frankly, in the markets where we have the greatest strength, automotive and aerospace, we're practically topped out there. Even though that will stay strong, and we believe they will stay strong into next year, we're not going to see more strength coming from then in the latter half of the year. But we will see the general seasonality that comes among our other market places and -- our other market space and our customers in there, especially the industrial market space, for example, as well as some weakening that we talked about earlier in auto, although we've diverted a lot of capacity to these other markets because of the flexibility we have internally. So that's a very generally-observed seasonality.

We personally saw a bit of it -- have begun already experiencing a bit of it. We have the shutdown just in July, the first week of July, which will take certain operating levels down a bit. For us personally, we have a couple of major equipment modifications that will occur, coordinated and synchronized with known customer outages as well in the latter part of the year. So it's not the weakness in the market demand but more the consumption pace and rate. And it's highly synchronized with where the customer base will be during that same period of time.

Okay, Sal, are your scheduled outages -- so what you're really talking about is scheduled outages in the second half versus the first half more than a change in the market; is that fair?

It's partially true, but it also has to do with the same kind of pattern that our customers see in demand, or we wouldn't have scheduled those outages in that time frame. So it's really in harmony with customer outages, as well. We'll be building a little inventory to help some of that, but other than that --

Mark, you inserted a word into our quote that I just as soon the rest of the audience not translate. You said significant seasonality, and our quote doesn't say anything about significant. The quote simply says that we see it down in the second half the year.

Okay. All right. Have you -- is backlog or pricing trends, is there anything in those issues -- anything in those data points that would suggest that there's any weakening going on in your end markets?

The only market that we see weakening in right now is automotive. That is coupled with the expected change in the heavy truck because of the regulations. Much of that capacity, though, is diverted to other product market lines, as we see now. And the annual other red hearing I'd throw in there is that we're still at the whim of what happens with the scrap and bundle spreads in terms of raw materials, and that's one that we've had struggled with all along. I know I've taken a lot of criticism from many of your colleagues because we haven't been able to predict that better than the market gets, so that's about it.

Again, Mark, I would have answer that had question much more succinctly. I would have simply said no. At a corporate level across the business, no.

Okay, terrific. Hey, thanks again, and congratulations on the good results.

Thank you very much.

Your next question comes from Wendy Caplan.

Thank you. Good morning. You were talking about outages, and I remember visiting the steel plants a couple years ago in the summer and finding that we were kind of off again/on again, depending on prices of -- energy prices for the day. Is that kind of happening this summer? What are you seeing relative to the power companies?

Well, there very definitely is a problem with power in general across the country. We have not seen real powerful problems with our ability to operate here. We have special arrangements. We we may pay a little bit more for it but other than that, we have not had power limitations with respect to our ability to operate.

Okay. You touched on this, you've always talked about the nimbleness with which you can move auto production into industrial and addressed it a few minutes ago. Can you kind of give us a sense of how much of that has moved and what you're expecting for the balance of the year, given that production is going down in auto?

Well, we've seen, for example, based on what we expected to see, probably 20% less in the way of demand in our auto markets, and we have absolutely diverted that to industrial and energy markets without a hiccup. It's basically a change in the recipe or the grade that we make, but we'll produce them in very similar roll sizes or very similar tubular sizes, very directly. So that kind of swing we actually saw this year.

Okay. And one last question. Your early comment, Jim, about your sales to China, that seemed to be growing pretty aggressively. I remember -- I mean, we've all read that China is putting on additional capacity. Where are we in terms of that increased capacity in China and what would be the impact? Is that business sustainable, given the increased production capacity in China itself?

You're talking specifically with relationship to the comments about steel sales in China?

Yes.

The straight answer is that the Chinese do not have the capability to make the kind of steel that we're selling in China. We are selling the cleanest, best, highest end of our product range, and we see over the next couple of years the opportunity to grow that market. We would be competing in that market with Japanese or European producers as opposed to Chinese producers.

Okay. And how fast do you think it could grow over time?

I would not like to project that. We'll tell you as it happens. I will tell you that we have been quite pleased with the pace of growth and see it -- just another one of our market diversification efforts that improves the differentiation of our product.

Okay. Thank you very much.

Your next question comes from Eli Lustgarten.

Good morning.

Good morning, Eli.

A couple of clarifications. Seven million, you had [inaudible] --

I'm sorry, Eli, you're breaking up every other word.

