Tennant Co (TNC) 2008 Q3 法說會逐字稿

Good morning, and thank you for participating in Tennant Company's third-quarter earnings conference call. This call is being recorded. If you do not wish to participate, you may disconnect at this time. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions). We ask that you remain online for closing remarks by management after the question-and-answer session.

Beginning today's meeting is Tom Paulson, Vice President and Chief Financial Officer for Tennant Company. Mr. Paulson, you may begin.

Thanks, Abigail. Good morning, everyone, and welcome to Tennant Company's third-quarter 2008 earnings conference call. I'm Tom Paulson, Vice President and Chief Financial Officer of Tennant Company. With me on the call today are Chris Killingstad, Tennant's President and CEO; Pat O'Neill, our Treasurer; and Karen Durant, our Corporate Controller.

Our agenda this morning is to review Tennant's performance during the quarter and first nine months and our outlook for the remainder of 2008. First I will review the financials and then Chris will update you on our operations. After that, we will open up the call for your questions.

Before we begin, please be advised that our remarks this morning and our answers to questions may contain forward-looking statements regarding the Company's expectations of future performance. Such statements are subject to risks and uncertainties and our actual results may differ materially from those contained in the statements.

These risks and uncertainties are described in today's news release and the documents we file with the Securities and Exchange Commission. We encourage you to review these documents, particularly our Safe Harbor statement, for a description of the risks and uncertainties that may affect our results.

Additionally, this conference call includes discussion of non-GAAP measures that include or exclude unusual or nonrecurring items. For each non-GAAP measure, we also provide the most directly comparable GAAP measure, and our earnings release issued today includes a schedule that reconciles these non-GAAP measures to our GAAP results.

Our earnings release was issued this morning via business wire and is also posted on the Investor section of our website at TennantCo.com.

In my comments today, all references to earnings per share are on a fully diluted basis. Also, please note that as I go through the financials, that I will generally not be commenting specifically on year-to-date financials, as those are detailed at length in the earnings release.

For the third quarter ended September 30th, 2008, Tennant reported that net sales increased 15.3% to $185.9 million versus net sales of $161.3 million in the third quarter of 2007. Contributing to the rise in net sales were acquisitions, price increases taken worldwide to mitigate higher material costs, and favorable foreign exchange effects. We continue to see results from our long-term strategy to build our international business with revenues outside of North America accounting for 42% of sales in the 2008 third quarter, up from 35% a year ago. The Applied and Alfa acquisitions added approximately 8% to consolidated net sales for the quarter and foreign currency exchange added approximately 3%. Organic net sales growth, which excludes acquisitions and the foreign currency exchange benefit, was approximately 4%.

Net earnings were $14 million, or $0.76 per diluted share in the 2008 third quarter compared to net earnings in the prior-year quarter of $11 million or $0.57 per diluted share. There were several unusual items that affected both the 2008 and 2007 third-quarter results. For easier reference, we have included a supplemental financial table in the earnings release that provides the impact of unusual items, which I will now review.

There were two unusual items that contributed to Tennant 2008 third-quarter earnings. Combined, these items resulted in a net benefit of $0.19 per diluted share in the quarter. We had a $2.7 million net foreign currency gain from the settlement of forward contracts, which added $0.09 per diluted share to earnings. And a favorable discrete tax items primarily related to US federal tax settlements, which added $0.10 per diluted share.

In addition to the 2008 third-quarter results included dilution of $0.01 per share from the acquisitions of Applied and Alfa.

For comparison, the third quarter of last year included a net tax benefit of $0.19 per diluted share, which was primarily related to the reversal of a tax valuation allowance on foreign net operating loss carryforwards. Also included in the Company's 2007 third-quarter results was a workforce restructuring charge of $0.06 per diluted share. The net effects of these two unusual items was a positive $0.13 per diluted share in the 2007 third quarter.

Next, let me review our revenues. In North America, 2008 third-quarter net sales totaled $107.2 million, up 2.4% versus the prior-year quarter. Acquisitions added approximately 0.5% to net sales in this market during the third quarter. We also benefited from annual pricing action taken in the 2008 first quarter, as well as from transportation and service rate increases and surcharges implemented in the second quarter. However, a decline in unit volume principally for industrial and outdoor equipment offset the majority of these increases. In addition, we continue to see a longer sales cycle during the third quarter with customers delaying purchases due to broader economic factors. Favorable foreign currency exchange effects on net sales in North America added approximately 0.5% during the 2008 third quarter.

