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0,1000041-nupathes-ceo-discusses-q2-2013-results-earnings-call-transcript.html,NuPathe,PATH,healthcare,2013.0,,individual,"November 12, 2012",8:30 a.m.,2012-11-12T13:30:00.000Z,20204,12302,7902,3,3,"['John Woolford - IR', 'Armando Anido - CEO', 'Keith Goldan - CFO']","['Michael Schmidt - Leerink Swann', 'Elliot Wilbur - Needham & Company', 'Annabel Samimy - Stifel Nicolaus']","**Operator**

Good morning, ladies and gentlemen, and welcome to the NuPathe's third quarter
2012 earnings conference call. [Operator instructions.] As a reminder, today's
call is being recorded. It is now my pleasure to turn the conference over to
turn the call over to Mr. John Woolford. Please go ahead sir.

**John Woolford**

Thank you, operator, and good morning, everyone. With me on today’s call are
Armando Anido, chief executive officer; and Keith Goldan, vice president and
chief financial officer. Terri Sebree, president; and Jerry McLaughlin, chief
commercial officer, will also be joining us for the Q&A portion of the call.

We issued a press release detailing third quarter 2012 financial results this
morning. For those of you who may not have seen the release, it is available
on our website at www.nupathe.com, in the Investor Relations section.

The format of today's call is as follows. Armando will begin with an overview
of recent corporate highlights. Keith will then provide a summary of our
financial results for the quarter, and Armando will end the prepared remarks
with a brief closing, followed by a Q&A session.

Before we begin, I would like to remind you that we will make various remarks
during this conference call that constitute forward-looking statements. All
remarks that are not historical facts are hereby identified as forward-looking
statements and include, among others, statements regarding our ability to
obtain FDA approval and commercial partners for Zecuity and the timing of such
events, potential benefits and commercial prospects of Zecuity, sufficiency of
our cash to fund debt service and interest obligations and continue operations
into the fourth quarter, and our plans, objectives, expectations, and beliefs
regarding future operations, performance, financial conditions, and other
future events.

Forward-looking statements are subject to numerous risks, uncertainties, and
assumptions that could cause actual results to differ materially and adversely
from those reflected in the statements, including those factors discussed
under the heading of Risk Factors in our Form 10-K for the year ended December
31, 2011, which is on file with the SEC and available through the Investor
Relations section of our corporate website.

As a result, you should not rely on any such forward-looking statements. While
the company may elect to update forward-looking statements from time to time,
the company specifically disclaims any obligation to do so. Also, today's call
may not be reproduced in any form without our expressed written consent.

I will now turn the call over to Armando Anido, Chief Executive Officer.
Armando?

**Armando Anido**

Thank you, John, and thank you all for joining us this morning. Over the last
few months, we have made significant progress. On our last call, I outlined
four key priorities for the next 12 months that are designed to increase
shareholder value.

First and foremost was to secure the necessary financial resources to achieve
these objectives. In October, we completed a $28 million sale of securities.
The securities were sold as units, each consisting of 1/1000 of a share of
newly designated series A preferred stock, and a warrant to purchase one share
of common stock. The purchase price per unit was $2.

In conjunction with the financing, we restructured our outstanding debt, and
undertook cost containment measures to further extend our cash runway. The
cost containment measures included a reduction in workforce, a reduction of
expenditures relating to commercialization activities for Zecuity, and a delay
in the filing of an IND application for MP202 until a codevelopment partner is
obtained.

Collectively, these actions served to focus the company on the most important
objectives for creating shareholder value: obtaining FDA approval for Zecuity,
securing commercial partners, and conducting additional prelaunch activities.
All told, we now have the financial resources to achieve these objectives.

Going forward, our first priority is to work closely with the FDA to obtain
approval of Zecuity. Our team did an outstanding job addressing the questions
contained in the FDA’s complete response letter, and during the quarter our
NDA was accepted by the FDA with a PDUFA date of January 17, 2013.

We have had regular interactions with the FDA since filing, and remain
confident in the approval of Zecuity. As I stated last quarter, we believe the
product enhancements we made before resubmitting the NDA have resulted in an
even more compelling product for migraine sufferers. Just as importantly, we
are actively pursuing U.S. and rest-of-world commercial partners for Zecuity.

As the first and only migraine patch, Zecuity is uniquely positioned to
address the significant unmet disease burden of migraine-related nausea and
vomiting, and is an attractive, specialist-driven, near-term commercial
opportunity. We believe the game-changing disruptive technology employed by
Zecuity will provide it with a long patent protection. We expect that a
partnership will occur after FDA approval.

Our other priority is to conduct additional prelaunch activities that build
upon the extensive launch preparations we have completed over the past two
years. We believe the patch has the opportunity to change the treatment
landscape for migraine, by making a tolerable, non-oral triptan therapy
available to the over eight million patients who frequently experience
migraine-related nausea and vomiting.

Our confidence stems from 1) our continued dialogue with our scientific
advisors, 2) recent data from a landmark study pointing to the significant
disease burden associated with migraine-related nausea and vomiting, both in
decreased patient satisfaction and markedly higher healthcare costs, and 3)
the consistent feedback from our physician and patient research that Zecuity
is uniquely positioned to address both headache pain and migraine-related
nausea and vomiting.

As we progress toward an approval for Zecuity, we are well-prepared for
commercialization. This includes market research with well over 700
physicians, more than 800 patients, and pharmacy and medical directors from
insurance companies accounting for more than 130 million covered lives in the
United States.

We have built a detailed field sales launch plan, including completion of
physician targeting, sales territory identification, and a sophisticated
geotargeting model that will allow us to optimize our marketing dollars by
geographic location. We have a managed care strategy to obtain reimbursement,
but it’s highly consistent with our brand strategy and product positioning.

In addition, we have constructed and are ready to implement our commercial
operations infrastructure, in which we are leveraging the latest technologies
to operate efficiently with seamless integration.

For our marketing efforts, we have finalized our branding and have a clear and
well-defined product positioning and messaging platform focused on migraine-
related nausea and vomiting that is impactful and well-differentiated from all
available and developing migraine treatment options.

As an example of our ongoing initiatives, later this week we will participate
in the American Headache Society Scottsdale Headache Symposium. We will
conduct an advisory board with many of the thought leaders in headache, and
host a scientific affairs exhibit booth where symposium participants can
interact with our R&D leadership team.

I’m also excited to share that the Zecuity Phase III pivotal placebo-
controlled trial was just published in the October edition of Headache, the
premier journal for headache specialists in the United States. The publication
highlights that Zecuity rapidly relieved both headache pain and migraine-
related nausea within one hour, with a very low incidence of triptan
sensations. As a result, this trial serves as the basis of the Zecuity NDA.

As you can see, we’ve been quite busy focusing on our key objectives. At this
point, I’d like to turn the call over to our CFO, Keith Goldan, to review our
financial results. Keith?

**Keith Goldan**

Thank you, Armando, and good morning everyone. We filed our form 10-Q on
Friday afternoon, and issued a press release detailing financial results for
the third quarter 2012 earlier this morning. NuPathe reported a net loss of
$6.2 million, for the third quarter of 2012, compared with a net loss of $7.3
million for the third quarter of 2011.

For the third consecutive quarter, operating expenses totaled just under $6
million, while clinical and regulatory expenses were lower in this most recent
quarter, due to the resubmission of the Zecuity NDA in July. This decrease was
offset by accruals for severance costs related to the separation of our former
CEO in July, as well as the reduction in force in September. As we recorded
all of these related severance costs in the third quarter, we expect to begin
to recognize the benefit of lower operating expenses beginning in Q4.

Research and development expenses were $2.2 million in the third quarter of
2012, compared with $3.9 million in the comparable quarter of 2011. The
decrease was largely attributable to reduced spending related to Zecuity,
NP201, and NP202 during the 2012 period, combined with the fact that the 2011
period included higher CMC expenses related to the purchase and manufacture of
clinical supplies for Zecuity.

Selling, general, and administrative expenses were $3.5 million in the third
quarter of this year, compared with $3.0 million spent during the same period
last year. The increase in 2012 can be attributed to separation expenses
accrued in Q3 as I mentioned earlier, partially offset by reduced activities
in commercial operations during the third quarter of 2012.

Net cash used in operating activities for the nine months ended September 30,
2012 was $15.1 million, primarily as a result of spending for normal operating
activities, costs incurred for the resubmission of the Zecuity NDA, as well as
other expenditures for the continued development of Zecuity. During that same
period, we also used $0.3 million of cash in investing activities and $6.4
million of cash for financing activities related to contractual debt
repayments.

As of September 30, 2012, NuPathe had $1.3 million in cash and equivalents,
and a working capital deficit of $7.6 million, compared with $7.5 million in
cash and equivalents and a working capital deficit of $4.9 million at June 30,
2012.

As Armando mentioned earlier, in October, subsequent to the end of the
quarter, we raised $28 million in gross proceeds from a security offering.
That financing resulted in net proceeds of $26.3 million, and we now expect
our existing cash and equivalents to be sufficient to fund operations, debt
service, and interest obligations into the fourth quarter of 2013.

I’ll now turn the call back over to Armando for closing remarks.

**Armando Anido**

Thanks, Keith. In conjunction with the financing, we also made some changes to
our board. Jim Datin, executive vice president and managing director, and
Brian Sisko, senior vice president and general counsel, both from Safeguard
Scientifics, as well as Richard Kollender, our partner at Quaker Partners,
were appointed to our board of directors on October 23, 2012.

At the same time, Jeanne Cunicelli, investment partner at Bay City Capital,
and Dr. Gary Kurtzman, senior vice president and managing director at
Safeguard, both resigned from the board.

We are pleased to welcome Jim, Brian, and Richard to our board. Given their
backgrounds and expertise, we expect them to contribute significantly to our
future success. I’d also like to take this opportunity to thank both Gene and
Gary for their valuable contributions and dedication to the company over the
past six years.

Again, it’s been quite a successful last few months for NuPathe. We realized
two important achievements. The company received FDA acceptance of our NDA for
Zecuity, and we strengthened our balance sheet.

These achievements leave us well-positioned to focus on our key objectives:
obtaining FDA approval for Zecuity, securing commercial partners, and
conducting additional pre-launch activities. We look forward to the January 17
PDUFA date, and remain confident in both the approval and commercial prospects
for Zecuity. We again thank all of our stakeholders for their continued
support.

With that, we’re now happy to take questions. Operator, please begin the Q&A
session.

","**Question-and-Answer Session**

**Operator**

Thank you. [Operator instructions.] And we’ll go first to Michael Schmidt at
Leerink Swann.

**Michael Schmidt - Leerink Swann**

I just had a question on manufacturing. Can you remind us of your long term
expectations on gross margin for the product? And what’s your plan with regard
to building launch inventory? Have you started accumulating product already
for the launch? Or are you waiting until after FDA approval to actually ramp
up manufacturing?

**Armando Anido**

Let me take the first one, and it’s around launch inventory. We will actually
not be producing any launch inventory ahead of approval. I think it’s prudent
from the standpoint of being able to conserve our cash appropriately. And once
we do receive approval, we will start the production of launch quantities at
that point.

From the standpoint of gross margin, let me have Keith fill you in on that.

**Keith Goldan**

I think consistent with what we’ve said in the past, we would expect gross
margins on Zecuity to be consistent with other commercially successful
patches. Obviously we expect some volatility in the beginning around launch,
but we would expect, within some time, to be right in line with other
commercially successful patches, which are typically in the 60s and 70s in
terms of percentage.

**Operator**

We’ll go next to Elliot Wilbur at Needham & Company.

**Elliot Wilbur - Needham & Company**

Armando, can you just talk in general terms about launch readiness? Obviously
given the reduction in personnel, I would assume that some of those people or
some of that was tied to some commercial folks, so I’m just sort of curious
when and how ready you’ll be, assuming approval, in mid-January.

**Armando Anido**

I think as I addressed in the presentation, the prepared remarks, there’s a
lot of work that had been done previous to our fundraising that we just
completed on the commercial front, and a lot of preparation already was in
place. Yes, there were a few commercial folks that were reduced, but we think
that at approval, we will be able to ramp up and ramp up relatively quickly.

Let me have Jerry McLaughlin, our chief commercial officer, actually address
some of the things that were done ahead of time, and then some of the ongoing
things that we have going.

**Jerry McLaughlin**

From a physician standpoint, we’ve completed our branding, our brand
positioning, quantitative segmentation, the messaging, so we’re really on that
precipice of being ready to put together our launch materials that will
support us once we have approval. And from a sales force standpoint, we’ve
already aligned the territories, put the training programs in place, and we’re
ready to go.

And we’ve taken it a step further with, as Armando mentioned in the remarks, a
geotargeting approach that we believe will be a competitive advantage that’s
going to allow us to allocate our resources more efficiently and be more
effective at launch.

What this model has done, it’s taken things like physician prescribing, but
not stopping there. Beyond that, including things like concentration and
importance of headache centers, patient demographics. As many know, our
demographic skews heavily toward female and the 25-50 year old range. And we
also look at things such as income and average copays. We look at cost of
local media. And last but not least, we’ve overlaid the entire managed care
landscape based upon our market research and also analogs.

And what that allows us to do is really allocate those resources at launch to
those geographies where we have the best environment from a physician,
patient, and payer standpoint to drive the launch, and be in a position to
shift accordingly. So we feel like we’re in pretty darn good shape, and we’ll
be ready to launch at a time point that’s not too long after approval.

**Elliot Wilbur - Needham & Company**

Is there anything you can or would be willing to share at this point in terms
of back and forth with the FDA that can speak something to degree of
confidence in success on the PDUFA date?

**Armando Anido**

I think that, as I mentioned in the prepared remarks, we’ve had good ongoing
dialogue with the FDA. I think we felt very good about the package that we
submitted to them. I think we had addressed all of the issues that they had
put forward in the complete response letter. And I think that what we’re
seeing is a very normal back and forth at this particular point. We still
believe the product will get approved. And I think nothing at this particular
point would indicate otherwise, that we’re doing anything other than going
toward approval.

**Operator**

[Operator instructions.] And we’ll go next to Annabel Samimy at Stifel
Nicolaus.

**Annabel Samimy - Stifel Nicolaus**

I guess on the back of the last two questions, what I’m hearing is that you’re
not preparing any launch materials before approval. And, you know, you had
taken some cost reductions in terms of commercial and maybe R&D activities. So
exactly how prepared are you to be able to launch this yourselves, if in fact
a partner is not there in the time that you need? And are you really in a
position to be able to launch this yourself if that partner is not there?

