Timken Co (TKR) 2006 Q4 法說會逐字稿

Good morning. At this time, I would like to welcome everyone to the Timken fourth quarter 2006 earnings release teleconference. [OPERATOR INSTRUCTIONS] Thank you, Mr. Steve Tschiegg, Manager of Investor Relations, you may begin your conference.

Thank you, and welcome to our fourth quarter conference call. I'm Steve Tschiegg, Manager, Investor Relations. Thank you for joining us today, and if you have any questions after our call, please feel free to contact me at 330.471.7446. With me today are Jim Griffith, President and CEO, Glenn Eisenberg, Executive of Finance and Administration and CFO, Mike Arnold, President of our Industrial Group, Jackie Dedo, President of our Automotive Group, and Sal Miraglia, President of our Steel Group. We have remarks this morning from Jim and Glenn, and will then all be available for Q&A. At that time, I ask that you please limit your questions to one question and one follow-up at a time to allow for an opportunity for everyone to participate.

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

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

Thanks, Steve, and good morning.

Last week, we announced a revised outlook on our near-term performance, lowering our earnings estimate for the fourth quarter of 2006. As you have seen from today's announcement, our results were consistent with what we previously outlined. We also provided and earnings per share outlook for 2007 of $2.50 to $2.70, excluding special items. A strong improvement from our earnings in 2006 of $2.13 from continuation operations. Before Glenn walks you through the numbers in detail, I'd like to provide a framework for our performance by focusing on our accomplishments in 2006 and a look forward into the rest of 2007.

2006 was another year of solid financial performance. We had record sales and profitability in our Steel Group, along with records in productivity and shipments. We also achieved record sales in our Industrial Group. And we significantly strengthened our balance sheet ending the year at about 25% net debt-to-capital, an improvement of five percentage points. In 2006, we set in motion sweeping changes for The Timken Company, which position us for continued profitable growth. We aggressively added capacity and targeted industrial markets, particularly in the heavy industry, distribution, and aerospace markets. Strong demand continues to create significant backlogs in these areas.

We are constructing our 7th, 8th and 9th Asian manufacturing facilities. Asian sales increased 16% in 2006. We now have more than 4,000 associates in the region focused on our goal to secure a leadership position and to support our rapid growth in Asia. Aerospace sales grew by 30% in 2006. With the acquisition of Turbo Engines and the creation of a new aerospace aftermarket facility in Mesa, Arizona, we continue to build an exciting position within the aerospace aftermarket. We executed several actions to focus our steel business in areas where we can differentiate, including the sale of our precision steel components business in Europe, plans to exit steel tube operations in England, and the divestment of Latrobe Steel, a $350 million specialty steel business. These actions, coupled with our investments at highly differentiated capabilities, such as expanding the size range of alloy steel bars and adding of custom heat treat capacity, will improve the consistency of profitability throughout the cycle.

In our automotive business we concluded four major elements of our previously-announced restructuring program. We reduced our automotive plant in [Versone], France to about half of its former size. We completed the closure of our Torrington and Norcross facility and we divested an unprofitable steering business. Additionally, we made progress on a fifth element: the closure of the Clinton, South Carolina plant, which is about halfway completed. We're on track to finish the restructuring by the fourth quarter of 2007. We took additional actions in the second half of 2006 to balance our automotive business to dramatically lower levels of demand from our North American automotive customers.

By the end of 2006, these combined actions resulted in the reduction in employment in our Automotive Group by more than 2,000 positions or about 16% of the work force. We will continue to take actions to improve execution, diversify our customer base, and refresh the product application portfolio of our automotive business while minimizing discretionary investment. We expect to bring this segment back to profitability in 2008.

Automotive performance was also impacted by an increase in our warranty reserve. Last year we discovered a product quality issue that had an impact on certain auto customers. Quality is a core value of The Timken Company, and we are determined to ensure a high level of quality and reliability in all of our products. The issue last year related primarily to a single production line at an individual plant and the production issue has been fully corrected going forward.

During 2006, we also completed a pilot of project O.N.E. in our Canadian operations. Project O.N.E. is the development of the infrastructure needed to effectively operate our global enterprise while providing improved customer service. Our first major U.S. implementation occurs later this year.

Looking ahead into 2007, we anticipate continued strength in many of our industrial markets, including aerospace, energy, mining and heavy industries. We expect to benefit from the capacity investments which will facilitate continued aggressive growth in these industrial markets. In 2007, we also see a more focused, less cyclical steel business and a smaller, improving automotive business.

In closing, it's clear that Timken is becoming a stronger company, sharply focused on opportunities that improve our ability to deliver value. We expect to generate substantial improvement in our 2007 financial performance as reflected in our earnings outlook.

Now I'll turn it over to Glenn for a more detailed review of Timken's fourth quarter performance and full-year results.

Thanks, Jim.