Okay, you had $7 million in pension and into health care benefits in the first quarter -- in the second quarter. You picked $7 million in the second half?

Correct.

And then how's that spread between the two quarters or is it spread relatively evenly?

It comes about -- we just had our, call it normal actuarial review and based upon the assumptions we've had built up, so for the full year we expect our expense to be down around $14 million compared to a year ago. So favorable pension expense favorable post-retirement claims experience. The $7 million benefit in the second quarter was effectively the $7 million for the first half. because effectively we had the review done in the second quarter. So we call it a $3.5 million dollars benefit year-over-year in the third and the fourth.

Is that continue into the next year?

Again, it's based upon experience. You know, what medical care costs will be, assumptions on retiring, age of retirement and so forth. But the assumption at that we had coming into 2006 is that we would see pretty much a comparable level of expense year-over-year and, in fact, we're actually doing better. So we're pleased with where it's going. We have not gone through our planning process, if you will, for next year, but I think suffice it to say it's moving in the right direction.

And can we talk a little bit more about auto? You said second half is better than the first half. Obviously, [inaudible] make money obviously. Are we going to make money [inaudible] will be break even a little better for the year and its not, why not? Why is it having such trouble getting into the black [inaudible]?

I'll at least give you from at least what we've said, then ask Jackie to provide the color around it. Effectively, we do believe we will be profitable for the year in automotive, in the automotive OEM business that we have. We did incur losses in the first half of the year, and again for the full year we expect to be back profitable, as we're starting to get the benefits of the restructuring initiatives that we're doing. We are seeing positive pricing in the marketplace.

We did get hurt a little bit on some volume levels in manufacturing that we expect to see improved. So it's our expectation, as Jackie mentioned earlier on the call, that the trend, the trend in our gross profit is improving, and that we expect the bottom line, the EBIT number, to be positive as we go forward. Jackie, you may want to add some color.

Eli, I'll just add that, as Glenn said, we continue to improve on our customer mix, globally, on our program differentiation. Our gross profit is improving, half-over-half and quarter-over-quarter. The issue with just barely making breakeven and staying in the red is one of timing, staying with our customers as they transfer product away from us or transfer product to us. I can tell you the trend's in the right direction. We feel we're in the right target range. Obviously, I'm disappoint that it's not black, but we're confident that it's trending, that our initiatives are appropriate, and the customers are responding.

And are we on track with this [inaudible] cost of capital. I mean, 10%, I think was what capital [inaudible] something like that. Is that a realistic expectation by the end of 2007 or '08?

It is a realistic expectation in that time frame. And to a question earlier, that I believe Andrew asked about size, as we've told you, we looked at our portfolio management and we know half of our auto business is earning or will be earning by the end of this year its cost of capital. The other half we are going through a restructuring and portfolio management with our customers, and we will either continue that business, based on new differentiated margin levels with our customers, or we will get out of it. And that will define the size of our cost of capital automotive business.

Fuel surcharges, [inaudible] weaken in the second half of the year and into next year?

Eli, I'm going to have to guess what you're asking. Are you asking are the surcharges going to remain in the second half of the year?

I know they're going to remain for the year, but you make money on just arbitrage spread between them, I mean, that's [inaudible] and the assumption that that begins to narrow scenario in the second half of the year?

We believe that they will narrow as they go into the second part of the year, yes.

How big is your China business -- I'm sorry. I didn't mean to cut you off.

Eli, this is Steve. You know, it would be helpful if you picked up your handset, if you haven't already done it.

Okay, is that better?

Oh, a lot better. Thank you.

Okay. How big is the China business at this point?

For the corporation?

Yes, and the steel that you're talking about, both.

What is your question, Eli? Is it for the corporation you're asking?

Both the corporation and steel in specific.

Our China -- our China sales -- Mike? It's ballpark $200 million of that steel on an annual basis is ten to 20.

Included in that and that -- I would say that number is more of just the Asia market, which obviously China is a big piece of it.

Okay, and then one final question. Your industrial business, you know, I guess we're all questioning the 6% growth rate and why isn't it bigger than that then you gave us mi -- some of as double digit. How much of the upside is capacity constrained? Is that really the problem that's showing that it's slowing down and that's expected, so the expectation that '07 could be stronger than '06 because of more capacity available?