In our EMEA markets, which encompass Europe, the Middle East and Africa, third-quarter net sales grew to $55.3 million, up 31.4% compared to the 2007 third quarter. Acquisitions added approximately 20% to third-quarter net sales growth in this region. Favorable foreign currency exchange effects increased net sales by approximately 6% in the quarter. Organic growth of about 5% in the third quarter of 2008 came from continued strong sales growth in the regions of central and eastern Europe and Middle East and Africa due to continued market expansion initiatives. Sales in the UK were lower than the prior year due to their weakening economy.

The selling price increase was implemented in August due primarily to rising material costs and this action increased sales and improved margins.

In Tennant's other international markets, which is comprised of China and other Asian markets, Japan, Australia, and Latin America, 2008 third-quarter net sales rose 61.4% to $23.4 million versus the comparable 2007 quarter. The Alfa acquisition contributed approximately 29% to the net sales increase while favorable foreign currency exchange effects benefited net sales by approximately 5% in the 2008 third quarter.

Strong organic growth in net sales was driven by unit volume gains in part due to expanded market coverage in emerging markets such as China and Brazil as well as higher selling prices. We are pleased that Tennant's gross margin was 42.3% for the 2008 third quarter, up from 41.4% in the 2007 third quarter. The 90 basis point increase in gross profit margin was due to a positive impact from selling price increases and lean cost reduction and global sourcing initiatives. These more than offset higher raw material and purchase component costs in the quarter. Foreign currency benefits and sales mix also contributed to stronger gross margins. While we had a nice uptick in the third-quarter margin, we expect pressure on our margins to intensify in the fourth quarter, making this increase difficult to sustain.

It's worth noting that through the first nine months, we have achieved approximately $9 million of gross savings from our global low-cost sourcing and lean manufacturing efforts. You will recall that $9 million was the low end of our savings goal for the year. We now expect to realize savings of between $10 million and $12 in 2008 from these initiatives.

Research and development expense of $6 million in the third quarter was flat with the prior-year quarter. R&D expense as a percent of net sales was 3.2% in the third quarter 2008 compared to 3.7% in the comparable quarter last year. Spending was within our targeted range.

We are developing a stronger cost control culture with the goal of lowering our operating expense as a percent of sales over the next few years. For the quarter, selling and administrative expense was reduced to 30.2% of net sales, or $56.2 million versus 31.5% of net sales in the 2007 third quarter or 30.4% excluding the 2007 third-quarter restructuring charge of $1.7 million.

Included in the 2008 third-quarter selling and administrative expense was $3.7 million related to the Applied and Alfa acquisitions and approximately $1.2 million of unfavorable foreign currency exchange.

The lower selling and administrative expenses in the third quarter was partly due to the first phase of control actions that we instituted earlier this year to better align expenses with sales. These actions included extending our policies to prevent non-essential hiring and reduce discretionary spending on a global basis.

Our third-quarter operating profit was up approximately 64% to $16.4 million compared with the 2007 third quarter. On a percentage basis, our operating margin was 8.8%, up from 6.2% in the prior-year quarter.

The effective tax rate in the third quarter and first nine months of 2008 was 22.6% and 33%, respectively. In the 2008 third quarter, the base tax rate, which excludes discrete tax items, decreased to 36% from the 38.5% we anticipated for the year during the 2008 second quarter. This was due to the current forecasted geographic mix of earnings and favorable current-year tax benefits, primarily from recently completing transfer pricing studies. We also had a favorable discrete tax item in the 2008 third quarter of $0.10 per diluted share, chiefly related to the settlement of the US federal tax examination covering 2005 and 2006, as well as the expiration of the statute of limitations in various jurisdictions and resolution of other tax matters. Tennant's base tax rate for 2008 is now expected to be approximately 36%, down from our previous range of 36.5% to 38.5%. And discrete tax items are anticipated to be insignificant for the fourth quarter.

Our estimate of the full-year tax rate does include recent acquisitions. We anticipate that the base tax rate of approximately 36% will be sustainable in the short-term. We're making good progress on developing a more comprehensive long-term strategy to achieve an even lower base tax rate in the future.