**Armando Anido**

Yeah, I think we would be in a position to launch by ourselves. Remember that
from approval until we’re able to launch is going to require several things.
One is I think we’re probably going to end up needing some incremental money,
is an important piece for us. I think secondly we will have to produce the
launch quantities, which will take some time, and is probably the critical
path item.

We have prepared the launch materials to a point where getting them ready to
submit to the formerly known DDMAC is something that could happen relatively
quickly after approval, once the final label is adjusted and we know what it
is. And then the hiring of the commercial team, post that, is something that I
think we would be able to ramp up and do relatively quickly.

I do want to point out though, we are searching for a partner. We are actively
in conversations. We think that a partnership will help to maximize the
overall value of Zecuity, and I think that even though we’re prepared to do it
in the specialist community on our own if we need to, I’d much rather be going
out with a partner that allows us to really optimize this brand.

**Annabel Samimy - Stifel Nicolaus**

Would you require another raise if in fact the partner is there shortly after
approval?

**Armando Anido**

You know, the timing of a raise and the like I think is something that we
don’t like to comment on. I think that the amount that we raise now obviously
would not be sufficient to do a highly effective launch, but would allow us to
do all of the work ahead to get ready. I think that at approval we are going
to be in conversations with various partners, hopefully with a partner that
brings us some non-dilutive up-front cash that allows us to effectively launch
this in combination with them.

**Annabel Samimy - Stifel Nicolaus**

And just one more question, when you mention you’ll be prepared to launch
shortly thereafter, or rather quickly, can you just characterize that a little
bit? Is that a quarter? Is that two quarters? Can you give us a sense there of
when we might think about adding sales to our projections?

**Armando Anido**

I think you should be thinking about fourth quarter of 2013 for the launch. I
think the manufacturing process takes some time to get ramped up and ready to
go, and I think that’s probably our critical path item.

**Operator**

And at this time we have no further questions. Mr. Anido, I’ll turn the
conference back over to you for any closing remarks.

**Armando Anido**

Thank you very much operator, and thank you all this morning for joining us.
We look forward to continuing to update you again in the coming months. Have a
great day.

![SeekingAlpha](https://static3.seekingalpha.com/assets/og_image_192-59bfd51c9fe6af025b2f9f96c807e46f8e2f06c5ae787b15bf1423e6c676d4db.png)

",SA1000041,,2012-11-12 13:30:00+00:00,2012-11-12,['PATH.O^B14'],21475004241,PATH.O^B14,US,325412,Manufacturing,Chemical Manufacturing,56201040,Healthcare,ORD,,,,,,,,,False,
2,1000191-sky-mobi-limiteds-ceo-discusses-f2q13-results-earnings-call-transcript.html,Sky-mobi Limited,MOBI,technology,2012.0,,regular,"November 12, 2012",08:00 am,2012-11-12T13:00:00.000Z,23019,17541,5478,3,1,"['Michael Tao Song - Chairman and Chief Executive Officer', 'Carl Yeung - Chief Financial Officer', 'John Harmon - CCG Investor Relations']",['Andy Yeung - Oppenheimer & Co.'],"**Operator**

Good morning. My name is Felicia and I will be your conference operator today.
At this time, I would like to welcome everyone to the Sky-mobi’s Second
Quarter Fiscal Year 2013 Earnings conference call. All lines have been placed
on mute to prevent any background noise. After the speakers’ remarks, there
will be a question-and-answer session. (Operator instructions).

Thank you. Ms. Harmon, you may begin your conference.

**John Harmon**

Thank you, operator. Good morning, and good evening everyone, and welcome to
Sky-mobi’s Fiscal Second Quarter 2013 Earnings conference call. With us today
are Sky-mobi’s Chairman and Chief Executive Officer, Mr. Michael Song, and
Chief Financial Officer, Mr. Carl Yeung.

Before I turn the call over to Mr. Song, I would like to remind our listeners
that in this call, management’s prepared remarks contain forward-looking
statements, which are subject to risks and uncertainties, and management may
make additional forward-looking statements in response to your questions.
Therefore, the Company claims the protection of the Safe Harbor for forward-
looking statements that is contained in the Private Securities Litigation
Reform Act of 1995. Actual results may differ from those discussed today and
therefore we refer you to a more detailed discussion of the risks and
uncertainties in the Company’s filings with the Securities and Exchange
Commission.

In addition, any projections as to the Company’s future performance represent
management’s estimates as of today, Monday, November 12, 2012. Sky-mobi
assumes no obligation to update these projections in the future as market
conditions change.

To supplement its financial results presented in accordance with IFRS,
management will make reference to certain non-IFRS financial measures, which
the Company believe that provide additional information to understand Sky-
mobi’s operating performance. A table reconciling non-IFRS financial measures
to the nearest IFRS equivalent can be found in the earnings press release
issued yesterday.

For those of you unable to listen to the entire call, a recording will be
available via webcast at the company’s Investor Relations section of Sky-
mobi’s website.

And now it’s my pleasure to turn the call over to Sky-mobi’s Chairman and CEO,
Mr. Michael Song.

**Michael Tao Song**

Thank you, John. Welcome everyone, and thank you for joining us today to
review our Fiscal Second Quarter 2013 results. We are pleased that our results
came in within guidance. With the market transitioned to the mass market
smartphones continue to accelerate and it is reasonable to expect that our
feature phone revenue continue to decline, against the background, we have
been able to increase our ARPU business and continued introduction of new
social games.

More importantly, we are executing well in our plan to build 70% presence in
smartphone market. We are putting the ecosystem in place to be one of the very
sizable user-base which enable us to build a profitable business as this
market is getting scaled. Our revenues for the third quarter were $22.3
million down about 19.3% year-over-year, with this trend feature phone market
declined by about 30% or more year-over-year for the quarter.

Confirming that, we continued to outperform to the macro-market, app store
downloads were $650,000 million downloaded by 22% year-over-year. Mobile
community carrier independent revenue throughout the third party channels,
including concurrency, increased by 14% to $5.9 million representing 26.3% of
total revenue.

Beyond the feature phone revenue the primary business focus of Sky-mobi
capture the growing mass consumer smartphone market. Our strategy is simple,
to build a large-scale user traffic across the smartphone products and then
monetize this traffic user again. The mainstream market of Chinese mobile
users, often do not have regular access to a PC or a (inaudible), for these
users their phone is their primary source of communication and entertainment.

This market is just starting to take off as the next generation of low-priced
smartphone begin to hit the market. We expect that, the next few quarters
we’ll see dramatic growth in this market and that we target. The new
generation of low-priced smartphone in the RMB 300 to RMB 1000 range is
scheduled to hit the market in volume around the Chinese New Year and
accelerate in growth into the second quarter of next year.

We have positioned ourselves by building a comprehensive ecosystem around the
specific players serving the mainstream mobile market. We now have partnership
with 78 partners in place including mobile phone manufacturers, design houses,
and distributors.

We are committed to pre-install our app store on their phones, this include a
major player such as the Lenovo, [Genair], [Dovi] and et cetera. As a whole
over 80% of handset manufacturer partner that worked with us in the past that
are now producing low-cost smartphone are pre-installed on smartphone
products.

Another important component in building our user traffic in addition to pre-
installed is offline retail store. There are three main channel for the
handset sales in China, namely carrier, large consumer electronic retailers
and nationwide mobile phone retail chains. The 500,000 of household retail
store located throughout china are (inaudible) for the over 60% of our handset
sales. Well carrier retail capture about 14%. We are penetrating this offline
network of retail partner who will enable us to position Sky-mobi directly at
the point of scale, where we can enable consumer to directly load their new
phone with app and games outside.

We’re expecting to make announcement in the near future on partnership with
one of the largest and the most recognized electronic chains in China. And
make way to 60% of Chinese handset sales which top mobile carrier to make way
into the remaining 40 of the handset sales. With this retail footprint, we
believe there are future possibilities around those online to offline model
other than distributed apps including location-based e-commerce service.

As of today, we have successfully acquired 3 million smartphone users, we are
using our app store and their number is growing. In September we are adding
20,000 users per day, by October we are adding 40,000 per day and in December
we’re targeting over 100,000 new users per day. Our target is reaching the
stable base of 20 million quickly. At which point we believe we are going to
be one of top mobile application distributor in China, and it can begin to
effectively monetize our user base, primarily through the mobile social games.

On the monetization side the games will continue to be primary way users are
willing to spend money. Our mobile monetization model is one of combined
[start] development and operate games with (inaudible) model with leading game
developers as distributor, operator, a well [prom] model in PC game market.

We now have 150,000 apps available on our smartphone app store. With the new
apps added every day, we found that there is a very high degree of interest
from apps developers in beginning on our platform given our strong track
record in app distribution and the payment, which generated over RMB 1.5
billion revenue, shared from our partners in the last five years. Expecting
(inaudible) to realize this highlight smartphone (inaudible), 80% of our
employee are now dedicated to smartphone opportunities, up from 60% in the
previous quarter.

In summary, we believe that Sky-mobi doing the best position job of the
transition from the feature phone to smartphone in China. We help you with a
strong ecosystem to spot our position in smartphones and we (inaudible) press
for the mass market to begin shipping in the December, January timeframe,
which will expand the market. Moreover we expected a major (inaudible) in the
app market where many current smartphone app store in China will leave the
market. And we think the social game will begin the primary source of revenue.
We believe our payment platform and the distribution, a major competitive
advantage and we are building our game portfolio to drive revenue as these
markets scales.

With that, we will turn the call over to Carl Yeung. He will discuss the
fiscal and business overlook in more detail. Carl, please.

**Carl Yeung**

Yeah, thanks a lot Michael. As Michael commented Sky-mobi business model is
currently in the state of transition, as the installed base of feature phones
where we are the number one player, is being rapidly replaced by the next
generation of smartphones.

In the early stages, smartphones were primary target of higher to middle
income consumers, as prices have declined to the range of below RMB 1,000 we
have started to see more mainstream market penetration. We believe that we
have done a great job in managing the transition in our legacy business, given
the nearly doubling in upcoming community ARPU over the past 12 months.

We launched four new social games in the second quarter, which helped us to
increase our committee ARPU from RMB 1.60 in second quarter last year to RMB
2.69 in the first quarter to now in the second quarter RMB 3.17. We believe
this progress validates our strategy of focusing on social game-based revenue
model and underscores our ability to effectively monetize our user base.

We are minimizing further resource allocation into the feature phone business,
while using the cash-flow generated to finance the growth market in
smartphones. Our first stage was to build a comprehensive ecosystem and
product offerings for smartphones. We believe we have been successful.

Our second stage is to scale-up the user base rapidly, which we expect to see
over the next few quarters. Our first stage with will then be to monetize this
user base. We believe that we have unique ability to accomplish this given our
payment platform, which is very difficult for competitors to replicate. While
we execute this strategy, we are being financially responsible in how we run
the business and to minimize our cash burden. We have a very strong financial
position to sustain the business as we move towards these new revenue streams.

Now turning over to our financials for the quarter, as a reminder, we disclose
revenue from two perspectives, by sources and by business unit. In the
interests of time, I will limit my discussion today to revenues by source. As
we believe, it is a more useful way for investors in analyzing and
understanding our collection model.

The breakdown of revenue by business units can be found in the press release
issued earlier. In addition in the discussion and analysis of cost of revenues
and operating expense which are primarily focus on non-IFRS results, as we
feels this is more useful for investors in understanding our operations and
performance.

Our total revenue for the second quarter of 2013 declined 19.3% to RMB 139.8
million or approximately $22.3 million compared to RMB 173.2 million in the
second quarter of 2012. Revenues collected from carrier channels were RMB 99.4
million or $15.8 million in the second quarter of 2013 representing 71.1% of
total revenues. These revenues decreased 30.9% year-over-year. Sky-mobi had
3.1 billion user visits and 657.2 million downloads of applications and
content from the Maopao application store in the second quarter, down 37.8%
and 22.2% respectively compared to the same quarter last year.

The decrease in application store user activity and downloads were primarily
due to the shrinking market share of feature phones, as a percentage of
overall mobile devices in China. Our average number of concurred online
members remained stable at about 142,000, slightly up from 140,000 in the
first quarter of 2013. Revenue collected from third party channels grew by
39.8% to RMB 36.8 million or $5.9 million and contributed 26.3% of total
revenues. Sky-mobi’s mobile community had 15 million active members and 778.4
million member log-ins in the second quarter of 2013, compared to 16.7 million
active members and 1.4 billion member log-ins in the same quarter last year

The reduction in log-ins reflected our transition away from social media
functions which we found did not generate meaningful revenues towards social
games which we can monetize successfully. Revenues from the Maopao community
increased due to increased spending per active member deriving from two of our
most popular mobile social games again Fantasy of the Three Kingdoms and Fairy
Magic World.

We expect that revenues collected from third party channels will contribute a
steady and increasing percentage of total revenues in future quarters as we
focus on growing our active mobile community member base and on diversifying
revenue collection methods away from traditional carrier based payment
channels.

Total cost of revenues in the second quarter of 2013 decreased 8.5 % to RMB
105.5 million or $16.8 million as compared to RMB 115.2 million a year ago.
Total non-IFRS cost of revenues in the second quarter of 2013 decreased 8.6%
to RMB 104.5 million or $16.6 million as compared to RMB 114.3 million in the
same quarter last year.

Cost associated with payment to industry participants decreased by 10.7% to
RMB 93.9 million or $14.9 million primarily due to decreased channel costs in
line with the decline in revenue collected from carrier channels, partially
offset by increased revenue sharing percentage with mobile service providers
and handset manufacturers and increased spending on higher quality mobile
content to realize improved customer retention in the Maopao Community.

Approximately RMB 9 million of accrued costs payable reversed into cost of
sales in second quarter 2012. There were no such reversal occurred in second
quarter 2013. Such accrued costs are not expected to recur in the current
fiscal year. Non-IFRS direct costs including salary benefits, depreciation,
office expenses and utilities directly related to the operation of the Maopao
application store and the Maopao Community increased 15.4% to RMB 10.6 million
or $1.7 million as compared to RMB 9.2 million in second quarter of 2012. The
increase was primarily due to increased costs in connection with greater
efforts to maintain proactive operations in the feature phone business, as
well as developing overseas markets and other revenues.

Gross profit in second quarter of 2013 decreased 40.7% year-over-year to RMB
34.4 million or $5.5 million. Non-IFRS gross margin in second quarter 2013 was
25.3%, down from 34% in the second quarter 2012, mainly due to the increased
revenue share percentage with mobile service providers and handset
manufacturers, and higher costs involved in acquiring high quality mobile
contents.