During the quarter, the company divested its Latrobe Steel business, which is now accounted for as discontinued operations. Sales for the quarter came in at $1.2 billion, while net income per diluted share was $0.37, including $0.20 from discontinued operations. Excluding special items, earnings per diluted share were $0.30, including $0.07 from discontinued operations. These special items included the benefit of CDO payments, which were largely offset by not losses from divestitures, charges related to restructuring and manufacturing rationalization, and goodwill impairment.

The rest of my comments will cover continuing operations and exclude the impact of special items. Sale in the fourth quarter increased the 3.5% over 2005, driven by strong demand across the company's broad industrial markets, which was partially offset by declines in automotive demand from North American customers. Gross profit margin for the quarter was 17.6%, 290 basis points lower than last year due primarily to the impact of lower automotive volumes, higher manufacturing and logistics costs associated with our industrial growth initiatives, and a $12 million increase in warranty reserves. SG&A was 13.8% of sales, 30 basis points favorable compared to last year, reflecting lower costs in the Automotive Group from actions taken to mitigate the impact of lower customer demand. This was partially offset by increased investments in our Asian growth and project O.N.E. initiatives.

EBIT for the quarter came in at $43 million or 3.5% of sales, 240 basis points lower than 2005. The tax rate for the quarter was 34.7%, compared to 30.1% last year, as the company had a lower overall percentage of its earnings in lower tax rate foreign jurisdictions. As a result, net income for the quarter was $21 million or $0.23 per diluted share, compared to $0.45 last year.

Now I'll review our business group performance.

Industrial Group sales for the quarter were $540 million, up 10% from a year ago, benefiting from strong demand across its broad industrial markets with the highest growth coming from aerospace, energy, mining and metal sectors, which also drove strong distribution sales. Industrial EBIT was $44 million or 8.1% of sales, 40 basis points lower than last year. The impact of favorable pricing and higher volumes was offset by higher manufacturing costs, including those related to capacity additions and facility rationalization, as well as investments in our project O.N.E. and Asian growth initiatives. Looking forward, we continue to expect strong industrial markets with improving margins as we better leverage our top-line growth through operating improvements.

Automotive Group sales for the quarter were $362 million, down 11% from a year ago. Significant reductions in demand by North American OEM manufacturers and actions to exit nonstrategic businesses more than offset improved pricing and new business. For the quarter, the group reported a loss before interest and taxes of $42 million compared to a loss of $8 million last year. Lower automotive volume resulted in reduced capacity utilization, which more than offset the positive impact of pricing and the benefit of restructuring and work force reductions. The quarter was also negatively impacted by an increase of $12 million in warranty reserves. As Jim mentioned, we're on track with our previously-announced automotive initiatives and will continue to take further actions to improve our overall performance.

Steel Group sales for the quarter were $358 million, up 9% from a year ago. The group benefited from increased pricing and continued high demand, especially in the energy, service center and general industrial markets. Steel group EBIT in the quarter was $40 million, up 12% from last year. The improvement reflects strong volumes in key markets along with price increases, high levels of plant utilization and labor productivity. This was partially offset by raw material costs not being fully recovered by surcharges. Based on our current outlook we continue to expect strong results from our Steel Group.

Looking at our balance sheet, we ended 2006 with net debt of $497 million, roughly $160 million lower than the end of last year, as the company benefited from the sale of Latrobe Steel. During the year the company invested roughly $300 million in capital expenditures, primarily to support growth initiatives and contributed about $240 million into our domestic pension plans. The company's leverage of net debt-to-capital at the end of 2006 was 25%, which was five percentage points lower than the end of last year and is below our targeted range of 30% to 35%, providing the company with financial flexibility to pursue strategic investments. The company's leverage reflects its adoption in the fourth quarter of FASB 158, accounting for pensions and other post-retirement benefits which negatively impacted our leverage by three percentage points.

In summary, we expect global industrial markets to remain strong and automotive demand to stabilize. We expect to see higher profitability and margins for the full year 2007, driven by improved operating performance. The company expects earnings per diluted share for 2007, excluding special items, to be $2.50 to $2.70 for the year, and $0.50 to $0.60 for the first quarter. From a cash flow standpoint, we expect to see higher free cash flow in 2007, benefiting from earnings growth, better working capital management, and lower pension contributions, which are estimated at $80 million for our domestic pension plans. As with prior years, we will consider making additional contributions to our pension plans by the end of the year. Capital expenditures should remain about the same as last year as we continue to invest in growth initiatives while cash taxes are expected to increase due to higher earnings, an estimated tax rate of 34% and having utilized all of our U.S. cash loss forwards in 2006. The company continues to be focussed on improving its operating performance while achieving its long-term strategic initiatives, including project O.N.E., Asian growth, portfolio management and industrial acquisitions.

This ends our formal remarks, and now we'll be happy to answer any questions that you have. Operator?