Now turning to the balance sheet, net receivables at quarter end totaled $142 million compared with $114.7 million a year earlier, a $27.3 million increase. Of this, $8.1 million is related to our 2008 acquisitions. The remaining $19.2 million is due primarily to net sales growth over the 2007 third quarter, especially in the last month of the quarter.

Accounts receivable days outstanding was 70 at quarter end versus 65 in the prior-year period. This increase stems mainly from a higher mix of international sales, which carry longer payment terms in North America and selectively offering extended payment terms in all geographies.

Our inventories at quarter end totaled $73 million, up from $63.5 million at the end of the 2007 third quarter. The $9.5 million increase totaled $5.4 million of inventory from our 2008 acquisitions with the remaining $4.1 million from higher inventory levels due to low-cost country sourcing, new product introductions, and higher demo inventory related to the transition of new products.

FIFO days inventory on hand was 89 days at the end of the quarter, the same as in the comparable period last year. Capital expenditures totaled $16.9 million in the first nine months of 2008, which was $6.9 million lower than in the first nine months of 2007. We now expect full-year capital spending in 2008 to come in a bit lower than previously anticipated and be in the range of $25 million to $27 million, including spending related to our recent acquisitions.

The CapEx range also includes our SAP upgrade and related infrastructure enhancements, which we accelerated by one year to improve the ability of our systems infrastructure to expand globally. In addition, we are investing in our Minnesota facilities to create a global R&D center of excellence.

These investments were initiated last year and we are completing them in order to improve our business processes and continue our new product innovation.

During the third quarter, we repurchased approximately 223,100 shares of common stock under the Board authorized 1 million share buyback program. Total cost of the shares repurchased in the quarter was $6.1 million. At quarter end, approximately 289,000 shares remained under Tennant's share repurchase program. We are willing to use our current authorization to buy back the shares remaining and will continue to consider the repurchase of shares whenever we feel our stock is undervalued. We will likely recommend another repurchase authorization to our Board of Directors in the near future.

Tennant's cash and cash equivalents totaled $22.8 million at the end of the 2008 third quarter compared to $23.9 million in the prior-year quarter. We had a debt to capital ratio of 29% at the end of the third quarter compared to 1.8% at December 31st, 2007. The increased debt to capital ratio reflects the drawdown of $97 million from our credit facility during the first nine months, primarily used to fund our Applied and Alfa acquisitions. We have just recently reviewed the banks in our global bank network and remain confident in their continued operating capabilities. At this time, I'll turn the call over to Chris.

Thanks, Tom, and thank you all for joining us this morning. We are pleased to report a solid third quarter, especially given the tough economic climate. During the quarter, we continued to make progress against our strategic objectives. On the growth side, this meant introducing new products and expanding our markets. We also continued to closely monitor our cost structure and leverage our efficiencies. As a result, we achieved sales growth in the quarter across all of our regions, and particularly in our emerging markets, such as China and Latin America. We also continue to drive gross margin improvement through a combination of higher selling prices, cost reduction programs and global sourcing efforts.

Throughout this year, the most significant risks to our performance have been rising commodity costs and continued economic uncertainty in North America and in Europe. With the recent global financial crisis, we have seen the downturn in the US economy adversely impact other regions, most notably, Western Europe.

During this period of economic uncertainty, our approach will be to continue to make selective and highly disciplined investments in our business that are balanced against our current rate of growth and that help protect our overall profitability.

Against that backdrop, I'd like to briefly review the results from our three business regions, discuss our cost control actions and outline our efforts to continue growing the business. But, before doing so, I'd like to note two events for which Tennant received recognition. First, we accepted the prestigious R&D 100 Award in Chicago last week from R&D Magazine for our ec-H2O technology.

ec-H2O was selected by R&D Magazine as one of the 100 most technologically significant products introduced into the marketplace over the past year. And second, Tennant was recently named by Forbes magazine as one of the 200 Best Small Companies for the second year in a row. I'm proud of these accomplishments and I want to commend everyone at Tennant for their role in achieving both of these honors.

Now, turning to our results in North America. As Tom mentioned earlier, we continue to see a longer sales cycle in our North American business with customers delaying their purchases due to the economy. Although third-quarter sales in North America were up slightly versus the prior-year quarter, primarily due to acquisitions and various pricing actions, we continued to experience a decline in unit volume for our industrial and outdoor equipment. It's not surprising that sales of larger, more expensive industrial and outdoor equipment have softened during an economic slowdown. That may be exacerbated by the most recent tightening of credit. We are well positioned as a market leader when activity in this segment regains strength.