Total operating expenses, primarily consisting of employee salaries and
benefits, training expenses, travel, entertainment and office related
expenses, decreased 4.2% year-over-year to RMB 49.7 million or $7.9 million.
Non-IFRS research and development expenses, sales and marketing, and general
and administrative expenses, and other expenses increased 6.6% year-over-year
to RMB 42.6 million or $6.8 million. The increase in non-IFRS operating
expenses was primarily due to an increase in headcount. The Company’s focus on
research and development of the Android platform and products to participate
in the competitive smartphone market and sustainable business development of
the Maopao Community.

Total headcount increased 2.1% to 685 employees as of September 30, 2012, up
from 671 employees as of September 30, 2011. The increase in headcount was
mainly due to our business strategy to expand the Maopao Community, as well as
in connection with higher staffing levels on the Android platform and Android
product development. Non-IFRS operating loss was RMB 7.3 million or $1.2
million compared to non-IFRS operating income of RMB 18.9 million a year-ago.

Net loss in second quarter 2013 was RMB 11.7 million or $1.9 million as
compared to net profit of RMB 7.1 million a year-ago. Non-IFRS net loss for
second quarter 2013, RMB 3.6 million or $579,000 as compared to RMB 19.8
million a year-ago. Basic and diluted loss per common share in second quarter
2013 were RMB 0.04 or $0.01. And basic and diluted loss per ADS were RMB 0.36
or $0.06. Non-IFRS basic and diluted loss per common share in the first
quarter of 2013 were RMB 0.01 or $0.00 and non-IFRS basic and diluted loss per
ADS were RMB 0.11 or $0.02. Sky-mobi ended the fiscal second quarter, with
approximately $95 million in cash equivalents and term deposits with no debt,
this is about 2.9 fold per ADS.

In August, we announced a RMB $10 million share buyback program, reflecting
the board’s belief that the stock is currently under valued. Today, we
repurchased approximately 730,000 ADS at an average price of $2.20. We intend
to continue to purchase shares while a complying of applicable regulations
regarding in volume and blackout periods.

Turning over to outlook, we continue to expect that Sky-mobi will focus on
maximizing revenue in a declining feature phone market, by improving payment
efficiency and increasing monetization. We have deployed the vast majority of
our employees to work on smartphone opportunities, so as to be well positioned
for a rapid expansion in that market.

A financial strategy is to invest responsibly in smartphone and to maintain a
strong cash balance by using cash flow generated from our feature phone
business to support the growth and development for smartphones. For the fiscal
third quarter 2013 ending December 31, 2012, we expect total revenues to be in
the range of RMB 120 million to RMB 130 million. We are also maintaining our
full fiscal year revenue guidance of RMB 545 million to RMB 560 million.

Okay. With that we like to open the call for questions please. Operator?

","**Question-and-Answer Session**

**Operator**

(Operator Instructions) And your first question comes from the line of Andy
Yeung with Oppenheimer.

**Andy Yeung – Oppenheimer & Co**

Hi, good evening, Michael and Carl. Thank you for taking my question. I have a
couple of questions today. My first question is about your smartphone strategy
as you’ve indicated currently the smartphone app market in China is pretty
competitive. So can you give us your view on competitive landscape and how
would you differentiate your smartphone app store from your competitors in the
marketplace?

**Carl Yeung**

Yeah, Andy, Thank you for your first question. The Chinese smartphone app
store is indeed very competitive. There are more than a dozen players in this
market including names of very well-known internet companies like [Chifu] et
cetera, et cetera. But there is a clear differentiation in terms of the market
segment that each are targeting. The current successful smartphone app store
so far are mainly the PC based smartphone market and they target the higher-
end smartphone segment, which we believe will be only 30% or so of total
smartphone shipment next year.

The real opportunity in Chinese Smartphone market is the mainstream market of
the device price between RMB 300 to RMB 1,000. These are the users that mainly
do not have 3G or PC access therefore the PC app stores have limited reach in
this market. How we differentiate from them is, number one, we have a clean
store strategy that they don’t have. Again, we’ve made significant progress
and today we have 78 partners that are working with us to clean store app
store. But the most interesting part of our strategy is our off line
component. There are – all the Chinese handsets are sold either via the
carrier retail channel or the large nation-wide retail chain. Of the 500,000
retail stores around China, it comprises about 60% of all mobile shipments.
Now the carrier comprise of the other 40. Now you will see that shortly we’ll
be announcing several partnerships in these key areas, with the hot players,
especially, with the retail channels. Therefore, we have a very differentiated
approach to get into users.

The other and most important part to attracting developer is monetization. We
have been monetizing the Chinese mobile app market for last five years. We’ve
shipped over RMB 1.5 billion to our partners in the past, and this a very
attractive composition. This has been built upon a carrier based, as well as
third-party based collection model that our competitors simply do not have to
scale. Therefore, we’ve been able to attract 160,000 apps on our app store so
quickly and we can have a app store filled with app that’s are interesting and
users willing to pay.

Hold on a second.

**Michael Tao Song**

No further details.

**Carl Yeung**

And of course Michael wanted to supplement that. We’ve been doing this app
store business for the past, since 2005. These are new market interests. We
know how the user demand and we know what the user demand is, we know how to
manage and rack the stores. This is an experience that our competitors do not
have. We have very sophisticated data analytical systems to know how to
basically put the right goods on the right shelf at the right time to generate
stronger future interests.

**Andy Yeung – Oppenheimer & Co.**

Okay, got it. So my next question is about your game revenue, since games
representing a pretty big portion of your overall revenue right now. So can
you give us some colors on how much of your revenue is coming from games and
what is your view on the emerging mobile game market?

**Carl Yeung**

Sure Andy.

**Operator**

(Operator instructions).

**Carl Yeung**

Yeah Andy of the current app store of course today’s revenue is mainly
generated from feature phones, we have a significant revenue from smartphones
yet. Of the feature phone app store are over 70 plus percent of our revenue
are from games which also underpin our experience and our know-how in
managing, publishing of games and collection of monetization for games. In the
next year, we believe that the – in smartphones the sales of games will
basically explode. We have very strong and convincing evidence that since most
of the games are adopting to this premium model there is a very strong demand
for user in having a very long time spending on games and as the device
getting more powerful, the screen is getting bigger; there are more
opportunities for games to generate revenue.

I can tell you today that [Foreign Language]. I can tell you that on
smartphones today currently there are companies that are generating over RMB
10 million in game sales on smartphones and there will be a dozen or more of
these companies next year and we’ll be definitely be part of that.

**Operator**

(Operator Instructions) And there are no further questions at this time.

**Carl Yeung**

Okay, thank you operator. Thank you all for the attention and interest in Sky-
mobi. We expect that the next few quarters will be very important as we work
to transition our business model. We are excited about the smartphone
opportunity and achievements we had so far in the short five months and
believe we are uniquely positioned to execute on our strategy.

So with that I would like to thank everyone for joining the call today and
wish everyone well for the week.

**Operator**

Thank you. This concludes today’s conference call. You may now disconnect.

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3,1000351-tmx-groups-ceo-discusses-q3-2012-results-earnings-call-transcript.html,TMX Group Inc.,TMXGF-PK,technology,2012.0,,regular,"November 9, 2012",8:00 am,2012-11-09T13:00:00.000Z,41159,20090,21069,3,5,"['Paul Malcolmson - Investor Relations', 'Thomas A. Kloet - Chief Executive Officer', 'Michael S. Ptasznik - Chief Financial Officer']","['John Reucassel - BMO Capital Markets', 'Jeff M. Fenwick - Cormark Securities, Inc.', 'Edward Ditmire - Macquarie Group Ltd.', 'Geoff Kwan - RBC Capital Markets', 'Richard Repetto - Sandler O’Neill']","**Operator**

Good morning. My name is Melissa, and I will be your conference operator
today. At this time I would like to welcome everyone to the TMX Group Third
Quarter 2012 Analyst Conference Call. All lines have been placed on mute to
prevent any background noise. After the speakers’ remarks, there will be a
question-and-answer session. (Operator Instructions) Thank you.

Mr. Paul Malcolmson, you may begin your conference.

**Paul Malcolmson**

Thank you, Melissa, and good morning, everyone. Thank you for joining us today
for the Third Quarter 2012 Conference Call for TMX Group Limited. As you know,
we announced our third quarter 2012 results this morning. A copy of the press
release and our MD&A is available on our website under tmx.com, Investor
Relations.

The MD&A contains further supplementary information, including the full third
quarter for TMX Group Inc., CDS and Alpha, which is on page 12. Today, we have
with us Tom Kloet, our Chief Executive Officer; and Michael Ptasznik, our
Chief Financial Officer. Following opening remarks from Tom and Michael, we’ll
have a question-and-answer session.

Before we begin, I would like to remind you that certain statements made on
the call today may be considered forward-looking. And I would refer you to the
risk factors outlined in today’s press release and MD&A and other reports
filed by TMX Group Limited with regulatory authorities.

Now, I would like to turn the call over to Tom.

**Thomas A. Kloet**

Thank you, Paul, and good morning, everybody. Thank you for attending today’s
call to discuss our third quarter results. This is the first report for the
combined organization, which now includes the results of TMX Group Inc., CDS
and Alpha for two months. And because TMX Group Limited is a new reporting
issuer, the third quarter of 2012 report is complex. But while the report
itself is complex, it’s quite clear that the global market environment has
continued to affect TMX Group’s financial performance. I’ll spend the next few
minutes on our operational performance for the quarter ended September 30, and
I will provide a brief update on our integration efforts of the new companies.
I will then turn it over to Michael to discuss our financial results with you.

We aim to leave as much time as possible available for your questions. So I’ll
begin with our equities business. It appears that the global economic recovery
remains fragile, moving at what some would call a glacial pace. It is also
evident that this situation is having pronounced impact, both on companies
that are looking to go public and on equity investor confidence.

IPO financing was down 74% in the third quarter of 2012 compared to the third
quarter of 2011, and down 68% on a year-to-date basis. We are continuing to
pursue our business development strategy during this lull. We are finding that
company interest is good. However, market conditions are most definitely
holding back, holding some new issuers back.

A bright spot in our equity trading statistic has been the level of total
equity capital raised on Toronto Stock Exchange and TSX Venture Exchange.
According to the World Federation of Exchanges, together Toronto Stock
Exchange and TSX Venture Exchange were third in the world in equity financing
rates for the first nine months of the year. In 2011, we were sixth in the
world.

Total financing was up 33% during the third quarter of 2012 compared to the
third quarter of last year and year-to-date financing dollars was up 5% year-
over-year. This financing activity is excellent for our issuers. They
successfully raised the capital they need to achieve their objectives, and the
market clearly welcomed these transactions. However, the number of financing
transactions, which is an important revenue driver for us, continues to be
behind 2011 levels. The number of financings was 8% lower in the third quarter
of 2012 compared to the third quarter of 2011. On a year-to-date basis,
financings were 21% lower on the exchange than last year.

Turning to equity trading now, again it is important to note that the decline
in equity trading volumes during the third quarter was not unique to our
markets. Total equity volume traded in the third quarter of 2012 decreased
significantly compared to the third quarter of 2011 levels in exchanges around
the world. Combined total volume on Toronto Stock Exchange, TSX Venture
Exchange and TMX Select was down 24% in the third quarter of 2012 compared to
the third quarter of 2011, and down 26% on a year-to-date basis.

Total volume on Alpha was down 35% in the third quarter of 2012 compared to
the third quarter of 2011, and was down 38% year-to-date. Revenue from CDS
clearing and settlement operations are also dependent on trading activity on
Canadian equity marketplaces. As a result, total trades processed on CDS were
down 29% in the third quarter of 2012 compared with the third quarter of 2011.
In the third quarter of 2012, activity in our derivatives business decreased
compared with the same period of 2011.

MX trading volume was down 9% from the third quarter of 2012 compared with the
third quarter of 2011. However, at September 30, 2012, the level of open
interest on MX was up 8% compared to September 30, 2011, and up 2% when
compared with June 30, 2012.

BOX trading volume in the U.S options market was down 21% in the third quarter
of 2012 compared to the same quarter last year. While the volume decrease was
disappointing, we note that industry volume was down 27% showing that BOX
achieved market share gains.

On a year-to-date basis, BOX volume was up 12% compared to the first nine
months of 2011. NGX trading and clearing volume was down 15% compared to the
third quarter of 2011, and down 3% in the first nine months of 2012 compared
with the same period of 2011.

In terms of business initiatives during the third quarter of 2012 new products
and services were introduced in a number of different parts of our
organization. These include a new equity trading risk product, issuer services
products, and a new derivatives market simulation tool which has seen very
good use since it was launched. But as you’re all aware the Maple transaction
closing was the main initiative achieved during the third quarter.

The final step occurred when TMX Group Inc. shares were delisted and TMX Group
Limited shares began trading on Toronto Stock Exchange on September 19.
Integrating TMX Group, CDS, and Alpha has been the key priority of the
organization from the moment the deal closed, and it will continue to be in
the near term. The planning and regulatory approval stages are now complete
and we have now begun to implement our integration plans.

A number of decisions have already been made which I will now summarize for
you. AS you saw in our release, we issued during the quarter and also CEO
elected to leave the company, Alpha is now led by Rob Fotheringham who is also
Senior Vice President of Equity Trading.

Alpha will continue to operate as a marketplace, because it has products and
features that our customers value. However we have determined, Alpha will not
be operated as a listing bank. We’ve also decided that Alpha’s outsourced
technology will be migrated on to our TMX Quantum trading platform. In
addition, Alpha will be moved into the TMX Data Center. We expect to complete
this migration work by the end of the second quarter of 2013. In addition to
streamlining our operations and helping us to achieve the target of synergies,
we expect these changes to Alpha’s technology will also deliver important
benefits to our customers, including increased efficiencies and reduced costs.

Corporate support functions are now in the process of being integrated across
the companies, which will deliver both operational efficiencies and costs
savings. It has been determined that 100 positions will be eliminated from the
organization over the next 12 months. Those are very difficult decisions but
were made after a thorough analysis.

Ultimately, all of the changes we are making are intend to improve execution,
enhance efficiency, and allow us to deliver greater value to our customers.
Achieving the right organizational structure and cost base will position us to
fund the future innovations needed to be the most effective business partner
possible for our customers and for all our stakeholders.