[OPERATOR INSTRUCTIONS] We'll pause for just a moment to compile the Q&A roster. Your first question comes from Bob Schenosky with Jefferies.

Good morning.

Morning.

First, quick question for Glenn. In terms of the pensions, what do you think -- where are you in terms of your funded rate at the end of 2006?

When you look at the balance sheet, Bob, you'll see that we're now with FASB 158, we're putting all the liabilities on the balance sheet that we're off and we'll have around $400 million, $410 of, call it liabilities associated with the pensions. The U.S. pension plans which we normally speak to, in the past the contributions we make because of the bulk of it were down to under $300 million now of unfunded positions. So we've made significant progress over the years, obviously putting in substantial cash this past year as we had in the past, and we continue to enjoy very strong returns on the assets that we have in the plant. From an interest rate perspective, interest rates have been relatively flat, so not helping or hurting us this year where, as you know, in the past it's been a factor. The fact that we can put in lower amounts of cash into the pension plans this year really speaks to the progress that we've made on that plan and as we said on the earlier comments, we'll look at our balance sheet, our cash needs for the year, and make an assessment of whether or not we'll put more into the plans. But as of right now, we're targeting $80 million this year.

Okay, great. I had a question for Jim. You talked about capacity utilization in two of the businesses. In terms of the industrial, where about did you -- I'm accounting for mix here, too, so we don't need to be specific -- but if you can give us a general sense of where you finished the year in capacity utilization and how much this additional capacity could mean in terms of revenues?

Bob, let me give an introductory comment and I'll let Mike answer specifically as it relates to the additional capacity. The challenge in answering your capacity utilization number is it varies across product lines from probably 120% in facilities that are completely oversold, to as low as 60% or 65% in some of our more automotive-oriented or facilities that have specific markets that are weak right now. We don't keep a number of what it is across the company. So with that as background, the answer is across the majority of our plants at this point on the bearing side, we have lots of capacity, on the steel side we are tight on capacity, and then there are selected areas where we're growing the bearing-producing capacity and I'll let Mike respond to those.

Yes, from a capacity perspective, the focus on the capacity increases, as you know, has been on the Asian market, the heavy industries, aerospace, and then serving the distribution markets. So we would expect about $70 to $75 million of additional sales in 2007 coming from the investments that we're making in 2006 on capacity increases, just for that market. Now, to make sure that the story's complete, that capacity increase will be ongoing. And since our third quarter conference call, we actually have announced two new facilities to be built in Asia, one in India and one in China. So as you will see, we'll continue to increase our capacity in those areas where we're currently constrained.

Okay, great. And if I could, one final question. You mentioned some of the markets that you anticipate continuing to improve or at least maintaining strength in 2007. Are there any specific markets in your industrial bearing business that you believe could weaken in 2007?

Yes, it's a bit the same story that we've talked about throughout '06. Some of the consumer markets we've seen not only some softening, but even from a strategic perspective, our sights are turned much greater towards the markets that are growing very rapidly and have great fits for us and where we're able to bring value. Again, some of the agricultural markets had remained soft through '06, although a little recovery from the end of '05. And then the rail industry, and it's more of a mix of what they're actually producing in North America where the freight car build rates were so significant coming out of '05 and into early '06 that, to a certain extent, they overbuilt the market so we saw some softness in that in the second half of '06 and going into '07. At the same time, tank cars has taken off significantly. So it's an interesting mix, but those would be the ones on the down side where we would have some concerns with regards to volume.

Okay, great. Thanks for your time.

You bet.

Your next question comes from Eli Lustgarten with Longbow Securities.

Good morning. First question is you talked a bit about the industrial bearing business top-line growth. My concern is the profitability, which tends to look very weak by comparison to peers and by comparison to industry conditions across the board. I mean, not running double-digit margins, below double-digit margins at this point in the cycle is almost embarrassing, and while I know you say margins are getting better, can you talk a little bit about what you expect for '07 and '08, and what kind of -- how long will it take to get the profitability levels more consistent with current demand levels in the industry?

Eli, this is Jim, I'm going to let Mike respond to the specifics, I just can't let you say embarrassing publicly. You know, we have stated consistently that the margins in our industrial business are constrained by the investments that we're making to put in project O.N.E., the information technology system, the investments we're making to grow in Asia, and the startup costs around the new plants that we are building. So they reflect conscious decisions to grow that part of the business. Now, I'll let Mike talk to you about specifics.

But how much is that impacting margins, can you quantify that, too?

Eli, we can give you some sense. We've talked about that over the last several quarters, that our investments in Asia, as an example, just building the infrastructure from which to grow our business significantly is impacting between 40 and 60 basis points. And that is ongoing and will still continue for some period of time as we continue to grow in those areas. So we can give you a sense of that. We would expect to return to double-digit margins in the second quarter and then a gradual improvement in those margins throughout the year. But they will be dampened versus, I think, what the typical expectations would be because of that ongoing significant investment that we continue to make for the growth of the company in industrial-focused markets and in particular, Asia, aerospace, and the heavy industries.