At the same time, we're seeing some of the more price sensitive customers migrate to smaller cleaning machines because of their attractive price points. The good news here is that Tennant can compete very effectively and capture this business due to our focus on new product innovation and the launch of more compact products over the past two to three years. I will talk more about our latest products in just a moment.

In our Europe, Middle East, Africa market, third-quarter sales were up 31.4% with organic sales growth of approximately 5% for the quarter and year-to-date periods. Going forward, we anticipate organic sales growth may be flat or even decline due to the widely expected deterioration in Europe's economic condition. However, Tennant remains well positioned in this region with our compact and environmentally friendly products.

Results from our other international markets, which include China and other Asian countries, Japan, Australia, and Latin America were, again among the highlights of the quarter with sales up 61.4%. We are pleased that nearly one-third of the gain in this region came from our Alfa acquisition, with much of the remainder due to higher volume in emerging markets, such as Brazil and China. This performance reflects our investments in these markets.

An investment that we made during the third quarter was to acquire a long-term exclusive distributor of our products in China called Shanghai ShenTan. The move will enable us to accelerate our direct sales and service business to support organic growth in an important region. We expect continued market penetration and expansion in these geographies throughout 2008 and beyond.

Turning now to our cost control and efficiency initiatives. Throughout this year, I've talked about how we are working to tightly control expenses and reduce costs globally due to the economic environment that we are experiencing. The first phase of our plans were put in place earlier in the year and we are beginning to see their benefit. Some of the cost-cutting actions that we have already taken include delays in nonrevenue generating new hires, reduced hours in the plants and a combination of deferrals and permanent cuts in discretionary spending. Additionally, one of our goals was to significantly lower our operating expenses as a percent of sales over the next few years. We made progress here by reducing selling and administrative expenses to 30.2% of net sales in the 2008 third quarter. In the fourth quarter, we will continue to align our cost structure with sales levels. As a result, we have informed employees that we are again reducing production and related employee work hours at our Minneapolis facility, where we make our largest equipment.

This move will help align our inventory levels with current market demands and improve our operational efficiency.

We also remain committed to further leveraging our efficiencies through ongoing global sourcing and lean manufacturing initiatives. As Tom noted, we had generated approximately $9 million in gross savings year to date from our global low-cost sourcing and lean manufacturing combined. And expect to save between $10 million and $12 million this year from these programs. We are continuing to increase the level of sourcing from low-cost regions, moving from 14% in 2007 to 20% by the end of 2008.

At this point, I would like to update you on our progress in building Tennant's growth through market expansion, acquisitions, and new products. The integration of Applied and Alfa remain on plan. We continue to be very pleased with the significant sales generated to date by both of these acquisitions. And, as I noted earlier, we also acquired our distributor in China in order to advance our market penetration there. We will provide further updates on the contributions from these acquisitions going forward.

We're also excited about this year's new products. As I've stated before, new products are a key driver of our revenue growth. We target 30% of Tennant's annual sales to come from new products. Year to date, we have exceeded this goal with 43% of our equipment revenues in the first nine months coming from new products launched over the past three years. Moreover, we have been successful in introducing new products that carry the same or higher gross margins than the ones that they replace.

We continue to be encouraged by the global market acceptance of our new products, most notably in commercial applications. In particular, Tennant's electrically converted water technology, ec-H2O, is surpassing our expectations and is actually exceeding our year-to-date internal projections. We also attribute much of the growth in our walk-behind scrubber line to ec-H2O. Our customers are eagerly adopting this environmentally friendly method of cleaning and this game-changing technology provides an entry point to expand our national accounts business.

During the 2008 third quarter, we completed the final launch of the six new products that we plan to introduce this year. We began shipping another new Tennant-branded product, the T2 scrubber, during the third quarter. The T2 is a small, battery-operated machine designed for use in tight congested spaces.

We also began shipping our newest product family, which is comprised of three products, a scrubber, an extractor and a ReadySpace carpet cleaner. The initial pipeline fill on this product family also is above our expectations.