Eli, this is Mike. Certainly in the highest growth markets, which is around energy, aerospace and in China, most power transmission-type products are capacity constrained because the growth has been so significant. That's why we're putting the capacity in. The capacity constraints are slowly but surely going away to a certain extent, but the good news is that even though we continue to increase at a double-digit rate on our capacity year-on-year, we still remain constrained to the standpoint that we have backlogs in orders of two years. So it means -- it's still a very attractive market. We still think that there is three to four years of growth in markets that are dedicated specifically to the Asia infrastructure bill. The energy markets across the world. And then our strategic plays with regards to the aerospace industries, et cetera.

You've asked the question, and it's the second time the question's been asked that infers that we're unhappy with the growth rate. I think the growth ray we see in the second quarter is consistent with the message that we have shared with you; that we believe this Company can grow at 4% or 5% a year on an organic basis, and that beyond that, the growth will be inorganic. And this is very consistent. What you see is a Company which is consciously improving its mix to improve profitability and growing in targeted markets. The results that we had in the second quarter of 2006 are very consistent with that.

Well, we can get into a debate. I accept that longer term, but the markets have been going faster than that up until now, and that's probably what the frustration is.

Again, we have focused on profitable growth, not just growth. And that means consciously we are exiting some markets and growing much faster than the 5% in significant market, and that is the direction of the Company. Since the -- Eli's couple other comments. Since we came out of these recessionary periods and the industrial markets have been growing, that the industrial group year-on-year has averaged 18% full-year growth.

Now, that's both organic and inorganic, but it's an even bigger number as you look at the markets that we have strategically targeted for the profitability and the attractiveness. And then even inside the industrial growth, through recalibrating what our portfolio of products, services and markets that we will serve, both industry and geographic. So actually, if you turn back and look at the total picture from that period of time, the growth has been actually very attractive, even more attractive in all the areas that we targeted.

Thank you.

Yes.

[OPERATOR INSTRUCTIONS] And you have a follow-up question from the line of Andrew Obin.

Yes, and I understand that you partially have addressed this issue, but we've been hearing sort of conflicting messages from the OEMs in the machinery space, CAT, Volvo, CNH, on the outlook for the second half of the year. Sort of construction equipment and agriculture, ex-mining. I was just trying to understand, without naming any specific customers, what is your sense from talking to your customers, what the industry production volumes will do in the second half of the year? And I'm talking specifically AG equipment and construction equipment?

Sure, this is where we begin to get into the details of the individual markets, but if you took agriculture, as an example, again if you go back to our comments over the last couple quarters, we would have said our sales in the AG-part industry would be down as much as 10% in '06 versus '05. So we see it, we understand it. Obviously, we are a significant participant in that market across the world. So we have these variations of where, as we mentioned before, we have those markets that are still accelerating their growth we're participating in and, in fact, achieving the growth, and then we have markets that are decelerating growth.

And as you pointed out, AG would be one of those that is actually is shrinking in some of the markets that we serve. So, again, walk through, if we categorize an off-highway industry that would include mining, which is tied to the energy market, which is just exploding, construction, which is very interest-rate sensitive, and government funding, which is decelerating growth, and then AG, which to a certain extent is shrinking, you get a very different picture as you break down those individual markets and we see that.

Just so rephrase what you've said, on construction, it still looks like in positive in the second half of the year and AG volumes are negative. Is that a fair sort of rephrasing of what you said?

Yes, that's a fair assessment.I think you have to make the judgment as to when we talk about agricultural and when CNH does or John Deere does, does it mean exactly the same thing? Because as you might imagine, depending upon this specific product line and/or market that they're going after, it may impact us or not. But in general, that would be correct.

Just another end mark. I've been hearing that on the truck -- for the truck industry, Class 8, what we're having, we are already starting to see some declines as distributors sort of [halfen-up] inventory going into the downturn next year. Is that something you guys are observing?

No, Andrew, we're seeing the truck orders are declining on a new-order basis because everybody's full and not accepting. But in terms of a production basis, the orders are full and continuing to ramp positively through the third and fourth quarter. We do expect a decline to start sometime in the first or second quarter, once the pipeline is done and the new legislation starts.

Got you. So as I'm sort of looking at your numbers, I should sort of peg your numbers to the OEM? They should be closely correlated to industry production. There's not going to be a lag or lead effect, right?

That's correct.