What have you factored in for the impact of Project O.N.E. and putting SAP system in the U.S. operation to impact margins in 2007? These margins should be in the 12% to 15% range at this point in time.

I think at this stage when you look at the margins year-over-year it should not constrain on at least the project O.N.E. side. We're spending at the level we would envision spending at, we're moving into our, call it third year of the project, so maybe it will be up a little bit but really shouldn't constrain. I think the other one, the Asian growth continues to be an area where we'll probably see a little bit more spending, but from a margin standpoint not having a significant impact.

What we're expecting to see in industrial, as Mike mentioned earlier, we have additional capacity that we're putting online in '07 that we've essentially had a lot of costs associated with that as we were ramping up for it. So we'll get the benefit of the top line, there will still be some constraints with T1 in Asia, although not incrementally increasing a lot, but still constraining overall margins, but we should some benefits within the group on that higher sale. So unlike 2006, where we saw the margins come off of '05 levels, we expect to see top-line growth in our Industrial Group as well as margin improvement in 2007 as we're further along on those projects.

How much of your business is aerospace now, when you got rid of Latrobe Steel you took away some aerospace business. So, how much is overall business, in industrial and overall is aerospace-related?

Eli, this is Mike again, aerospace from an industrial perspective would be approaching 10% of our total business. And growing at a rate of about 30% in '06 versus '05, and we expect to continue a pretty significant growth rate going on. That's where the majority of our acquisitions are coming from and our focus is on expanding into services and higher-value businesses.

A question on the steel industry, you indicated the goal was a more stable result. Is the profitability we saw in the fourth quarter in the steel industry sort of a new steady state level after Latrobe Steel that we should expect for '07?

Eli, good morning. This is Sal Miraglia. Probably, with the one exception, I would say, that there was the bizarre distortion of the radical fluctuations in the cost of the factory bundles, which is a little unusual and is now returning to normal. I think for the most part that is a fairly accurate statement. We kind of look at 2007 as going to be looking a lot like what 2006 looked like. To your other question about aerospace, you were right, we have, for the most part, the majority of our aerospace materials participation was through Latrobe. We have just a very small amount that we now continue to produce for certain very targeted landing gear bearings, but that's about it and it's not very substantial.

Eli just maybe to clarify a little bit more to make sure I understood your question on the fourth quarter with steel now without Latrobe's numbers and we'll now have a backout of continuation operation numbers in our K based on quarters. But you have to also appreciate the seasonality of the business, I wouldn't take the fourth quarter in steel without Latrobe and then assume that's normal run rate for each of the quarters. The fourth quarter would seasonally be a lower level of performance. I think what we've said overall for the group, excluding Latrobe, so continuation operations that we expect to see the steel business at comparable levels of profitability, which are records for them in '07 compared to '06.

Do you have an idea what the operating margin in steel was X-Latrobe for the year? I don't think we have all the data to pull that out yet. If we can guesstimate it.

I believe the number for steel, again, continuing operations would be around 14% in 2006.

And we expect '07 to be similar to those kind of numbers?

That's correct, Eli.

Thank you.

Next question comes from Mark Parr with Keybanc Capital Markets.

Good morning, guys.

Good morning.

Jackie, sorry. I had a couple of questions. First, Glenn, what is the estimated P&L impact for pension in '07 versus '06?

Good question. We should see improved results benefiting from our pension. We will have lower pension expense year-over-year because of the contribution. The only reason I'm a little hesitant at giving you a number is because it's subject to what interest rates do this year and other assumptions. But clearly some of the increase that we're benefiting from and the guidance that we provided reflects a lower level of absolute pension expense.

Okay. Just to round-number it, would it be $10 to $20 million, that kind of level?

Rounded numbers, yes. It would clearly be in that range. Again, depending upon interest rates and other variables. But that's a reasonable assumption.

Okay. Terrific. Had a couple of questions on steel. First of all, what percentage of your steel business is subject to scrap pass-through agreements?

Good morning, Mark. Sal Miraglia here. Nice to hear from you.

Hey, Sal.

Actually, 100%. We have virtually every one of our contracts now. It was started probably in the middle of our -- what we call contract season 2004, and finished by the end of 2005, beginning of 2006. Virtually every one of our contracts have scrap index adjustments for raw material fluctuations.

Okay. So is it fair to say that the reduction in scrap levels in the second half of '06 had a negative effect on your margins?