Our teams are now turning to the hard and exciting work of capitalizing on the
opportunities present by having CDS and Alpha as part of the TMX Group. Our
integration work to-date continues to be in line with the targets we set
earlier, which is to achieve annual cost synergies of approximately $20
million on a run rate basis beginning in the first quarter of 2014.

Before I turn the call over to Michael, I want to take a moment to recognize
Peter Krenkel, who is retiring as NGX President at the end of this year. His
successor, Jim Oosterbaan has joined the company and they are now in the
process of finalizing the transition. Peter has led NGX since its creation in
1994. He is a great leader, a great colleague and frankly he’s been a super
guy to work with. On behalf of everyone at TMX Group, thank you very much for
your service to NGX and TMX Group, Peter and we wish you the very best.

I’d also like to take the opportunity to thank Ian Gilhooley, who has been CEO
of CDS, for his service to both CDS and the Canadian marketplace. Ian
announced earlier this year that he is retiring at the end of 2012. We are
currently recruiting his replacement who will report to me. Ian, we wish you
the very best as well.

Finally, I want to be sure you’re aware that the Toronto Stock Exchange
celebrated its 160th anniversary last month. Way back on October 24 of 1852, a
group of Toronto entrepreneurs met, they created a Broker Association, which
form the framework for the Toronto Stock Exchange. We applaud their vision.
The Exchange started out with trading on 18 securities. Today, there are over
4,000.

On day one the founders could sit around one table. Today, we have more than
110 participants representing traders from all over the world. I won’t even
try to summarize how the speed of trading has evolved over the last 160 years.
Let’s just we have come a very long way. But over these 160 years, TSX has
been Canada’s economic engine. We have changed, adapted, innovated and
successfully operated through up-cycles and down-cycles.

I think historic milestones like these provide important perspective. They
encourage one to pause and take a long view, both of what came before and
excitingly at what lies ahead. So on October 24, we gathered all of our
employees across the country and celebrated our past. And perhaps more
importantly, we toasted the future of our company. Collectively, our team is
focused on maximizing the opportunities in front of us, and on positioning TMX
to grow and thrive as economic conditions improve.

I will now turn the call over to call over to Michael to review TMX Group
Limited’s third quarter financial performance. Thank you.

**Michael S. Ptasznik**

Thank you, Tom and good morning everyone. Before I go through our financial
results for Q3, I want to talk about the approach that we’ve taken in the
earnings release and the MD&As report on a highly complex quarter. The
financial statements include the operating results of TMX Group Inc., CDS and
Alpha from August 1, 2012, and comparative financial statements for TMX Group
Limited only for and as at the three and nine months ended September 30, 2011.

In the press release and MD&A, we have provided you with a supplemental view
of the operating performance and cash flows of TMX Group. Our discussion of
revenue, operating expenses, net income attributable to non- controlling
interest and cash flows for the quarter, and nine months ended September 30,
2012 includes the operating results of TMX Group Inc. from July 1, 2012 and
January 1, 2012 respectively, along with those of CDS and Alpha from August 1,
2012. These measures are compared with what we had reported at TMX Group Inc.
for the three and nine months ended September 30, 2011. We have called this
Supplementary Information.

Simply put, for discussion purposes, the operational comparison in our
document and what I’m about to discuss has been prepared for the most part as
of TMX Group Inc. acquired CDS and Alpha on August 1, 2012. While we have made
our best efforts to give meaningful context to the results, while we remains
clear in reporting for 2012 are the negative impacts on our business,
resulting from the sustained global economic slowdown.

As Tom mentioned, key drivers across our business were effective. Revenue was
$162.3 million in Q3 2012, down 3% compared with $167.8 million in Q3 2011,
reflecting lower revenue from issuer services, cash markets trading,
derivatives trading, and clearing and technology services and other. These
decreases were largely offset by the inclusion of $14.8 million of revenue
from CDS and $3.2 million of revenue from Alpha, effective August 1, 2012 and
increased revenue from information services, which includes the revenue from
TMX Atrium, which we acquired July 29, 2011.

Issuer services revenue in Q3 2012 was down 15% in comparison to Q3 2011,
driven by initial listing fees, which were down 58%, primarily due to a
decrease in the number and value of new listings on Toronto Stock Exchange and
TSX Venture Exchange. Additional listing fees in Q3 2012 decreased 12%,
primarily due to a decrease in the number and value of additional financing
and TSX Venture Exchange and the number of additional financing at Toronto
Stock Exchange. The decrease of 8% in annual sustaining fees was due to the
overall lower market capitalization of listed issuers of both exchanges at end
of 2011, compared with the end of 2010 and also due to reduction in certain
fees that were effective on January 1, 2012.

In our Trading, Clearance, Depository and related revenue lines, cash market
equity trading revenue decreased 7% primarily due to decreased volumes on
Toronto Stock Exchange and TSX Venture Exchange in Q3 2012, compared with Q3
2011 and as a result of changes to our market making fee schedule for Toronto
Stock Exchange, which came into effect on October 1, 2011 including
introduction of monthly credits.

Partially offsetting the decrease was the inclusion of $2.8 million of revenue
from CDS clearing and settlement revenue and $1.4 million of revenue from
Alpha effective August 1, 2012. Along with the clearing revenue, CDS
depository revenue of $7.9 million is included for August and September 2012.

Derivatives markets revenue was down 14%, compared with Q3 2011 reflecting
lower revenues from BOX due to a decrease in industrywide volumes, partially
offset by the positive impact on BOX revenues, depreciation of the Canadian
dollar against the US dollar in Q3 2012 compared with Q3 2011. Revenue from
BOX was also higher in Q3 of last year due to the inclusion of options
regulatory fees. As of May 14, 2012, the fees charged and the related costs
incurred by the BOX SRO entity are no longer consolidated into the TMX Group
results.

Lower volumes largely due to decreased trading in the BAX contract, index
derivatives and equity options led to a decrease in trading and clearing
revenue from MX and CDCC. However, open interest was up 8% at September 30,
2012, compared with September 30, 2011.

Energy markets revenue was down 4% in Q3 2012, compared with Q3 2011,
reflecting a 15% decrease in total energy volume on NGX, primarily due to a
decrease in natural gas volumes, partially offset by the impact of the
depreciation of the Canadian dollar against the US dollar and by NGX having
deferred less revenue in Q3 2012 on a net basis, than in Q3 2011, due to a
decreased level of forward contracts.

Information services revenue was up 10%, compared with Q3 of last year,
largely due to the inclusion of $1.8 million of revenue from Alpha and $1
million of revenue from CDS from August 1, 2012. The increase in revenue was
also attributable to revenue from TMX Atrium and higher revenue from co-lo
services, data feeds and PC-Bond.

Technology services and other revenue decreased 38% overall, primarily due to
net foreign exchange losses on US dollar account, accounts receivable in Q3
2012 whereas we recorded net foreign exchange gains in Q3 2011. The decrease
also included the loss in revenue from IIROC following the termination of our
contract to provide services effective March 31, 2012, which amounts to
approximately $6.7 million on an annual basis.

In addition, revenues from prior periods included revenue related to services
that were provided to CDS, which have now been eliminated upon consolidation
effective August 1, 2012. This revenue from CDS was approximately $1.7 million
in 2011. Offsetting these decreases in revenue was the consolidated revenue
from Razor Risk effective from February 14, 2012. Technology services and
other revenue, includes $2.7 million of revenue from CDS services, SEDAR, SEDI
and NRD. The current contract is due to expire on October 31, 2013. At the
June, the CSA announced that it’s seeking competitor proposals to acquire
certain services in connection with the operation over CSA National Systems
including these services.

Operating expenses in Q3 2012 were $100.2 million, up 39% from the $72.3
million Q3 2011, due to the additional operating expenses included from
acquisitions. These included $13.5 million or expenses from CDS and $3.1
million of expenses from Alpha for the two months. There was also an increase
related to the incremental amortization of intangible assets related to TMX
Group Limited’s acquisition of TMX Group Inc. of $6.5 million. In addition,
the increase was attributable to the inclusion of an aggregate of $4.2 million
of incremental expenses related to TMX Atrium, Razor Risk and ir2020.

Year-to-date through September 30, 2012 revenue was $492.1 million, down 4%
from the first nine months of 2011 reflecting lower revenue from issuer
services and cash markets trading. These increases were partially offset by
the inclusion of $14.8 million of revenue from CDS of $3.2 million of revenue
from Alpha and increased revenue from Information Services, including revenue
from TMX Atrium, derivatives trading and clearing, and technology services and
other.

Operating expenses in the first nine months of 2012 were $265.5 million, up
20% for the first nine months of 2011, primarily due to the inclusion of $13.5
million of expenses from CDS and $3.1 million of expenses from Alpha. There
was also an increase of $6.5 million related to the incremental amortization
of intangible assets related to TMX Group Limited’s acquisition of TMX Group
Inc. In addition, the increase was attributable to the inclusion of an
aggregate of $15.3 million of incremental expenses related to Atrium, Razor
Risk and ir2020.

There was also an overall increase in salary and benefits cost, information
and trading system costs, and depreciation and amortization somewhat offset by
lower G&A cost due to the inclusion in the first nine months of 2011 of a
commodity tax adjustment of $4.8 million relating to prior periods. TMX Group
Limited held cash and marketable securities totaling $378.3 million at
September 30, 2012 including cash and marketable securities held by TMX Group
Inc. which was acquired on July 31, 2012.

Cash flows used in operations were $67.1 million in Q3 2012, a decrease of
$120.2 million compared to cash flows generated from operations of $53.1
million in Q3 2011 primarily due to $84.3 million in Maple transaction related
cash outlays and $14.5 million of interest paid on TMX Group Inc.’s $430
million of debt, which has since been repaid and the $1.5 billion in debt
incurred to support the Maple deal.

For the nine months ended September 30, 2012 cash flows used in operations
were $105.9 million, net of $99.3 million of cash outlays pertaining to Maple
related costs and TMX Group Inc. paid $29.9 million in dividends on its common
shares in August 2012.

And finally, yesterday the Board declared a quarterly dividend of $0.40 per
common share to be paid on December 7, 2012 to shareholders of record on
November 23, 2012.

With that, I will turn the call back to Paul for the Q&A session.

**Paul Malcolmson**

Thanks, Michael. Melissa, could you please outline the process for the
question-and-answer session.

","**Question-and-Answer Session**

(Operator Instructions) Your first question comes from the line of John
Reucassel from BMO Capital Markets. Your line is now open.

**John Reucassel – BMO Capital Markets**

Just a clarification, Michael, if you could just help me, if I am looking at
page 12 of the MD&A and you have income from operations there of $61.1
million, if I want again EPS number on that for kind of the fully loaded pro
forma. I just want to make sure I understand the process, I’d figured the non-
controlling interest or the minority interest and then I’ll take out the
financing costs, which look to be like $9.3 million, and then taxes. Is that
about right, is that how you do that?

**Michael S. Ptasznik**

I think the $9.3 million was only for the two months time you have to treat
that with it was for full quarter.

**John Reucassel – BMO Capital Markets**

Okay, so okay so and as the scores in the some the average rate on the $1.5
billion of debt?

**Michael S. Ptasznik**

Sorry yeah it’s at disposal, if you are going to normalize this you’ll take
the $1.5 billion of debt, use the rates that we provided in the MD&A, which is
around 3 points, I think it’s around 3.6 mark for the quarter.

**John Reucassel – BMO Capital Markets**

Okay.

**Michael S. Ptasznik**

Plus or minus 3.6, 3.7.

**John Reucassel – BMO Capital Markets**

Yeah.

**Michael S. Ptasznik**

So you have the interest expense and…

**John Reucassel – BMO Capital Markets**

And the tax rates we assume, it all TMX Group tax rate.

**Michael S. Ptasznik**

Yeah, I mean a normalized tax rate would be around the 27% range.

**John Reucassel – BMO Capital Markets**

Okay. Okay that is helpful. That is helpful, so thanks for that clarification
now, the amortization of this intangible, it looks like its tax deductible,
but it’s going to be around for a long time. Is that correct?

**Michael S. Ptasznik**

Yeah it’s not, it’s technically not tax deductible, but there is a future tax
asset put on the books, so that when you do the P&L from the P&L standpoint,
it is tax deductible from a cash standpoint, it not

**John Reucassel – BMO Capital Markets**

Okay, okay I got it. So it’s an accounting?

**Michael S. Ptasznik**

Exactly.

**John Reucassel – BMO Capital Markets**

It’s an accounting okay. So that is an accounting expense. So that is helpful.
Two last questions, first how much cash or capital on the old format, you had
a restricted cash. How much should we think about now that you have CDS and
CDCC or another, how much do we think about your cash you need to kind of keep
around for business.

**Michael S. Ptasznik**

But the number it is in the MD&A, I don’t know which page number, but it’s in
the MD&A, $250 million is the amount that we now believe is required to
provide enough capital for the recognition order purposes, in addition to the
working capital plus some of the other requirements under CDS.

**John Reucassel – BMO Capital Markets**

Okay. And last question Tom. I don’t know want you feel left out.

**Thomas A. Kloet**

It’s okay.

**John Reucassel – BMO Capital Markets**

So in the past, TMX has given kind of medium to long-term growth targets. Are
you guys willing to do that now, given that you have seen Maple for a while?

**Thomas A. Kloet**

No, we haven’t given guidance now for quite sometime and it’s not the intent
to give guidance now.

**John Reucassel – BMO Capital Markets**

Okay, I’ll be in queue, thank you.

**Operator**

Your next question comes from the line of Jeff Fenwick from Cormark
Securities. Your line is now open.

**Jeff M. Fenwick – Cormark Securities, Inc.**

I just wanted to start off with a question on CDS here. You noted in the MD&A
that they have lost the contract for IIROC over the last year. And you have a
few more that are up for competitive bid right now. What was the situation
with the IIROC agreement there? Was that also a competitive bid? I’m just
trying to get a read on what kind of risk we have to the existing other
contracts there.

**Michael S. Ptasznik**

Just to clarify first that the loss of the IIROC technology revenue was not a
CDS event first of all. It was a TMX event. And we had explained that last
quarter, if you may recall we had a revenue item that came in for the early
end of that contract. And it wasn’t lost in a competitive bid, essentially
what happened was the IIROC had made a decision several years ago to create an
inter-market surveillance system that would allow them just smartly, I will
add, to be able to do market surveillance across marketplaces. Now we have a
multi-marketplace environment, that’s really important to make sure that those
execution requirements are fulfilled.