I talked about the launch of these last quarter, so you may recall that these compact maneuverable cord electric, floor care machines were specifically designed to quickly and effectively clean small, congested spaces in the education, health care, retail, government, and commercial office markets. The products are marketed globally under the Tennant brand as the R3 Carpet Cleaner, the T1 Cylindrical Scrubber and the E5 Carpet Extractor. They are also marketed in North America under the Nobles brand, as the Strive Compact Carpet Cleaner, the Speed Scrub Cylindrical Scrubber and the Speed EX Carpet Extractor.

Built on a common platform, these three products also demonstrate our emphasis on lean manufacturing. These new, smaller and more compact machines have the potential to expand Tennant sales because they extend our reach into market segments where we have been traditionally underrepresented. They offer an attractive price point in this tough economic environment. And, they have a shorter replacement cycle.

Going forward, we remain focused on leveraging our global cost structure, investing in international expansion and developing and launching innovative new products. Despite current macro economic conditions, we are confident in the long-term strength and value creation potential of our business.

Before I turn the call back over to Tom, I would like to officially welcome the newest member of our Board of Directors, Carol Eicher. Carol is Vice President and Business Director for Primary Materials, a $2 billion business of Rohm and Haas. She brings 30 years of expertise in global manufacturing operations and market expansion. And we are very pleased to have the benefit of her knowledge, experience, and insight. Now, Tom will provide a review of our outlook for the remainder of 2008. Tom?

Thank you, Chris. As a reminder, we do not provide quarterly guidance.

Looking ahead to the fourth quarter and beyond, as you will recognize, it's difficult to predict what impact the global financial crisis will have on our customers. Our outlook is based on what we know at this point in time. We now anticipate full-year 2008 earnings in the range of $1.97 to $2.07 per diluted share. This reflects the $0.19 per share net benefit of unusual items recorded in the 2008 third quarter, including benefits from both the foreign currency forward contract settlement net gain, and discrete tax items, and a lower base guidance range for current economic conditions. This range includes the impact of our three 2008 acquisitions, Applied, Alfa, and Shanghai ShenTan, which are expected to continue to be modestly dilutive in the fourth quarter due to economic conditions.

Our outlook for the remainder of 2008 assumes further economic deterioration in North America and Europe, essentially flat organic growth globally, a base tax rate for 2008 of approximately 36% and insignificant discrete tax items for the fourth quarter.

Previously, our outlook for the full-year 2008 earnings per diluted share was in the range of $1.85 to $2.10. Earlier this year, when the global economic conditions were relatively stronger, we believed that we would achieve our goal of 9.5% operating margin in the fourth quarter of 2008. While we still view this as an attainable interim goal, we do not anticipate reaching it this year given the further economic deterioration that we expect in North America and Europe. We still believe our business has the opportunity over the next few years to achieve further operating margin improvement beyond the 9.5% interim goal. We expect to be able to provide an update to our strategic goals when we are in a position to provide annual guidance for 2009. Orders in our fourth quarter to date have been slow and the shaky global economy presents a serious challenge.

Despite the current economic uncertainty, our strategies are working. Our business model is sound. We are well positioned to compete in our global markets and we remain confident in the long-term strength and growth potential of Tennant's business around the world. With that, we would like to open up the call to any questions. Abigail?

(Operator Instructions). Ted Kundtz, Needham.

Thank you. Hello, everyone. A couple questions. One, could you talk about your target for cost reduction next year?

We're not prepared to give a specific target for next year, Ted. What I will say is that on an interim basis, meaning over the next call it three years or so, hopefully sooner than that, we would like to see ourselves get to that operating expense as a percent of revenue target in the 27% range. As you know now, we're more in the 31% range, and that expense is excluding R&D. We view it as a significant opportunity, and it will become an area of focus for us going forward as well as the continued focus against growing the top line, obviously.

Okay. How about the impact -- are you seeing any benefit from the cost deflation going on here? A lot of the component prices may be going down here, and what kind benefit do you think you could get from that environment?

We certainly hope that we see a benefit from that as we go into next fiscal year. What we're seeing right now to date as we're entering the fourth quarter is a couple different things. One, I'd like to remind you that we have been aggressively pushing off cost increases with our suppliers. And we're starting to see some of those increases come at us, even though we are seeing hopefully some deflation in that area in the fourth quarter. But we are -- some of the push-off that we have had, we're starting to see that come and we believe would hit us in the fourth quarter.

The other area that we have fairly significant exposure to is steel, and also to derivatives of oil, being the plastics area and the resins area, and we are not seeing declines in those areas yet. From a steel standpoint and from a resins and plastic standpoint, we're not seeing our suppliers pass on declines to us, and so we aren't seeing those benefits as you might expect yet in the fourth quarter. We do certainly hope that we see some benefit as we go forward next year.