Not a considerable amount. I mean, you've got to look at the timing effects for most of that, Mark, but the issue that we saw most was just the bizarre impact that we had with respect to the huge decline in the automotive plant consumptions and the major adjustment that the big integrated makers had taking up to 16 blast furnaces out. There was a very weird dynamic there that ended the final part of the year, in fact just December, with an anomaly with respect to that. Probably more affected was the point Glenn made earlier, which is simply the seasonal reduction in activity that we normally see coming into the low work-level holiday period and end-of-year inventory adjustment behaviors that --

Yes, I hear you on the seasonality of the business, but what I'm trying to get at is -- are lower scrap prices generally a negative influence on margins? And so I'm assuming that the converse is true. If that's true, then higher scrap prices would be additive to margins. Is that a fair assumption?

Mark, this is Jim.

Hey, Jim.

It's not a fair assumption. A goal of our surcharge program is to neutralize the impact of scrap prices. What causes the variation is the difference between the indices that we use to price those contracts and the market price in a given month of the specific grades that we need to purchase that month or the ability to buy different alloys in scrap, and that sort of thing. And it's not as predictable as saying it is directly related to the level of scrap prices.

Well, that's kind of what I was getting at. So I mean, so bundles are up $40 or $40 or so in February, and your scrap buy, which is not 100% bundles might only be up $30 or something?

Conceivably those numbers could be right but there is -- it's very difficult to predict the relationship between the index prices and the actual purchase price. I mean, I can understand why you're exploring it, but there isn't -- at least we haven't found an easy way to predict that relationship.

Okay of I hear you. I appreciate that, I had a couple other questions, if I could. For the steel business, can you tell us, excluding Latrobe, what the tonnage growth was '06 versus '05?

Yes, I can Mark, as a matter of fact. If we exclude Latrobe, we were probably in the neighborhood of about 10% higher shipment volumes, that includes the slowdown in the automotive segment, as well.

Right. And then just lastly, on the steel for your contract negotiations for '07, what sort of base price increases on average were you able to realize versus '06?

I actually don't share base price data, Mark. I apologize for that. But that's confidential data.

Okay. Could you tell us if it's positive or negative?

No, sir.

Okay. All right. Thanks very much.

You're welcome, Mark.

[OPERATOR INSTRUCTIONS] Your next question comes from Andrew Obin with Merrill Lynch.

Hi, can you hear me?

Yes.

Hi, yes, good morning. Just a question on the automotive business and I guess over the past couple of months we've been struggling with declining auto volume. And if you could just give us sort of your view for this business, sort of 12 months from now, what do you think is going to happen to the Big Three volumes and what do you think is going to happen to mix between light and trucks and how do you think you're going to respond to that? Just sort of more detail, more top-down view.

Good morning, Andrew. Jackie. How are you?

Hi, how are you.

Good. Let me try to give you a feel for where we see the market going, along with everyone else out there that's predicting. If you look at the consensus for light vehicle out there production for North America, which is the primary issue, it's around 15.3, 15.2. We've pushed our assumption for the market for the year down to 14.9. We think that what we've seen in the third and fourth quarter of the year last year is structural and that for those platforms and companies who have yet to announce that being a structural change, that they will and we've built our forecast around that. We especially continue to see decreases in alignment with where you see the heavy inventory levels still on the light trucks and S.U.V.s. Other than that, we'd see the market growth and decrease in North America consistent with who's winning and losing from last year.

One other comment maybe to help you on the medium/heavy truck side which is an important part of our auto business, that's going through a significant decrease this year and we're projecting a 30% year-over-year decrease in the market of medium/heavy truck in North America, with European medium/heavy truck flat to slightly down, and Asia/Pac medium/heavy truck growing as rapidly as past cars, if not a little bit ahead of that.

In terms of what that does for us, we had restructuring in place, which you all have known about, as we were going through the portfolio of known about as we were going through the portfolio of automotive and are continuing on that further restructuring group and path. We'll have that completed by the third and fourth quarter of this year. Secondly, we announced at the end of last year a response to this shift in lower demand. We have continued our response to that proportional to we believe is not a short-term shift but a structural shift, and that's why we've continued with the amount of headcount pulls that Jim spoke to in his opening comments.

How has your thinking adjusted and were there big changes to the plan in the past month? I'm sorry if I missed it.

ELi -- or I'm sorry, Andrew, you broke up, could you --

I was just wondering, can you just change -- can you talk about how you plans, how your restructuring plans for automotive have changed over the past, let's say, month or so and just give us specifics in terms of headcount reduction, etc.? Or were there any changes?

Now I'm stuttering a little by. The straight answer to your question is over the last couple of months the plans have not changed. Effectively we have taken three actions: took at the beginning of last year a decision to do a formal restructuring. The difference is that one's focused at getting fixed costs out. As a part of that, then we divested the steering business late in the year. And then in the early part of the fourth quarter, late third quarter of last year, we saw this downturn particularly in light trucks somewhat responding to the heavy truck downturn and we took a decision, as Jackie said, to take headcount down. As we see the market today, our plants are approximately balanced in terms of [manning] to the level of output that's required. We have some restructuring to complete and then the focus of our operations will simply be driving those plants to higher levels of performance and driving those restructuring to the bottom line.