Corresponding to that, they went to a vendor, we were not in the business of
building inter-market surveillance technology we hadn’t been in that business
they went to a fairly well recognized vendor to do it. They achieved their
goal bringing it in price, correspondingly to that we made the determination
upon working with IIROC that it was best for the marketplace that rather than
IIROC use our old surveillance equipment to do the surveillance work they do
over TSX and TSX Venture that the economics of having that work done via the
system they bought was in the best interest of the marketplace. So, that’s
what happened with that technology.

There wasn’t a bid per se, but it is really the result of the market becoming
multi-marketplace environment and IIROC became a vendor that could provide
that kind of technology. So, that’s why that agreement ended and why in the
last quarter we actually had revenue we recognized as a result of your early
termination of that agreement. With respect to the CDS Inc. business which I
think is what the second part of your question was. The CSA has in accordance
with what the government does periodically, as I understand it, gone out to
competitive bid process to see, if there are other that essentially open up
bidding for this contract.

The contract’s been extended once already to CDS. It’s clear in our view that
we continue to provide service that exceeds the SLA agreements or the service
level agreements and we are an excellent vendor for that, but the CSA will go
through this process and we’ll see how that comes out. But I can’t give you
anymore of a read as to where that, this is a process that will take some time
for the CSA to work its way through, in the meantime, we are trying to operate
the system as best we can everyday.

**Jeff M. Fenwick – Cormark Securities, Inc.**

Okay, fair enough. And then maybe we can just flip it over to the other side
of the perspective there around growth from CDS. I think it sounds like the
REPO initiative you guys have been working on in clearing, the contribution is
relatively modest today, and it looks like there was some commentary out of
the government, I think with the Bank of Canada that maybe suggesting that it
would be okay for the financial firms here in Canada to use global clearing
entities other than you guys. How do you feel in terms of opportunity to grow
new revenue areas for CDS going forward from here in the current environment?

**Thomas A. Kloet**

I think there are a number of, as we get to understand CDS better and
understand the links between CDS and the rest of the organizations, I think
there are a number of opportunities we can pursue to grow the product and
services offering of CDS well beyond the core clearing and depository services
that it offers today. I remain optimistic that we are going to have some new
business development, that will take time, some of it’s going to be de nova
new build or we may have to acquire some products and services as well, and
bolt them onto CDS’s existing offerings, or other parts of the institutions
offering.

With respect to, so I’m quite optimistic, now let me go back to the early part
of your commentary and your question about REPO and OTC derivative clearing.

With respect to the REPO project, I want to remind everybody that we have only
completed Phase one of at least a three-phase project, and probably a four-
phase project with the next phase of phase two being where we allow the buy-
side to come into the REPO product offering.

So we’re in the early days and early stages of this offering. Now, that CDS
and CDCC represent the same corporate family, we’ll find that the development
of that will be easier to manage for sure, but I remain optimistic that what
we’ve provided gives real value to the marketplace, and I think the Bank of
Canada has been very clear about the fact that having REPO clearing is an
important value. And I think in the end, this is a journey that will end well,
but it’s a journey that we have to stay on and continue to work to develop the
product and service.

With respect to the OTC derivative clearing that we would hope would be on the
other end of that process. Bank of Canada has allowed the market participants
to use an international clearing organization or international clearing
organizations to clear in the current term their interest rate swap contracts.
We recognize that, that’s the global reforms and the commitments of both the
G8 finance ministers and then later ratified by the G20 leaders themselves,
committed to doing that, that’s an important part of the financial reform
that’s going on here.

But we view that and I think in Bank of Canada’s comments, I don’t want to put
words in their mouth, but I think they allowed for the fact that they would
like to see a domestic solution offered as well for those interest rate swaps
that are executed among domestic counterparty.

We continue to think we’re the best entity to give that service. And, in fact,
we feel stronger about it now that we have CDS as part of the family. So we’ve
not given up that view. We are studying the economics of it and the economics
have to make sense for our shareholders, and we have to have the development
path forward to do that. But the first step in that journey is to continue the
REPO project. And that’s where we are at is in the effort of implementing
Phase two. So I hope that helps give you some clarity. These developments take
time to both develop and to build a marketplace for.

**Jeff M. Fenwick – Cormark Securities, Inc.**

Thanks, Tom. That’s a lot of good color there. And then, Mike maybe just one
quick one. The amortization number there in the quarter, how much of that
would be over just the two months, or I’m trying to get a sense of what the
run rate is going to look like going forward?

**Michael S. Ptasznik**

The $6.7 million is the incremental for the two-month period.

**Jeff M. Fenwick – Cormark Securities, Inc.**

Okay. All right. Thank you.

**Operator**

(Operator Instructions) Your next question comes from the line of Ed Ditmire
from Macquarie. Your line is now open.

**Edward Ditmire – Macquarie Group Ltd.**

Good morning, gentlemen.

**Thomas A. Kloet**

Good morning.

**Edward Ditmire – Macquarie Group Ltd.**

Can I ask about the philosophy around the uses of free cash flow over the next
few years? I would presume there is a focus on deleveraging, given the
relatively high leverage versus publicly traded exchange periods, but there
has also been plenty of commentary and speculation that TMX is unusually
acquisitive. Can you comment?

**Michael S. Ptasznik**

It’s Michael. I think the answer is we are, yes, you are right, we are going
to look to reduce the debt and use the free cash flow to pay down the debt.
However, as we stated historically, we will continue to look for opportunities
to growth the business and whether that’s using the cash or whether we would
look to equity finance if it was strategic and made sense both strategically
and financially for the business, we will look to continue to grow the
business through acquisitions as well. But with respect to just normal
operations and barring any opportunities, now we will look to pay down the
debt over time.

**Edward Ditmire – Macquarie Group Ltd.**

And so there is not an overriding schedule that you are going to hold yourself
towards in terms of the deleveraging, i.e., for the right opportunity that
could be put on hold, so that you could spend more money on acquisitions, et
cetera, it’s just flexible at every point in time?

**Thomas A. Kloet**

Well, you can see in the credit agreement, there is a schedule where we have
requirements in the covenants, and they do tighten over time. So there is
incentive for us to continue to pay down the debt that exists. But as I said,
there are means whether it’s debt financing based on the earnings of the
potential acquisitions or whether it’s equity financing, we will look to
continue to grow the business. As necessary, we do want to reduce the debt,
but we also don’t want to give up on opportunities to grow the business.

**Edward Ditmire – Macquarie Group Ltd.**

Okay. Thank you.

**Operator**

Your next question comes from the line of Geoff Kwan from RBC Capital Markets.
Your line is now open.

**Geoff Kwan – RBC Capital Markets**

First question just on that exhibit on Page 12 with the three months period,
just wanted to get a sense, because part of that would have been with all of
the entities, how indicative that might have been of any potential synergies
that might have been realized initially?

**Michael S. Ptasznik**

There is no synergies in Page 12, so the synergies we’ve just started to
implement some of the changes, then we’ve made some of the final decisions in
getting regulatory approval, so the quarter that’s represented on Page 12
would not include any synergies.

**Geoff Kwan – RBC Capital Markets**

Okay. And then given that you guys have had a closer look at all the
operations now, are you able to comment about, roughly on the pace of
realization on synergies, as well as the recording of the integration costs,
any incremental stuff going forward?

**Michael S. Ptasznik**

Well, I would say, we are still on track for achieving the full run rate of
synergies of $20 million in the first quarter of 2014. We have informed about
a 100 employees that they will be affected through the transaction. But those
will be phased in over time depending on the transition of both the technology
and some of the other integration initiatives that we have. So we don’t have
an update as to how that we got phased in, but we have, as I said, started to
make decisions, and started to move forward with the integration plan.

**Geoffrey Kwan – RBC Capital Markets**

Okay. And then last question I had was just maybe expanding on Ed’s previous
question on free cash flow usage. Absent doing some sort of acquisition, how
do you think about the dividend? Is there a certain level of leverage that you
want to get to first before you might consider an increase on the dividend?

**Michael S. Ptasznik**

Yeah, I would say for the next while, I mean this is something that we have to
continue to discuss with our Board, but the primary use of the cash will be to
pay down the debt for the next while. The dividend rate currently is a healthy
yield and it’s a reasonable payout. The focus will be on the reduction of the
debt, but it’s something that we will continue to revisit over time.

**Geoffrey Kwan – RBC Capital Markets**

Okay. Thank you.

**Operator**

Your next question comes from the line of Rich Repetto from Sandler O’Neill.
Your line is now open.

**Richard Repetto – Sandler O’Neill**

Yeah, good morning, Tom, good morning, Michael.

**Thomas A. Kloet**

Hi, Rich.

**Michael S. Ptasznik**

Hi.

**Richard Repetto – Sandler O’Neill**

I guess my question and I apologize if this has been asked or not, but given
the events over the last year and a half, not only the Maple transaction, but
the earlier proposed merger with the LSE. I guess, so what are your thoughts
on cross border or international expansion? I know you have a lot on your
plate up front right now with Maple, but did you see that as an opportunity
moderate to longer-term? And how would you view that, in what ways?

**Thomas A. Kloet**

I think Michael largely just addressed that. But as he indicated and as we’ve
indicated that elsewhere, our first focus is really on completing the
integration. We have a major task in front of us to complete the integration
and to achieve both the synergies and the cost savings that we have in there.
So that’s out key focus and what I would call the near-term.

We’ve made great progress thus far Rich. We put together the plan under the
new recognition order. We had to go to the securities regulators and get
approval on that integration plan, and we’ve achieved that, and we’ve started
to execute that plan. We want to make sure not to take our eye off executing
that plan, so it’s important to shareholder value. And when I talk about
synergies there I don’t just mean expense synergies. But I also mean we will
look for the new products and services we can add to the existing business.
And that’s quite exciting for us.

All that said, while we are juggling the need to pay down the debt, because
Michael indicated there are important covenants within the debt agreement that
we clearly are incentive to comply with. The marketplace is moving and there
will be opportunities out there that will be very interesting to us. And we’re
going to continue look at that as well. This has become a very complex
organization that we have now. But it is also not an organization with strong
shareholders behind it. We’re committed to grow this company and build our
business, whether it’s domestically or internationally and we intend to
balance all of these things and look at opportunities as they arrive.

So the real answer to your question is that, we’re very focused on the
integration. But we’re still watching these opportunities come forward. Our
pencil is very sharp. But we will look at those opportunities and depending on
whether or not, they fit the balancing act that I’m referencing will look at
them very seriously.

**Richard Repetto – Sandler O’Neill**

Okay, that’s helpful Tom. And we’ll be watching how the TMX Group emerges as
well. Thanks.

**Thomas A. Kloet**

Thanks.

**Operator**

Your next question comes from the line of John Reucassel from BMO Capital
Markets. Your line is now open.

**John Reucassel – BMO Capital Markets**

Just a quick follow-up, Tom, could you talk about the high-frequency traders
and just the trends in the volume or percentages that has been going on the
exchanges, particularly the TSE and Alpha?

**Thomas A. Kloet**

Well, in Canada, first let me back up and say that. Just remind everybody that
as an exchange, we have some data on high-frequency traders, principally via
our ELP program. But we don’t have the full visibility of that that you might
think we do, because we receive orders via the brokers don’t participate on
marketplace, and that’s we know, that’s our direct customer.

But we do have some anecdotal data and we have some visibility as to who’s
participating in our marketplace and we’re out selling the marketplace around
the world to get that. But my observation would be first that to remind
everybody, that the high-frequency trader penetration in our market for sure,
it’s less than it is elsewhere in North America and certainly less than it is
in North America and in Europe.

And my anecdotal view and my team may correct me here, but is that the
percentage of our marketplace represented by high-frequency trading has kind
of stayed steady and their volumes down consistent with our volumes are down
generally. I don’t think there’s been a big difference in the percentage of
market share that they represent. There is puts and takes here and there, but
it’s not dramatic.

So it continues to be kind of I’ll give you a broad range, between the 20% and
30% range probably. But maybe a bit less than 20% or maybe 15% to 20%, I would
guess. But clearly they’re watching the regulatory environment with care, and
as are we, it’s our continued view, particularly my view that they add
liquidity to the marketplace and that they keep spreads narrower than the
market would be without them. But we’ll have to see what comes out of all the
various regulatory reviews.

**John Reucassel – BMO Capital Markets**

Okay, that’s helpful.

**Michael S. Ptasznik**

But generally, it’s down a little bit as a percentage of the overall market
share, but not dramatically.

**John Reucassel – BMO Capital Markets**

Okay, that’s helpful. And then just on page 13 of the MD&A again, it looks
like you’ve separated CDS revenue into depository and there are some in the
cash trading and some in information services. Is that correct?

**Michael S. Ptasznik**

Yes, it is. And it is broken out within those individual sections in the
actual, in the quarterly reconciliation and in the documents.

**John Reucassel – BMO Capital Markets**

Okay, I’ll get there. Thanks Michael. Thank you.

**Michael S. Ptasznik**

You’re welcome.

**Operator**

There are no further questions at this time. Mr. Malcolmson, I’ll turn the
call back over to you.

**Paul Malcolmson**

Well, thank you everyone for listening today. The contact information for
media as well as Investor Relations is in today’s press release, and we’d be
happy to take further questions. Once again, thank you and have a good day.

**Operator**

Ladies and gentlemen, this concludes today’s conference call. You may now
disconnect.

![SeekingAlpha](https://static3.seekingalpha.com/assets/og_image_192-59bfd51c9fe6af025b2f9f96c807e46f8e2f06c5ae787b15bf1423e6c676d4db.png)

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Good morning and welcome to the China Natural Gas Earnings for Third Quarter
2012 Conference Call. All participants will be in a listen-only mode.
(Operator Instructions). Please note this event is being recorded.

I would now like to turn the conference over to Jackie Shi, please go ahead.

**Jackie Shi**

Thank you. Good morning and thank you for joining China Natural Gas third
quarter 2012 conference call. Joining us today are, Mr. Kang CEO of the
company and Mr. Zhaoyang Qiao, the Chief Financial Officer. I will be
interpreting for Mr. Qiao today. We appreciate your patience with
interpretation.

Before we begin, I would like to remind all listeners that throughout this
call, in addition to historic business, the company and its representative may
make statements which constitute forward-looking statements within the meaning
of the Private Securities Litigation Reform Act of 1995 with respect to China
Natural Gas. Forward-looking statements include statements concerning plans,
objectives, goals, strategies, future events, our performance and on line
assumptions and other statements other than the statements that are historic
in nature.