Thank you very much.

[OPERATOR INSTRUCTIONS] And you do have a follow-up question from the line of Holden Lewis.

Great, thank you. Another way, I guess -- I'm looking at the automotive margin is, as you said, you would have been slightly positive in Q1 had it not been for the write off. In Q2, you obviously backed off from that. But I mean, I guess as I look at it, your volumes or at least your revenues were higher in Q2 than they were in Q1. Presuming we talked a lot about pricing and that should have been incrementally more positive in Q2 over Q1. The absence of some of the -- the absence of some of the lower margin work certainly that -- I mean, these things are all building. You would expect that they would have some sequential benefit, plus the volume, and yet it seems like the mar -- or the profit took a step backwards.

I guess that raises the concern of when we do see the automotive volumes coming down, when we do so the trucking coming down, how is it that we're going to be able to get out from under those volume trends with what we're working with, given the trend that we saw in Q2? Wrong way to think of it?

Yes, let me help you through this. First, the Q1 to Q2 difference of roughly $2 million is -- you know, unfortunately it's a [big yard] kind of plus or minus breakeven. It's within the range of tough to predict and in accordance with the process we're going through with our customers on multimillion dollar contracts, that we're either re-signing up or walking from and agreeing on time phasing. So to try to peg a $2 million difference in profitability or $1.5 million or so over a 90-day period is just a very rough thing to do and I wouldn't want you to read too much into it.

We are restructuring our volume through our manufacturing restructuring program in automotive. We are core producing our S&A costs. We are improving our mix and those are on time. We understand where the truck market is going and have taken that into account. And on the truck side, that's mostly tapers, where as you know we use our assets to support Mike, and we've gone through the last six months and reduced our backlog and are serving his distribution against that. So I'd ask you not to overread a 90-day shift of a $1.5 to $2 million, but rather look first half to first half and understand that you're seeing a positive shift there of five, and it's consistent with the steps we're taking.

Okay. I guess it just seems like -- in all these internal things, it seems like the trend is positive or making progress and that with regards to volumes and the actual profitability, it seems like we've really been moving a little bit more sideways, and that just raises the question, at this point are we still more tied to volumes than initiatives but --

Holden, I think you sum up Jackie's comments, there is as much noise in the quarterly numbers as the progress that we're making on a regular tactical basis. That's what led us last year to decide we had to do a major restructure. So you will continue to see gradual but slow improvement until we start to see the impact of the restructure.

You indicated that half your business in automotive now is earning its cost of capital. What was that a year ago?

A year ago, beginning of '05, it was probably about 35% to 40%.

And now it's 50% plus?

Yes.

All right. Thanks.

You're welcome.

Your next question comes from [inaudible].

Hi, I have a quick question. If you look at the automotive business, is this business going to earn appropriate margin like a double-digit operating margin in the next 24 months?

[Vassu], this is Jim. As I -- as we discussed in New York, our target is to bring the auto business to earnings its cost of capital, and that requires us to get margins in the 7%, 8% range. Once we get there, we will continue to drive it up with new products, new applications, and that is our target. Now with the wins of margin squeeze due to raw material cost and the downturn in Detroit, we are behind our expectations on that, and at this point with the uncertainty in the market, I'm not going to go on record as to whether we'll get there in the next 24 months or not. But that is the track. and as Jackie said, in the parts of that business that we cannot get there, we will not compete.

So is it fair to say that maybe that $1.7 billion is going to end up being whatever number it is, 1.5, but that 1.5 is going to, in the next two years, earn, you know, 10%, which is your cost of capital?

You just spit back numbers that I didn't say. To earn our cost of capital, we have to get to operating margins on the order of 7% or 8%, and we are not on record saying that that will happen in the next 24 months. Certainly aspire to that, but we're not on record with that. That is just the track that you're going down.

Great. Thank you.

At this time, there are no further questions. You may proceed with any closing remarks.

All right. Thank you all for your interest and discussion. I think this is as good a teleconference as we have had. We certainly are excited about the quarter that we put, but as I said we're more excited about the level of innovation, the improvements in execution and the potential that they have for profitable growth of The Timken Company. Thanks again.

Thank you for joining us today. If you have any further questions, please call me, Steve Tschiegg, at 330-471-7446. This concludes our call.

Ladies and gentlemen, this now completes today's conference call. You may now disconnect.