Okay. Yes. I would think you would.

We sure hope so. For sure.

Yes, for sure. Could you talk a little bit about the new product goals for '09, the new product introduction goals for '09?

I think the only thing that -- and I'll see if Chris want to jump in and say more about this -- the only thing that we've talked specifically about is that we do intend to take our ec-H2O technology and expand it beyond walk-behinds and put it on ride machines. And we would anticipate to do that early in the year.

We will continue to have a goal of our new products being in excess of 30% of our revenue from products introduced in the last three years. I am certainly not ready to commit that we will be at the kind of levels we've been this year. But new products will continue to be a really important part of our organic growth going forward.

Yes. We continue to invest in excess of 3% of sales in R&D. The product pipeline remains robust. We have not divulged publicly yet what our plans are for next year. But we hope to have some interesting new products in the marketplace.

Okay. Because you traditionally try to get at what? A half-dozen or so new products out in the market every year, 5 to 6? Something like that?

I don't know if it's -- anywhere between three, between three and eight. If you look back historically, absolutely.

And you expect that as well?

Yes.

And one last question. The D&A went up. Is that going to be the current run rate? You did 6.9 in the quarter in depreciation and amortization, up from $5 million in Q2. Is that the run rate going forward?

It's a fair way to think about it. I mean we will still be -- excluding acquisitions for the year -- we will still be on our base, somewhere in the $20 million to $21 million D&A range. But as you look at it on a run rate basis, the quarter is a fair representation of the future.

Okay. So it did jump up a bit. Okay. Thanks and I will jump back in. Thanks.

Seaver Wang, Utendahl Capital Partners.

I just had a couple questions. With the -- you've done a very good job of diversifying your markets, especially to -- outside of North America. With the strengthening of the dollar, what kind of effects does that have on you? And then just another quick question on margins for the smaller products that people are kind of gravitating to now.

What was the question specifically on the margins, Seaver? I'm sorry, I didn't catch it.

Oh, just are they comparable to the larger --?

Oh, sure. Let me comment on both of those. One, our sourcing -- our strategy overall is to really, as much as possible, to manufacture in the same currency that we sell in. So we would hope that we won't see any material or would not expect to see any material impact on our margins overall as we go forward with the strengthening of the dollar. Clearly on a reported revenue basis, we're not going to have the kind of increases we have been seeing. This quarter, I believe our revenues were up 3% relative -- related to currency. It was about 5% last quarter, and that is certainly going to be quite different in the fourth quarter. But overall, given our strategy, the way we source, we don't see the currency changes having a material impact on our margin structure.

As you go to small product margins, I'm talking generalities here, but our larger equipment tends to have slightly higher margins than our smaller equipment, but it's not significantly different. And we have made great progress over the last several years to continue to enhance the margins of our small products through multiple different efforts, lean, sourcing, higher revenue levels. And now they are still slightly lower, but quite comparable.

But the margins -- obviously, the margins or the profit per unit --?

Is lower. Certainly, yes. I'm talking on a percentage growth margin basis.

What are -- I mean are they going from a $15,000 machine to a $10,000 machine? What's the kind of --?

It's such a wide range, Seaver. It's really hard to comment. As you know, our larger equipment can vary from $20,000 machines up to $180,000 machines. And our smaller equipment is -- can be in that $3,000 range up to a fair amount higher than that. So it's really hard to comment specifically there.

Okay.

Clint Morrison, Feltl and Company.

ec-H20 -- obviously it sounds like it's been very successful and I know you are getting an upcharge and improved margins. Can you give us any kind of sense as to sort of -- what is the additional sort of profit and pricing you are getting on that new technology? And has your thoughts changed at all with it being accepted as aggressively as it appears to have been?

I will comment on a couple pieces of that and see if Chris has anything to add to that. We are -- we still continue to believe we will get an up-charge for the product. It varies fairly dramatically given the price of the equipment that we're selling. But it's somewhere north of a 15% up-charge. And we hope that on a sustainable basis, it will be higher than that. But we do firmly believe we will get an up-charge from it.

The other side is that it's part of our strategy as we introduce products with new technology that the products they are replacing will have higher gross margins. And we anticipate that products with this technology on it will have higher margins than our products that don't have it.