These forward-looking statements are based on management’s expectations and
are subject to risk and uncertainties that may result in expectations not
being realized and it may cause actual outcome to differ materially from
expectations reflected in these forward-looking statements. Potential risks
and uncertainties including product and a service demand acceptance, change in
technology, our economic conditions, the impact of the comparison of pricing,
the impact of government’s regulations and other risks contained in these
statements, filed from time to time with the SEC.

Also forward-looking statements whether raising our goal, and whether made by
on behalf of the company, express, quality, cash flow statements because
forward-looking statements are subject to risk and uncertainties, we caution
you not to place undue reliance on these statements. Forward-looking
statements made during this conference call only represented management’s
estimates as of today November 12, 2012. China Natural Gas assumes no
obligations to update these projects in the future at market condition change.

At this point, I would like to turn the call over to Mr. Qiao, the CFO of
Natural Gas. Mr. Qiao, please go ahead.

**Zhaoyang Qiao**

(Interpreted). Welcome everyone to China Natural Gas third quarter 2012
earnings conference call. Today we are very pleased to share with you our
quarterly financial results to talk about our future advancements. It is
Zhaoyang Qiao the CFO of China Natural Gas.

First, before we go into the details of our third quarter financial results
for 2012, please allow me to share with you some highlights of our performance
during this quarter. We remain optimistic about the continued support of
government policies that are encouraging the adoption of the cleaner burning
fuel and the increased adoption of CNG and LNG technology, which we anticipate
we have a positive impact on the results of our operations over the coming
years.

So far, we have made certain progress in the expansion of both our CNG and LNG
business into Hubei Province. In April 2010, we received the approval from
local government authorities in Hubei Province to be with LNG fueling station,
posting land and in harbors. And the reserve LNG stations, we are currently
going through lessons with procedures and had fuelled these LNG stations.

Our revenue in the third quarter 2012 decreased 15.8% to $31.06 million from
the $36.90 million in the third quarter of 2011. The decrease was primarily
attributable to the sales volume decrease.

The sales of Natural Gas was $27.9 million for the third quarter of 2012,
which is down 13.4% from the $32.23 million in the third quarter of 2011. The
sales of Natural Gas, gasoline and installation continued steadily 89.8%, 2.1%
and 8.1%.

Our gross profit in the third quarter of 2012 decreased 26.1% to $10.48
million, compared to the $14.18 million in the third quarter of last year. The
decrease in part, gross profit was primarily attributable to the decrease in
the natural gas revenue from our fuelling stations and increase in protecting
cost of LNG.

The operating income in the third quarter of 2012 was $2.72 million,
representing a decrease of 61.1% year-over-year from the $7 million in the
third quarter of last year, primarily attributable to the decrease in gross
profit of natural gas, and the increase in the selling expenses.

The operating margin decreased about 8.8% during this quarter compared to the
19% a year ago. In the third quarter of 2012, the income tax expense was $0.09
million compared to $1.53 million in the third quarter of last year.

Net loss in the third quarter of 2012 was $1.5 million compared to the net
income to the $4.55 million in the third quarter of 2011 primarily
attributable to the increase in non-operating expenses related to the loss of
the $4.02 million on disposal of five fuelling stations during the third
quarter of 2012.

Now, I would like to turn your attention to our balance sheet and the cash
flow. Because the balance sheet is a snapshot and the moment in time, I would
like to address specifically only lined items that have significant change or
that at least had material impact to our ongoing operations.

By the end of the third quarter our cash and cash equivalents was $8.16
million compared to the $9.62 million as of December 31, 2011. The decrease
was primarily attributable through the construction of R&G plans and other
projects and is the repayment of the loan from the XED and principle of
payback senior loans.

Reflecting our business models, our cash, our converting cycles are very
attractive. As of today, accounts receivable was $2.06 million and our day
sales outstanding remains below 10 days.

The net cash provided by operating activities was $21.08 million for the nine
months ended September 30, 2012 compared to net cash provided by operations
about $15.75 million for the nine months ended September 30, 2011. The
increase was primarily due to the decrease in prepaid expenses and other
current assets, increase on earnings revenue and decrease in accounts
receivable.

And this concludes the prepared remarks from Mr. Qiao. And operator, so we are
open to the questions.

","**Question-and-Answer Session**

**Operator**

(Operator Instructions). And our first question comes from Robert Baird of
Milleni Securities.

**Robert Baird – Milleni Securities**

Hello, I wanted to ask about the news item on September 11, when you announced
that the holders of the senior notes I think in the amount of $40 million had
notified the company that the company is in default and that they wanted to
take action to address that situation. I wonder what’s happening with that,
have you renegotiated the terms of those notes.

**Jackie Shi**

Okay. Just hold on, I need to translate it to our teams.

**Robert Baird – Milleni Securities**

Okay.

**Shuwen Kang**

This is CEO, Mr. Kang of the company. So, thank you very much for your
question. As you know, at end of the July this year, and we are communicating
with the Apex side to negotiate the new terms for these senior notes. And
currently we’re still in the process of negotiation with Apex side. And there
is, new demand commence, we will keep you posted there maybe 8-K or something
like that.

**Robert Baird – Milleni Securities**

All right, okay. The other question I had is, have you – can you provide us
with any kind of revenue guidance for the fourth quarter or next year, revenue
guidance or earnings guidance, will you return to profitability. I guess, the
main reason you weren’t profitable in the quarter was the $4 million one time
item.

**Shuwen Kang**

Okay.

**Robert Baird – Milleni Securities**

Okay.

**Jackie Shi**

Okay, just hold on.

**Zhaoyang Qiao**

(Interpreted). This is Mr. Qiao, CFO of the company and thank you for your
questions. As we said, it’s the guidance for Q4 of this year, maybe we were
same as the – the same as the last year.

**Robert Baird – Milleni Securities**

The same as.

**Zhaoyang Qiao**

(Interpreted). Same as 2011.

**Robert Baird – Milleni Securities**

The guidance for the entire year of 2012?

**Zhaoyang Qiao**

(Interpreted). For the Q4.

**Robert Baird – Milleni Securities**

For the Q4, okay sure.

**Zhaoyang Qiao**

(Interpreted). And for the 2013 guidance, our sales side and the company just
adjusted its developmental strategies. We will decrease our current CNG
business and we are expanding into our new business, LNG business as you can
see from our earnings results, the company just bought 50 LNG vessels and we
were focused more on our LNG business. And so far for the entire 2013, maybe
the revenue and the profit maybe seemed increase but we can’t give you a
specific numbers right now.

**Robert Baird – Milleni Securities**

Okay. But you think it would be similar to 2012, is that what you’re saying?

**Zhaoyang Qiao**

(Interpreted). As I said earlier, and we will decrease our CNG business and we
will increase our LNG business in the forthcoming years. From personal
estimates and the revenue and the profit maybe at least the same as the last
year, it went to a better maybe in the future maybe I mean it’s perfect and
revenue maybe much here than previous years.

**Robert Baird – Milleni Securities**

Okay, all right, thank you for that. And one other question, the stock price
is pretty bad and I’m wondering do you have any thoughts on the stock price
and what might be done to make it better?

**Jackie Shi**

Okay, just hold on.

**Shuwen Kang**

(Interpreted). This is Mr. Kang, CEO of the company. And he said, thank you
very much for your questions. And you know, and the stock price is – they are
bad at this stage. And then because of the company’s the third quarter
financial result and company’s US litigation matters. And from its current
perspective and it will deal with better way with US litigation matters and we
will increase our profit under the revenue guidance in the forthcoming
quarters. We think the stock price maybe keep on increasing in the future.

**Robert Baird – Milleni Securities**

Okay. When you say US litigation, are you referring to shareholder litigation
against the company, is that what you are talking about?

**Shuwen Kang**

(Interpreted). Yeah.

**Robert Baird – Milleni Securities**

What’s happening with that, that’s just ongoing?

**Shuwen Kang**

(Interpreted). Currently we are in the protest of the negotiation with SEC
side.

**Robert Baird – Milleni Securities**

Okay. All right, thanks very much for taking my questions.

**Jackie Shi**

Okay, thank you.

**Operator**

(Operator Instructions). I’m showing no further questions. I would like to
turn the conference back over to management for any closing remarks.

**Jackie Shi**

Okay, thank you.

**Zhaoyang Qiao**

(Interpreted). Okay, ladies and gentlemen. This is closing remarks from Mr.
Qiao. As you know, we appreciate everyone’s time and support and a chart from
the shareholders. We are doing our best to continue to operate our business.
And we are looking at very promising future for the natural gas industry as a
whole. And during the next one or two years, we believe the company will have
a major step forward. Thank you very much for your time.

**Operator**

The conference is now concluded. Thank you for attending today’s presentation.
You may now disconnect.

**Jackie Shi**

Okay. Thank you.

![SeekingAlpha](https://static3.seekingalpha.com/assets/og_image_192-59bfd51c9fe6af025b2f9f96c807e46f8e2f06c5ae787b15bf1423e6c676d4db.png)

",SA1000451,,2012-11-12 13:30:00+00:00,2012-11-12,"['CHNGQ.PK', 'CHNG.OQ^C12']",8590937497,CHNGQ.PK,US,486210,Transportation and Warehousing,Pipeline Transportation,50103030,Energy,ORD,,,,,,,,,False,
8,100051-gsc-investment-corp-f2q09-08-31-08-earnings-call-transcript.html,GSC Investment Corp.,GNV,financial,2008.0,,regular,"October 15, 2008",10:00 am,2008-10-15T14:00:00.000Z,27004,13100,13904,3,4,"['Richard Allorto - Chief Financial Officer', 'Richard Hayden - Chairman', 'Seth Katzenstein - Chief Executive Officer, President']","['Greg Mason - Stifel Nicolaus', 'James Ballan - J.P. Morgan', 'Jasper Bundt - Fox-Pitt Kelton', 'Bob Martin']","**Operator**

Welcome to the GSC Investments second quarter fiscal 2009 financial results
conference call. (Operator Instructions) Now for opening remarks, I would like
to turn the call over to the Chief Financial Officer, Mr. Rick Allorto.

**Richard Allorto**

I would like to welcome everyone to GSC Investment Corp's second quarter 2009
earnings call. Before we begin, I would like to read a brief statement. This
conference call contains statements that to the extent they are not
recitations of historical fact constitute forward-looking statements within
the meaning of the Private Securities Litigation Reform of 1995.

Actual outcomes and results could differ materially from those forecast due to
the impact of many factors. We do not undertake to update our forward-looking
statements unless required by law. A replay of this conference call will be
available from 1:00 p.m. today to Wednesday, October 29. Please refer to our
earnings press release for details. The second quarter 2009 shareholder
presentation is available in the investor relations section of our web site,
www.gscinvestmentcorp.com.

I would now like to introduce our Chairman, Richard Hayden who will be making
a few introductory remarks.

**Richard Hayden**

Welcome to all our shareholders. Needless to say, the last quarter has been a
period of tumultuous volatility and disruption in the global markets. We've
seen de-leveraging. We've seen de-risking. We've seen de-rating of almost
every asset class. We have not been immune, but on balance I think we have
done well as Seth will detail later.

Before proceeding, I want to spend a few moments on stock ownership and
emphasis the fact that GSC and the management team as a group are the largest
shareholders in GNV. I assure you, we are very, very focused on preserving our
capital currently and maximizing our value in the future.

As you know, the Board of Directors recently promoted Seth Katzenstein as the
CEO and President of our company. He succeeds [Tom Englestein] who is going
back to his roots in the distressed investment area, but he will continue to
be an advisor to the BDC and indeed, he maintains an office two doors down
from Seth so we will look forward to his continued support and advice.

Seth is the head of our credit and portfolio management for the U.S. COO
group, and he has been the portfolio manager for the BDC since the IPO in
March of '07. He was worked at GSC and its predecessor for over 10 years and
before that, at Solomon Brothers. I've worked with Seth during my eight years
at GSC and I have the highest confidence in his judgment, his credit skills
and I think he is extremely qualified to lead us during these challenging
markets. The Board of Directors and I certainly look forward to working with
him and his team in the months and years ahead.

I also want to mention that Alex Wright who heads the U.S. COO group has
assumed the primary responsibility for origination of deals for the BDC and
will continue to work closely with Seth as he has for several years. I will
now turn the call over to Seth for an update on the company's performance in
the last quarter.

**Seth Katzenstein**

I would also like to welcome you onto our second quarter conference call this
morning. I will briefly comment on the current market volatility and then I
will review our investment portfolio and strategy. Afterwards, I'll turn the
call over to our Chief Financial Officer, Rick Allorto who will review our
second quarter financial results.

Over the past month, a number of historic events have unfolded which have
resulted in unprecedented volatility in the financial markets. Although we
could not have predicted this unprecedented economic upheaval, we believe that
our investment strategy is staying high in the capital structure of our
portfolio companies, positioned us best under the circumstances.

Almost 70% of our portfolio is invested in senior secured obligation and
almost 17% of our portfolio is invested in a CLO that is collateralized by
more than 90% senior secured first lien term loan. We believe that this
investment strategy sets us apart from other business development companies.

Our business strategy has been and remains to employ a modest amount of
leverage to make portfolio investments that pay an attractive risk adjusted
return, and to distribute our net investment income as an attractive dividend
to our shareholders. Our strategy is designed to withstand normal capital
market volatility because short term changes in the fair value of our
investment portfolio do no directly affect our ability to generate net
investment income.

While we are obviously concerned about the continuing deterioration in the
financial markets and the economy in general, the financial impact on our
portfolio companies and our credit facility, we are pleased that we have been
able to maintain our dividend despite the decline in the fair value of our
investment portfolio caused by an unprecedented dislocation in the corporate
debt market.

Our net investment income per share was $0.42 for the second quarter versus
$0.38 in the first quarter. We declared and paid a dividend for the second
quarter of $0.39, equal to our first quarter dividend. For the second quarter,
our net asset value per share was $11.05 compared to $11.75 as of May 31. At
the end of the quarter, 21% of our corporate debt investments were first lien
term loans, 39% were in second lien term loans and 24% were in senior secured
notes which means that more than 80% of our corporate debt investment
portfolio was invested in secured obligations.

We believe that being senior and high in the capital structure increases the
probability of significant recoveries from troubled investments. Our corporate
debt portfolio is diversified with investments in a variety of industries and
issuers. As of August 31, we have 44 corporate debt investments in 23
industries and our average portfolio company investment was $3.5 million.

We have increased diversification of our portfolio. Since May 31, 2007, the
concentration of our top ten corporate debt investments has declined from 59%
to 51%, and the concentration of our top five investments has declined from
41% to 31%. Our stated goal is to limit any single corporate debt investment
to no more than 5% of our investment portfolio, and in fact, our average
corporate debt investment is less than 2.5% of our investment portfolio. Jason
Incorporated is the only portfolio company that exceeds our 5% limitation.