And just a follow-up question, we've been focusing on repricing a lot of the contracts that we have with the Big Three, I guess. Where are we in that process and do you find that the customers are responding differently now? Are you being more forceful or are we just sort of going through the process and we're just going to be down with it, it's a three to five-year process and it just goes along?

Andrew, on the pricing, we're continuing on the process. We've not backed off our intensity. We go through and look at the portfolio as contracts come up. And for -- as the contracts come up, we look for cost of capital or better contracts with minimal, if no, annual giveback. If that's not attainable, we look at exiting that capacity from automotive markets and look to use it elsewhere.

And so where are we in that process? Are we two-thirds done, are we 50% done? And when are we going to be done?

We'll be done over the next -- through the end of next year as the final longer term contracts come up. We're 75% done right now from number of contracts and percent of sales.

Let me ask you another question. Given the success in pricing that we've had, if it wasn't for this big swing in volumes, and I understand that it's just a guess, but do you think we would have seen a profitability, improvement in profitability versus last year if it wasn't for the volume swings?

If we had not had the volume erosion and the warranty issue, we would have had a break-even or better year in automotive.

Okay. Thank you very much.

Your next question comes from Omar [Malek] with Golden Tree Asset Management.

Hi guys, good morning. I had a couple questions. A quick one going back to steel, you had mentioned the margin being lower partly because of the asset sale but also because of the seasonality. I was just trying to understand the seasonality aspect of the fourth quarter. When I look at 2005, it looked like the margin was about -- the adjusted EBIT margin was about 100 BPS lower than it was in the first quarter and actually in line with Q3 '05, so I'm just trying to understand it going from 15.4% margin in Q3 of '06 to 11% in Q4 of '06.

Well, let me just -- Omar, this is Sal Miraglia. Let me talk a little bit about the seasonality issues. The seasonality has a lot to do with plant operations and customer activity. What we did see in 2006 was, as we talked at the last teleconference, what we expect it to be and what we saw, a reduction in some of our big-volume automotive customers. There was a great deal of schedule elimination at the North American Big Three that was unanticipated, and as a consequence, that was a plant operation that just didn't occur. So that's a different -- that's a structurally different environmental condition than the year earlier. But that was added on top of what we normally see. And we normally do see a lighter customer activity level as we come into the end of the year, just because of the standard holiday conditions and, as I mentioned earlier, everyone's attempt to hit year-end working capital targets.

Great. And on the automotive segment, I know you guys mentioned that you expected to perform better than the second half of '06. And so I think that's the guidance that's been given thus far. So I'm just trying to understand, if I was trying to -- what you think the adjusted EBIT margin would be for '07? Or just roughly, is it more of a break-even number or is it in line with -- or are you saying it's going to be better than the second half of '06, which I think is a negative 10% EBIT margin? I just didn't know which number it was closer to.

Well, if I got your question right, Omar, you're asking about the first half versus second half performance projected in automotive?

I'm just wondering if '07 automotive, if the EBIT margin would be closer to break-even or closer to the second half of '06, which take into account Q3 and Q4, is like a negative 9%, negative 10% margin.

I guess the way we would characterize it is that if you look at the performance year-over-year, we expect to see improved performance within automotive. Obviously, the second half in '06 was much lower than the first half because of the dramatic change in the automotive production levels.

So as we go into now the first half of '07, we clearly expect to see improved performance in auto compared to the second half of '06. But on a comparative purpose, compared to the first half of last year, that will be down. I mean, improved performance, but again we were essentially break-even in the first half of the year especially if you took out the buildup in bad debt reserves that we put in anticipation of some of the issues that occurred. That I think was mentioned earlier, we expect to see improved results in auto as we go into the second half of '07, even compared to the first half of '07. So, it'll be a steady progression. We'll continue to realize the benefits from the restructuring initiatives that we're doing, the headcount reduction that's going out.

The only thing that we've held off on saying or speaking to -- when is the breakeven point in automotive? We got into that trap last year and we committed to what we thought we could do, as Jackie just commented, we believe we would have achieved it if the market hadn't changed. Right now, what we're just saying is that improved performance from the second half of '06 progressively throughout the year and we'll comment on when we're back to profitability, when we're there, but clearly that's the goal and we're going to get there, hopefully sooner than later.

Okay, great, so it would be too early to say that 2007 would be better than 2006 in terms of the EBIT margin automotive, correct?

Well, no, I think we're fair to say that we expect to see improved performance and we expect arguably to see lower volumes because, again, at a better run rate than at the second half of the year. But automotive markets, as Jackie said, are relatively stable now off of the lower level, even though we've taken a maybe a little bit more pessimistic view of it. Expect to see improved profitability and improved margins within the Automotive Group.