Okay. Mechanical question. I noticed your goodwill intangibles drop about $10 million from the last quarter. Was there a re-evaluation? Or what went on there?

Do you want to comment, Karen?

Sure. We had our valuation report completed for Applied acquisition and we did end up with a larger intangible value, primarily related to the valuation for the UK customer list. So there was an increase in the intangible for that. And similar to the previous question, we did then also have a corresponding uptick in our amortization expense.

Okay. Thank you.

Ted Kundtz, Needham.

I had a few follow-up questions. Are you seeing any pricing pressure on your existing equipment? You mentioned a shift of people going to maybe some lower-cost equipment, but how about any pricing pressure from your competitors?

We -- and this is obviously always a generalization. We continue to believe we're going to be able to hold our pricing. And our pricing benefits on a global basis have been in, certainly in the high 3% range and I can't say for sure we're not going to get pressure there. But to date we do believe we're going to hold onto the pricing benefits that we have had through the first nine months of the year into the fourth quarter.

Okay. And just a second question, is your current cost structure, at least the way you're targeting it for the fourth quarter, kind of in line with a forecast for a zero growth, organic growth, kind of a no, zero, unit growth type environment?

We are assuming that essentially we will see flat organic growth. Obviously, the acquisitions will add onto that. And what I would say the easiest way to comment on the operating expense side of that, would be Ted, we'll continue to spend within range on R&D. So we will continue to be somewhere within the 3% to 4% on the R&D side. On the rest of our operating expenses, we should be somewhere between a percentage point to 1.5% lower than prior year. So we will see in the fourth quarter some acceleration of our operating expense -- our lowering of our operating expense as a percent of revenue, as we see more of the full benefits of our actions. And yes, we are as prepared as we can be for a no-growth kind of environment in the fourth quarter based on the way things have started out.

Okay. Have you -- can you share any thoughts about your next-year outlook at all in terms of the -- are you still thinking the same way the rest of us are thinking?

Yes, I sure wish we could. We're just -- we're not prepared to do that. We certainly would anticipate that we provide our point of view on next year in our next call, which is what we've typically done. So I wish we could, but we -- we're just not prepared to do that. A lot of companies are.

I guess if we go into a more sharper slowdown in the early part of next year, are you prepared to just cut costs further?

Yes.

Do you have a contingency plan in place to do that?

We absolutely have a contingency plan. We've been -- we honestly, as we talked before, we entered the year too aggressively from a top-line growth standpoint. We put together detailed plans that would -- we will be prepared to execute if, depending upon the length of the downturn and how it plays out. And we are very serious about the fact we've worked extremely hard over the last couple of years to not only take our gross margins up, but also improve our operating margins. And if the economy gets tough, we're going to work like heck to make sure we maintain the gains that we've had over the past few years.

Okay. And do you think your cost reduction effort in the global outsourcing, could it be the same relative number as it is this year? Is that still a possibility? Is that still on plan to continue that effort?

Yes, what I would say is that -- and we haven't given the specific numbers embedded in the $10 million to $12 million, but what I would say is that given the strength of our low-cost sourcing efforts, we believe that we can have another year of maintaining that savings level and having a similar savings level next year. So we feel we're very bullish on our sourcing efforts.

Terrific. Okay. Thank you.

James Bank, Tennant Company.

That's Sidoti & Co. I was wondering -- I know you can't quantify '09, but I was wondering if you could qualify it a little bit more? Obviously you're a GDP plus company. We can all see what's going on out there, but I would like to know, what was the weight in your environment back in the 2002, 2003 time with building service contracts versus the weight now?

Yes, all we could really comment there is really small. Building service contractors weren't even on our radar screen during the last economical downturn. So it's very different today than it was back then.

We were a predominantly industrial equipment company. Our commercial product offering had not really been developed. We had very, very slow part of our sales in that segment of the market and we hadn't really expanded internationally yet either. So we're a much more diversified business today with building service contractors still -- I still think we're underrepresented in building service contractors, and so it's a big growth opportunity for us, which is a good thing in this environment because they tend to maintain their cleaning contracts and have to buy equipment to maintain those contracts, and they are increasingly buying from us.

So how does that work? Does the national account come to you and purchase the equipment? Or does, hypothetical, an ABM come to you and purchase the equipment, because they're the ones who had serviced or contracted this (multiple speakers) contract?