During the quarter, in response to market conditions, we modified the criteria
for watch list investments in order to provide an earlier warning of
potentially problematic assets. As a result, we added two portfolio companies
to our internal watch list, increasing the total to six. However, following
the end of the quarter, we exited our investment in EuroFresh, reducing our
internal watch list to five investments.

As anticipated, during the quarter another watch list credit, Atlantis
Plastics became our first investment to be carried on a non-accrual basis.
Atlantis filed for a Chapter 11 bankruptcy protection on August 10. We expect
to realize a recovery of 55% to 60% of par by the end of our third fiscal
quarter.

Our single largest investment is the equity tranche of our internally managed
CLO. This fund is invested in 124 issuers across 31 industries which helps
protect the CLO from performance problems associated with any individual
company or industry. 90% of the collateral is invested in first lien senior
secured term loans with the balance of its portfolio invested in a combination
of second lien term loans, high yield bonds and mezzanine CLO securities.

The CLO's portfolio continues to perform well with only two watch list
investments and no non-performing investments. And as a reminder, the CLO has
no mortgage related investments. The next payment date for the CLO is October
20, and we expect the annualized cash on cash distribution to be in excess of
20%.

Also, we recently posted on our website, gscinvestmentcorp.com, a primer on a
CLO which we believe you might find useful.

I'd now like to turn the call over to Rick to review our second quarter
financial results.

**Richard Allorto**

In my review of our financial performance, I will compare our performance to
the fiscal quarter of 2009 instead of the second quarter fiscal 2008. We feel
that our sequential quarterly performance provides a more meaningful
comparison because we were still ramping our portfolio at that time last year
and did not have the CLO investment. Please refer to our 10-Q which we will
file later today for additional information regarding our year over year
performance.

GSC Investment Corp's net loss for the second quarter ended August 31, was
$2.6 million or $0.31 per share. Our net investment income was $3.5 million or
$0.42 per share and our net loss on investment was $6 million or $0.73 per
share. For the six months ended August 31, our net income was $244,000 or
$0.03 per share.

Our net investment income was $6.7 million or $0.80 per share and our net loss
on investments was $6.4 million or $0.77 per share. As of August 31, our net
asset value per share was $11.05, a decrease of $0.70 per share from the prior
quarter.

For the second quarter ended August 31, our total investment income was $5.8
million, and increase of $120,000 versus the prior quarter. Our investment
income was comprised of $5.3 million of interest income, $489,000 of
management fee income associated with the CLO investment, and $90,000 of
miscellaneous bank interest and fees. The increase versus prior quarter is
mainly attributable to a higher effective interest rate earned on the CLO
equity investment.

For the second quarter ended August 31, our total operating expenses before
manager reimbursement were $2.6 million, a decrease of $177,000 versus the
prior quarter and consisted of $624,000 in interest and credit facility
expenses, $706,000 of base management fees, $407,000 of incentive management
fees, $261,000 in administrator expenses and $643,000 in general and
administrative expenses.

The decrease versus the prior quarter is attributable to a decrease in
interest and credit facility expense due to a lower average borrowing during
the quarter, partially offset by an increase in incentive management fees.

We recorded $261,000 in manager expense waiver and reimbursement for the
quarter ended August 31, resulting in total operating expenses after manager
reimbursement of $2.4 million, a decrease of $140,000 versus the prior
quarter.

The largest write down in the quarter was $3.3 million and our investment in
the CLO equity. We valued this investment based on a discounted cash flow
model that utilizes pre-payment, reinvestment, and loss assumptions that are
based on both historical experience and projected performance.

The unrealized loss is primarily a result of changes we made in these
assumptions in response to the current credit environment. Additional details
on the unrealized losses in our portfolio are available in our shareholder
presentation which can be found on our web site.

As of August 31, 29% of our investments were liquid and fair valued based upon
market quotes. 31% were fair valued by an independent third party valuation
firm, and 40% were fair valued internally. Approximately 60% of our
investments fair value are based primarily on market input, or valued by an
independent third party valuation firm.

The quarter ended August 31, we did not have any significant asset
realizations and recorded a net realized gain on investments of $174,000. As
of August 31, we had borrowed $66.3 million under our credit facility and had
$33.7 million of undrawn commitments. The actual amount that we can borrow is
based upon a dynamic calculation that includes such factors as market values,
asset ratings and recovery rates and portfolio diversification.

Over the past three quarters, the market values of our assets has declined by
approximately 11% and several investments have received ratings downgrades.
Accordingly, the total collateral balance for our bond base has declined and
limited our access to draw down on the remaining commitments. As of August 31,
the availability was $1.5 million.

That concludes my financial review. I will now turn the call back over to
Seth.

**Seth Katzenstein**

I just have a couple of follow up comments. Over the past several weeks, the
leverage loan market has experienced significant selling pressure caused by a
technical imbalance of buyers and sellers. Buyers continue to remain extremely
cautious as rebounds have been followed by even deeper losses. This cycle will
continue until a sufficient amount of leverage has been removed from the
financial system and confidence has returned.

Although we can't control the effects of market volatility on our investment
portfolio, or predict the severity or duration of the anticipated recession,
we think our increased diversification and strategy of remaining high on the
capital structure will serve us well. I would like to thank all of our
shareholders for their support during this especially difficult time. I look
forward to working with each of you.

I would now like to turn the call over to the operator to start the question
and answer session.

","**Question-and-Answer Session**

**Operator**

(Operator Instructions) Your first call comes from Greg Mason – Stifel
Nicolaus.

**Greg Mason – Stifel Nicolaus**

First I wanted to talk about your Deutsche Bank credit facility. If we're
remembering right that has an $88 million minimum net worth covenant. You guys
are at $91 million right now and Seth, you just said that the levered loan
markets since August has significantly deteriorated, so is it reasonable to
expect that you will violate that covenant next quarter and are you having
discussions with Deutsche about that?

**Seth Katzenstein**

You're correct. Minimum net worth is $88 million and at the end of the quarter
we had about a $3.6 million in our cushion on that covenant. We won't test
that covenant again until January when we have to report our January borrowing
base, so we have a little bit of time on that to see how the markets perform.

As respect to discussions with Deutsche Bank, it's a little premature to
comment on that, but that is certainly one item under consideration.

**Greg Mason – Stifel Nicolaus**

What are your thoughts in discussions with Deutsche, the concerns about the
line just being pulled because of the credit environment versus being re-
priced.

**Seth Katzenstein**

We have a good relationship with Deutsche Bank. They've been supportive of us
since we put the facility in place shortly after going public, and we look
forward to continuing to work with them. But it's premature to comment on
anything specific about the facility at this time.

**Greg Mason – Stifel Nicolaus**

Moving on the CLO, you said the decline in equity was due to some changes in
your assumptions. Can you tell us what you're assuming, for example [queue
mode] of loss assumptions for the CLO and how are those trending today
relative to your expectations?

**Richard Allorto**

There are two primary modeling assumptions. You calculate the fall rate
assumption in looking and modeling out the future cash flows. Historically, we
have generally looked at as a firm, the 2% default case and again, there's
some current estimates in the market and these are forecasted estimates of a
much higher expected default rate. So we did increase that assumption.

The next major assumption is the discount rate in your net present value
calculation, and that's one more derived at the current environment we're
seeing in conjunction with the fair value accounting and trying to determine
what we think we could exit this for and large of a discount we think a
potential buyer would require.

Actual performance to date, we've had no defaults in the facility so the
increase in the default rate is currently just based upon the modeled
assumption.

**Greg Mason – Stifel Nicolaus**

Can you tell us what the new constant rate default rate is?

**Richard Allorto**

We ran various models ranging from 2% up to 6%, and we looked at discount
rates, not present value discount rates in the range of 25% to 35%.

**Greg Mason – Stifel Nicolaus**

Can you tell us of the $5.3 million in interest income, what was the CLO
equity contribution to that $5.3 million?

**Richard Allorto**

$1.1 million.

**Greg Mason – Stifel Nicolaus**

You kind of touched on it, but in the past you said you expected about half of
the benefit from that CLO equity to come in the August quarter and the full
impact in the November quarter. What do you expect that $1.1 million to go up
to assuming that the current collateral remains unchanged?

**Richard Allorto**

Round numbers would be the $30 million times 20% effective interest rate, so
$1.5 million.

**Operator**

Your next question comes from James Ballan – J.P. Morgan

**James Ballan – J.P. Morgan**

I wanted to ask a little bit about the net investment activity. It looks like
the number for the exits and repayments on the quarter slowed pretty
significantly. Is this something you think was a result of just your portfolio
specifically or do you think this is more of the market impact and has that
slow down persisted since the end of the quarter?

**Richard Allorto**

Right now, we're very cautious and conservative in how we're going to invest
our portfolio. There's a significant slow down in the new issue activity which
is one area that we focused on a lot since we went public, and for all intents
and purposes, originators are not underwriting new transactions and the
forward calendar is basically empty.

But there are a significant number of opportunities in the secondary market,
and we are continuing to evaluate those. But you have to take into account
that a lot of the seasoned deals have weakened structures and you really do
need to be cautious as you're kind of picking through them in this current
credit environment.

So that certainly has been a factor in our investment pace. In addition, we
focused a lot last quarter as strategies industries were rolling off and
partially putting that money to work ahead of time in anticipation of the pay
down so we have front loaded activity a little bit in the prior quarter.

The combination of those in conjunction with just focusing on liquidity in
general on our portfolio accounts for the more limited investment activity
relative to our historical pace when we were ramping.

**Operator**

Your next question comes from [Jasper Bundt – Fox Knit Kelton]

**[Jasper Bundt – Fox Knit Kelton]**

Can you give us any color on the portfolio migration in terms of your internal
rating system? Where did you see movement? Could you give us any updates in
terms of some of your larger holdings like [Kemper Sports] and McMillan? Are
there any action with those companies that would be worth noting?

**Richard Allorto**

I think the big thing to note is the fact that we added two names to our watch
list during the quarter really as a result of expanding the criteria so we
could have an earlier warning system in place to focus on their performing
credit. The two credits that were added were IDI, also known as Interdent and
McMillan were added during the quarter. So that brings the total to six for
the quarter, but you have to exclude EuroFresh which we have divested and
Atlantis Plastics which ultimately will go away later this month, if not this
month, certainly by the end of the quarter. That's really what we're focused
on.

If you look at the rest of the portfolio and critically, we don't anticipate
any additional payment defaults or non-performing assets between now and the
end of the fiscal year. Beyond that, it's a little difficult to forecast given
the fact that if we're not in a recession, we will be.

**[Jasper Bundt – Fox Knit Kelton]**

In terms of your credit facility, if you had a borrowing base of $1.5 million
and then you had about $66.5 million total facility effectively which would
give our $68 million. When and how often does that get re-priced in terms of
your assets and when do the calculations get done? Is it safe to assume that
you'll have a facility of effectively $68 million through third quarter, or
does it last longer? When will that change?

**Richard Allorto**

We report our bond base to Deutsche Bank on a monthly basis. There are a
handful of assets in the calculation that do get currently priced, but the
majority of the portfolio, the pricing we'll use our August 31 values.
Beginning in October, for then the next three or four months, but there are a
number of limited assets that are priced at the current price.

**Seth Katzenstein**

I just want to emphasize something. The markets are extremely volatile but we
as a practical matter because we get to use the fair values on our books and
records, only have to mark our portfolio for the borrowing base on a quarterly
basis, other than the exceptions that Rick mentioned that are valued monthly.

So it does smooth out availability and the fluctuations in our portfolio with
respect to our credit facility.

**[Jasper Bundt – Fox Knit Kelton]**

I also noticed in your shareholder presentation, it looks like the EBITDA
underlying your portfolio went up a bit. Is that concentrated in a few
companies that have flowing cash flows or is that across your portfolio?

**Richard Allorto**

It's definitely a trend we're seeing across our portfolio as companies are
reporting weaker year over year results. For people on the call it's Page 7 of
the shareholder presentation, when you compare that to the slides of the
previous quarter, it's depending on the asset category, but over all it's
about a quarter of a turn increase across the whole portfolio. And that just
really a decline in overall performance of companies, and we're on top of it,
and we think ultimately the fact that we focus on investments that are high on
the capital structure and senior secured will ultimately protect us and serve
us well.

**Operator**

Your next question comes from Bob Martin.

**Bob Martin**

Can you give me the non-accruing loans at fair value as a percent of total
loans?

**Richard Allorto**

The only non-accrual is Atlantis Plastics which at August 31 fair value was
$3.5 million. As a percentage of the total portfolio, that equals 2.2%.

**Bob Martin**

Are the non-accrual loans the same as securities over 90 days delinquent?

**Richard Allorto**

No, Atlantis became a non-accrual because of the bankruptcy filing.

**Bob Martin**

Do you track 90 day delinquent loans?

**Richard Allorto**

Yes and no. We have no other loans that are payment default. Our policy would
be to continue to accrue, however potentially establishing a reserve against
that accrual up until a point where a company does file bankruptcy.

**Bob Martin**

Other BDC's report securities over 90 days delinquent and it's good to have a
yardstick to have the figure from you to compare with other companies.

**Richard Allorto**

Our 90 day delinquency would be zero. And to the extent that we have any
delinquent loans we would report that in our Q.

**Bob Martin**

Some BDC's report portfolio company weighted average net debt to EBITDA ratio.
Do you do that?

**Richard Allorto**

We don't report it that way in our Q, but if you look at Page 7 in our
shareholder presentation, we break out by each asset category the credit
stats, and we focus on leverage ahead of our investments and leverage through
our investments. Page 7 does a pretty good job of breaking that out.

**Bob Martin**

You mentioned your asset coverage ratio was 238%. This is the first time for
me to notice that spec. Can you give me some information as to how that
compares with other companies? How does that compare with you coverage ratio
in the past?

**Richard Allorto**

Starting with the second part, how it compares with our performance in the
past, over the past three or four quarters, I would say that's roughly in
line. Last quarter was a little tricky. We have a very large asset redemption
in strategic industries and made a pay down on our credit facility on the last
day of the quarter. I think last quarter was 256%.

Historically, I want to say we're right around the range we're at for the
quarter end at 238%.