Qualitatively, there were two things that happened in the second half that shouldn't reoccur in 2007. One is the warranty issue. And secondly, the second half, really the fourth quarter, was a time in which many of the employment reductions were actually implemented and so those are, at least the majority of those, behind us. That would indicate significantly better performance as we go into 2007.

Okay. So, just so I'm understanding, the '07 EBIT margin would be better than '06? I understand you're saying there's improvement, I was just asking a "yes" or "no" question in terms of if you thought the '07 EBIT margin would be better than '06 in the aggregate for the whole year?

Right, it's a "yes" or "no" question, the answer is yes.

Okay. Sorry. And I guess I thought, I wanted to understand where -- how some of the cash moved. Because I know that -- I thought there was something like $255 million of cash from asset sales, and then $35 million of assumed debt. And so I guess if all of that went down -- so I thought that would be a net debt reduction of $290 million, so I think I was about $100 million short. Was some of that for pension? I didn't know what I was missing.

I don't know what point-to-point reference that you're making for debt, but clearly if you look at our cash flows on our financial statement, you'll see the cash generated from divestments of around $200 million.

Okay.

So what reference point are you looking, year-over-year or over the fourth quarter or --

You know, I'm just looking from quarter-to-quarter.

Obviously the bulk of the decline in our debt came through the divestments, we obviously -- fourth quarter for our company from a seasonal standpoint is normally very good cash generation from working capital. SO, the big drivers for us were those two issues.

Okay, great. Thanks a lot, guys.

Your next question is a follow-up question from Eli Lustgarten with Longbow Securities.

Good morning. Somebody has to ask the longer-term question on automotive. We had a loss here in '07, you're looking at probably profitability in '08, but it doesn't appear that we're getting towards the cost of capital yet -- five years after doing it. I mean, at what point are there more definitive steps to be taken to get this business to where it ought to be or exit more of it because it's taking forever and what has been a very good automotive environment and now becoming more questionable?

Eli, this is Jim. The bottom line is, we've taken a number of steps to improve our auto performance. And while Jackie's not been here through the full five years that you referred to, I certainly have been. It included pricing improvements, divestiture of nonstrategic assets, a major restructuring initiative and now a major employment downsizing initiative. In 2007, our focus is to drive those changes to the bottom line and make the business profitable. Pure and simple. At the same time, while taking the open capacity we have and attempting to shift it to serve profitable segments of the auto and industrial market. And that's our focus for 2007.

I guess I'm asking longer term. I mean, is there any sort of new target of when you think this business can earn its cost of capital and to what degree can you maybe take difficult steps to realize that either these businesses could be exited more easily, because there's not enough industry capacity for the customers to go someplace else. It's almost hard to understand why we can't hit a target and get this business to a cost of capital return in a reasonable amount of time.

I think the straight answer, it reflects a little bit on Glenn's comment on the timing of bringing it to break-even. I think given the five years of change, we'd have a credibility problem if we said to you that we haven't and have confident in a plan to bring it to its cost of capital. Our focus is to bring it to profitability and then we'll talk about the balance of the objectives.

Okay. Thank you.

Your next question is from George [DeLugos] with Baldwin Brothers.

Thanks for taking the call. Jackie, in 4Q you did $360 million of business, how much of that was with the Big Three?

Fourth quarter specifically, I'd have to look. I can tell you right now our Big Three percentage is out 60%.

Is that both OEM and parts?

That's just OEM.

Okay.

The parts business is reported through our industrial.

Got it. Okay. Volumes, I know you're giving volumes, the industry volumes a haircut in '07. What's your capacity utilization at those levels?

Our capacity utilization at those levels is roughly 80%.

Okay.

On the automotive [inaudible]

If you're wrong and things are better or things get better in '08, are you going to go after the business or are you going to structure this thing for very, very low unit sales?

Well, we're pursuing a cost basis as if we're right. In terms of what we go after, most of these assets are shared. Mike and I will be trying to make the best judgment for the portfolio of the company.

So you're going to have an arm-wrestling match with him.

Yes, though if you see him, he'll probably win.

All right.

Just to make a straight answer from the guy who will referee the arm wrestling match, the drive is to move the capacity to serve profitable markets. And that's the basis on which we'll make the decision. And as we said, our approach for 2007 is not to undertake significant amounts of additional restructuring, it's to focus on getting that product into the hands of the customers who are willing to pay prices that are consistent with achieving profitability.

Fair enough. Lastly, with the $360 million, how much is international versus North American? I know your press release uses the word "North American" an awful lot.

North American is about 70%, little shy of that, of our automotive business.

Okay. Is the other 30% profitable?

The other 30% is more profitable. I'd have to look at the specific products and customers.

Okay. Lastly, I'm going to end it now, 29% of 4Q was automotive, that's one of the lowest numbers you guys had in a long time. Where is it going to be in a year? Percent of corporate sales.

The growth in our business will be in the industrial market segment. The answer as to what the percentage is depends on the relative strength of the various markets that we serve over that time.