Generally it's the building service contractor that comes to us and purchases the equipment. There are some end users, end user national accounts that either own the equipment or they specify the equipment that the BSC needs to buy.

But one of the things we are doing increasingly is that we're working both with the end user and with the BSC to ensure that we can provide the best solution for both. And we haven't done that historically. The last three to four years, our focus has been on the BSC segment and not really focusing on end users. I think we're getting a lot of benefit from working both sides of that equation.

What percentage of your sales right now, if you had to guess, would be building service contracts versus as you put it, the old industrial channel?

We haven't provided that breakout yet, James. I mean what we can say is right now to date, our revenue growth with building service contractors on a global basis is our fastest-growing part of our business. So it is a very important part of our business. We remain underrepresented and it's a fastest-growing element of our business, and a really important part of our future and we think is one of the main reasons why we'll continue to hold up significantly better than we did in previous tough economical times.

Okay. Now, to start the year, was your guidance -- your earnings guidance, was that GAAP?

Yes.

It was? Okay. So it has been GAAP for --

We've been consistent in trying to -- I shouldn't say trying -- into providing the details within the GAAP numbers, but the actual guidance numbers in all three where we started the year, where we provided last quarter and where we're right now are all GAAP guidance numbers.

Okay.

And hopefully the schedule that we'd provided on the release will allow you to pretty simply go between reported numbers and taken out -- meaning GAAP -- and the unusuals are within those numbers. Both on last year and this year.

Now, within the quarter, neither Applied or Alfa was dilutive to earnings?

Yes, we were actually diluted by about $0.01 from both the transactions in the quarter.

All right, so $0.05 in the first quarter, and what was it, about $0.02, or $0.03 in the second?

Yes, we're at about $0.07 through the first nine months from a dilution standpoint.

Okay. And how many shares were repurchased in the quarter?

223.

Okay, so year-to-date?

Does anybody have that number handy? We'll have that number in just one second here. My memory is not that good.

No, that's okay. And is that anything -- what's left on that program?

Year to date, we bought 450,000 shares and we have 289 remaining on it.

Okay. And then, sorry to jump around a little bit, but the replacement cycle for your equipment side, what does that tend to be? Can be as detailed or granular as you want or (multiple speakers)

You know, it's so diverse depending upon the value of the equipment, the type of equipment, the environment that it's used in this. But if you picked a round number in the five to six-year range would be a reasonable way to think about the replacement cycle. But again, there can be pieces of equipment that are smaller and used 24 hours a day. They can have a very quick replacement cycle. There can be larger industrial type equipment that when used appropriately and not in as tough of an environment that will easily last in excess of 10 years. So it's really broad.

Okay. All right, terrific. That's all I have. Thank you.

Robert Damron, 21st Century Equity.

[Mark Zinsky] actually. Just two quick questions. First of all, could I get some scope on how China is going in terms of efficiencies there? And in terms of the market, commercial real estate apparently is slowing down a little bit there. Are you seeing any impact from that? Or is it that the expansion is so new that that's really not having an impact on you?

And then secondly, in terms of your variable interest rate on your long-term debt, is that's bumping up now?

Yes. Chris will take China and then we'll talk about the interest rate here.

In China, the majority of our sales in China are still our big equipment sold into customers that have migrated manufacturing facilities and other operations to China. So that's still the majority of our business. We are -- we now have a product portfolio of low-cost commercial equipment for the first time and we're just beginning to penetrate the commercial marketplace. So even with a slowdown versus historical growth rates, we are so underrepresented, we -- at least for now, we should be able to see a decent growth even in the current environment.

Okay.

From an interest rate standpoint, we are LIBOR plus on our facility, so we have seen a slight uptick in our interest expense. So we will -- we should see a slightly higher interest cost in the fourth quarter relative to the third quarter.

Great. That's it. Thanks a lot.

This concludes the question-and-answer session. Please stay on the line for final comments from the management team.

Thank you for your time today and for your questions. We are pleased with the continued progress on all of our key strategies and initiatives. Despite the current macro economic conditions, we remain confident in our business model and are firmly committed to the long-term strategic direction that we have established. We believe a continued focus on our strategies and international market expansion, new products and operating efficiency gains, coupled with strong cost controls, positions us for long-term success. We look forward to keeping you posted on our progress. Take care.

This concludes your conference call for today. You may now disconnect.