Okay. That's it. Thanks.

The next question is a follow-up question from Mark Parr with Keybanc Capital Markets.

Thanks very much. Hey Jackie, we've had discussions in the past about the percentage of pricing or how much pricing momentum you've been able to achieve, I was wondering if you could give us an update and some color on that for '06 and how you see that emerging incrementally for '07?

Yes, Mark. We continue to go through the contracts as they come up. We had a good year in '06 against our pricing objectives. Like in '05, with the exception of the volume. Obviously, we didn't hit the price value we expected from a quantity standpoint, because we didn't have the volume to price it against.

Can you give us some idea of what the pricing levels were achieved or what levels were achieved?

I'm trying to figure out a reasonable way to talk about it. I can tell you that we've reduced our forward-going contracts by -- let's say, our average contracts are three years, and we've reduced our average annual giveback by over a percent and a half. That said, we are working with our customers to get to the cost of capital on our assets, as well as to a value that they'll subscribe to, and it really, it depends very much on the product and where it stands in both of those terms. So I can tell you we're not taking contracts that the customers don't see sufficient value to pay us at our cost of capital or better, and we're tracking the market pricing around that very carefully.

Okay. Just one last, if I could. As far as the '07 versus '06, would you look, are we kind of in a mode of diminishing returns or could you talk about the potential for pricing upgrades this year compared to what you achieved in '06?

From a percentage of contracts coming up, we will continue to go after the contracts in the same fashion we have. So percentage-wise for each contract you shouldn't think of it as diminishing.

Okay.

We are -- I'm sorry?

I said -- I just said yes, I understand.

Okay. And we are about three-quarters of the way through that full cycle that we started talking about a little over 30 months ago. And we'll begin to look at those original contracts we signed 30 months ago as they come up, with the same attitude that if we can't find a win-win situation between us and the customer, their value and our assets, we will continue our process of portfolio management.

Okay. I appreciate that. That's very helpful. I had one last question, if I could. Jim, it was either you or Glenn I think that talked about an interest in looking at industrial acquisitions. And I was wondering if you could give us, A. a little color strategically in terms of what you're most interested in, and then secondarily, magnitude of appetite. How much money would you be willing to allocate for additional acquisitions here over the next 12 to 18 months?

Mark, I'll take the latter part and then have Mike talk about the industrial growth acquisition opportunities.

Thanks.

We talked about the strength of the balance sheet in that we target 30% to 35% leverage. So if you look at where we are now at 25%, it gives us a significant amount of room, several hundreds of millions of dollars in order to get back to that leverage level. So for the right opportunity we've got substantial capacity to do strategic acquisitions and frankly, we, as in our Torrington acquisition, for the right one we're ready to go above that level knowing that our cash flows will bring us back in line. So, we're ready for the acquisitions, it's now where are we going? With that, I'll pass it on to Mike.

OK, thanks, Glenn. Yes, Mark, just a couple comments. Our focus, if you go back and look at the acquisitions we've made, we're focused on the same markets that we've talked about that are our strategic strengths and are actually growing. So aerospace services into the aftermarket, that's been a key area, we'll continue to look at that. We are moving towards the expansion of our product lines, in particular those areas where we can leverage our capabilities, our brand name and our position in the aftermarket and distribution services across any industry. And then we're looking at opportunities to, in fact, acquire capacity where we are building it in Greenfields, and particularly in Asia, but the ability to acquire some of that capacity.

Thanks again for all the color, I really appreciate it.

Your next question is a follow-up question from Omar [Malek] with Golden Tree Asset Management.

HI guys. I just had a quick follow-up question and I have the slides from your prior call. Just wanted to ask -- Roughly what percent of the business would you say is auto now, just in terms of the overall sales?

So again, you look at auto across the whole company, you're probably looking, I'm going to give you a rounded number, we'll have to go back because of the changes that we've had with obviously the divestitures and so forth, but probably around 40% would get you in the ballpark. It's, again, what's in our automotive business as we break it out, the segment, Jackie referenced the automotive aftermarket, that's in our Industrial Group, obviously the automotive sales that are sold within our Steel Group.

Great. Thank you.

Ladies and gentlemen, we have reached the end of the allotted time for questions and answers. Mr.Jim Griffith, are there any closing remarks?

Again, thank you for your interest in the company. I appreciate the depth of the questions and the interest in the company. Obviously, what you've heard from us as a company that is in strong position, moving forward dynamically, growing in industrial markets, trying to lock in the profitability, the performance that we've got in steel markets and with a smaller and increasingly improving performance in our automotive segment. Thanks for your interest and investment in The Timken Company.

Thank you for joining us us today. This is Steve Tschiegg. If you have any questions call me 330.471.7466. This concludes our call.

This concludes today's Timken fourth quarter 2006 earnings release teleconference. You may now disconnect.