**Seth Katzenstein**

Our strategy is different than some of the other credit oriented BDC's. We
focus on loans and securities that are high in the capital structure, that are
senior secured and probably have a little bit lower of a rate, interest rate
or coupon, and we offset that by employing leverage. So when you compare our
asset coverage ratio to other BDC's, we might have a little less coverage
because we have always employed a strategy of utilizing leverage to generate
net investment income and pay out an attractive dividend to our shareholders.

**Operator**

You have a follow up question from Greg Mason – Stifel Nicolaus.

**Greg Mason – Stifel Nicolaus**

One thing I'd like you to comment on about portfolio exit opportunities. Some
other BDC's have talked about their ability to as an investment violates a
debt covenant to pro-actively modify those investments. Since you tend to buy
more into club deals where you're one of several senior debt sponsors, what
are your opportunities to work with your portfolio companies and potentially
modify investment rates or covenants?

**Richard Allorto**

The situation is pretty similar for us as well. The extent of the issuers that
we invest in run into covenant problems and violate either financial covenant
or in the extreme case, can't pay their interest and principal. They're going
to have to work with us and the other lenders in the bank group or the other
bond holders to come up with a solution.

And those solutions entail a number of things including equity contributions
from the financial sponsors that own the company to provide liquidity or to
reduce debt which is what we would focus on, and then also increases in rate
and fees to compensate the lenders for the risk associated with the credit.

But our focus is on protecting the investment not necessarily increasing our
returns. We want to make sure we get our money back. Our strategy has always
been predicated on that and so we're going to use those situations as
opportunities to increase the company's liquidity position and to get paid
down if possible.

**Greg Mason – Stifel Nicolaus**

Can you talk a little bit more about how many lenders are at the table? You
guys have talked in the past that you do club deals and not broadly syndicated
deals. How many senior lenders are at the table typically in the investments
that you're in?

**Richard Allorto**

It's going to vary per investment. It's definitely issuer specific depending
on the size of the company and who ultimately originated the loan and
structured it. But for the traditional, more club like deals it could be
anywhere from five to ten, maybe a dozen. But it's going to vary.

**Operator**

We have no further questions. Mr. Katzenstein, I'll turn the conference back
over to you for any closing remarks.

**Seth Katzenstein**

We would like to thank everyone today for their participation and please do
not hesitate to contact either Rick Allorto, Michael Yip or myself if you have
any additional questions. Have a good day.

![SeekingAlpha](https://static3.seekingalpha.com/assets/og_image_192-59bfd51c9fe6af025b2f9f96c807e46f8e2f06c5ae787b15bf1423e6c676d4db.png)

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9,1000591-exide-technologies-ceo-discusses-f2q2013-results-earnings-call-transcript.html,Exide Technologies,XIDE,industrial-goods,2013.0,,individual,"November 12, 2012",9:00 am,2012-11-12T14:00:00.000Z,53785,21554,32231,3,11,"['James Bolch - President, Chief Executive Officer', 'Phillip Damaska - Executive Vice President, Chief Financial Officer', 'Carol Knies - Senior Director, Investor Relations']","['William Bremer - Maxim Group', 'Kelly Dougherty - Macquarie', 'Craig Irwin - Wedbush Securities', 'Kirk Ludtke - CRT Capital Group', 'Sean Britain - Bayside', 'Stan Manoukian - Independent Credit', 'Michael Guarnieri - Nomura', 'Max McGregor (ph) - McGregor Enterprise', 'Joe Von Meister - Bennett Management', 'Randy Gaulke - Muzinich', 'Scott Vogel - Davidson Kempner']","**Operator**

Good morning. My name is Brandy and I will be your conference operator for
today. At this time, I would like to welcome everyone to the Exide
Technologies Fiscal 2013 Second Quarter Results call. All lines have been
placed on mute to prevent any background noise. After the speakers’ remarks,
there will be a question and answer session. If you would like to ask a
question during this time, simply press star then the number one on your
telephone keypad. To withdraw your question, press the pound key. Thank you.

I would now like to turn the call over to Ms. Carol Knies, Senior Director,
Investor Relations. Please go ahead, ma’am.

**Carol Knies**

Good morning and thank you for joining us. You may view the slide presentation
for today’s discussion on our website at
[_www.exide.com_](http://www.exide.com). The presentation is located on the
Investor Relations homepage under Events.

On the call today is Jim Bolch, President and Chief Executive Officer, and
Phil Damaska, Executive Vice President and Chief Financial Officer. At this
time, I’ll review our Safe Harbor statement, then we’ll provide details of
Exide’s fiscal 2013 second quarter results as of September 30, 2012, followed
by a question and answer period.

Listeners should be aware that certain statements on this call may constitute
forward-looking statements as defined by the Private Securities Litigation
Reform Act of 1995. As such, they involve known and unknown risks,
uncertainties and other factors that may cause the actual or expected results
of the company to be materially different from any results expressed or
implied by such forward-looking statements. These factors are enumerated in
further detail in the company’s most recent Form 10-Q filed on November 9,
2012 with the United States Securities and Exchange Commission. Any statements
made during this call are made as of today and the company undertakes no
obligation to update any of these statements in the future.

At this time, I’ll turn the call over to Phil Damaska, Executive Vice
President and Chief Financial Officer.

**Phillip Damaska**

Thanks, Carol, and good morning. Today’s presentation differs from our
traditional quarterly earnings call format. I will begin by spending the next
few minutes reviewing the fiscal second quarter financial results and then Jim
will review several key strategic actions we have been taking to refocus our
businesses which have the intended result of returning Exide to a positive
earnings trajectory. We certainly hope you will find this useful in
understanding not only the what but the why we are taking the actions we have
announced. We will also endeavor to provide you with an understanding of the
anticipated financial implications of these actions. Now please turn to Slide
4.

Net sales in the quarter were up slightly excluding the negative impact of
foreign currency translation and lower lead-related pricing. Transportation
Europe and rest of world enjoyed higher after-market sales and industrial
Americas continued to see strong revenue, up 8.5% excluding lower lead-based
pricing. Excluding the unfavorable impact of foreign currency translation,
second quarter gross profit was lower than the comparable prior year period by
approximately $15 million. Of this amount, the Americas region was negatively
impacted by approximately $18 million, a result of continued high core costs
and lower LME-based pricing.

Operating income declined versus the prior year period primarily as the result
of higher core costs, compressed margins on third party lead sales, and much
lower LME-based lead prices. Net loss for the current quarter was 13.9 million
or $0.18 per share compared to a prior year period net loss of $3.6 million or
$0.05 per share.

Please turn to Slide 5. Our year-to-date U.S. lead production was
approximately 164,000 tons, down about 2.5% from the prior year period. As the
pie chart indicates, 78% was used to satisfy internal demand. External lead
sales decreased about 4,600 tons compared to the first half of fiscal 2012 as
we began to phase out this volatile revenue stream. Higher core costs
negatively impacted third party lead sales during the quarter, resulting in
significantly lower profits as these sales of (inaudible) sales as compared to
the prior year.

During the quarter, the average cost of purchased spent batteries as a percent
of LME remained at record levels. Core supply in October was much improved and
we have seen a corresponding softening in price while lead on the LME has
increased slightly. If these factors would remain at these levels or improve
further, operating income would benefit, everything else being equal.

We remain focused on improving our collection of spent batteries at more
economical levels. Our captive core return volume is up 14% sequentially over
the first quarter. Additionally as we reduce our transportation OE volume and
our third party lead sales, our captive core rate should be further improved
due to this customer mix change.

Turning to Slide 6, I’d like to review our operating segments. Industrial
Energy Americas net sales, excluding the lead-related pricing, was up about
8.5% in the current quarter as compared to the prior year second quarter. The
margin impact of stronger sales, however, was more than offset by $6 million
of reduced lead margin, the result of historically high lead of spent
batteries compared with lower LME-based price reductions. Expected price
increases did not materialize as competition backed off previously announced
price actions. Industrial Energy Europe and rest of world reported an
approximate 2% increase in net sales excluding lower lead pricing and
unfavorable currency translation. Operating margin held steady in the quarter.
Our European business reported higher operating income for the second straight
quarter while our import business in Asia Pacific continued to see margin
pressures from local producers.

Transportation Americas net sales, excluding unfavorable lead-related pricing,
decreased about 2% compared to the prior year second quarter. Both gross
margin and operating margin were down as compared to the prior year period
primarily due to lower aftermarket unit sales and continued higher cost of
cores combined with lower LME-based lead pricing. Third party lead sales
accounted for about $4.5 million of the reduced gross profit in the current
quarter. Transportation Europe and rest of world net sales, excluding foreign
currency translation and lead-related pricing, were flat in the fiscal ’13
second quarter versus the prior year period.

Gross margin and operating income declined as a result of lower carryover
pricing implemented in the second half of fiscal 2012, as well as an
escalation of core costs as a percent of LME. Although not as dramatic as
we’ve seen across the Americas, the cost of spent batteries has been rising in
Europe. Such cost increases are beginning to result in higher premiums paid
for lead. We expect these increases to be passed through in the form of
escalators.

Please turn to Slide 7 for an update of our liquidity position. At September
30, 2012, we had total liquidity of $211 million versus $228 million at
September 30, 2011. The current year includes $74 million in cash and
approximately $135 million under the revolving credit facility. As is
typically the case, to meet seasonal demands we added inventory in the period,
albeit at a lower rate than in the prior year comparable quarter. We used $99
million of free cash flow in the first half compared to a use of $87 million
in the prior year period. Consistent with the prior year, we expect third
quarter free cash flow to be close to break-even and to generate free cash
flow in the fourth quarter sufficient to offset a substantial amount of the
year-to-date burn.

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

**James Bolch**

Thanks, Phil. As Phil mentioned earlier, my comments are focused on key
strategic issues and actions for each business for both the near and long-
term. Let me begin with a focus on our Americas region. Slide 8 is summary
view of the important issues facing our Americas business. We’re disappointed
with the quarter and year-to-date results for the Americas segment. This
business has been faced with a rapidly changing economic environment and we
are aggressively adapting the business to deal with these new external
realities. This involved continuing to execute the strategic actions we have
already announced plus accelerating new initiatives. I’ll cover the actions we
have in place to address these issues during the next few slides.

Please turn to Slide 9. As we’ve discussed in the past, our Americas
transportation business has carried approximately one plant of excess capacity
for quite some time. About a year ago, we announced the planned shutdown of
our Bristol, Tennessee flooded battery plant to right-size our transportation
capacity. We have been executing on this initiative since then and continue to
be on schedule to transfer all flooded battery assembly from Bristol to
Salina, Kansas and Manchester, Iowa by the end of our fiscal third quarter.
I’m pleased to report that we are on track with certification from our OE
customers, a key milestone for the transfer. Formation of the process to
charge batteries will follow over the next three to six months as we complete
installation of new state-of-the-art formation equipment in the receiving
plants.

Following the complete closure of Bristol, we expect to have two plants at
substantially full capacity. As consistently stated, we anticipate an annual
improvement of 20 to $25 million in operating income as a result of this
initiative. A portion of this will be realized as early as this fiscal fourth
quarter with an anticipated full run rate beginning in the early part of
fiscal 2014.

Turning to Slide 10, I’ll brief you on our lead recycling capacity situation
and the revised strategy relating to our North American lead supply chain.
Approximately 400,000 metric tons of recycling capacity will have been added
to the North American market by 2013. Core supply and product demand have not
kept pace. This imbalance has likely contributed to high spent battery costs.
While we still believe that our recycling assets continue to offer us a
competitive advantage, we believe in this environment it is no longer prudent
to maintain capacity in excess of our internal needs. Some of the excess
capacity was historically sold profitably at LME-based prices to third
parties. As core costs have increased and LME has declined, profit from this
business has been reduced and become quite volatile.

In addition to our previously announced transaction with respect to our
Frisco, Texas recycling operation, we have decided to idle lead production in
our Reading, Pennsylvania plant. As shown on the chart, we will reduce our
capacity by roughly 150,000 tons by these actions. As a result, we are exiting
third party lead sales and will now procure 25% of our lead needs from
external tolling and primary lead suppliers. This supply equation will offer
us more much flexibility to optimize supply sources and freight logistics as
conditions change.

While we believe taking this combined capacity offline should relieve some of
the pressure on core costs, this was not the only reason for the decision. In
addition, we will avoid capital spending of as much as $50 million that would
have been required to bring Frisco and Reading into compliance with new
regulatory air emission requirements. The Frisco closure remains on schedule
and we continue to anticipate net proceeds of 35 to $38 million in mid-
calendar 2013. We expect to cease production in Reading by the end of this
fiscal year. Cash restructuring charges related to Reading are expected to be
4 to $5 million and a charge related thereto will be recorded in our fiscal
third quarter.

As with our Frisco workforce, we regret the impact this decision will have on
our Reading-based employees. They are a dedicated group of employees and we
will attempt to relocate those who have an interest and will work with state
and local officials to support the remainder.

Please turn to Slide 11. As we have described on previous calls, the
fundamental dynamics of lead recycling in North America have changed.
Historically core prices and LME have been correlated; or said another way,
the core price to LME ratio has been fairly constant. Over the last year, this
ratio has trended much higher and become less predictable. As previously
described by Phil, core cost in the Americas coupled with lower relative LME
lead prices continue to pressure margins significantly - $38 million year-to-
date. Clearly there has been a shortage of spent batteries and increased
demand with the new smelting capacity I discussed previously.

To adapt our business to this new market reality, we are exiting or reducing
our exposure to customer segments without corresponding core returns, namely
third party lead sales and automotive OE customers. Equally as important is to
obtain a higher percentage of captive cores at less than market pricing. We’ve
taken a number of steps to address this and are seeing steady progress.
Examples include utilizing our transportation branch network to focus on
industrial captives, up 19% in Q2 versus Q1; achieving better transportation
aftermarket customer mix with customers such as Pep Boys; and core collection
programs through our branch locations with core purchases up 50% in Q2 over
Q1. Results of these activities are promising. In particular, our return of
spent industrial batteries in the month of October was at an all-time high.

Lastly, we continue to negotiate with customers on pricing to better match our
lead input costs. We already achieved agreement from certain key customers on
escalators that consider both LME and core cost factors.

Please turn to Slide 12 for a discussion on the Americas industrial business.
As you are aware, industrial Americas has been our most profitable business.
Although margins have been pressured this year due to lead, this business
remains a significant opportunity for profitable growth. We remain excited
about the continued adoption of our Tubular motor power products. To support
increasing customer demand, we added a second line of Tubular capacity at our
Kansas City plant, which is already operating at a high utilization level.
Plans for a third line are under development and will be installed as demand
dictates.

With the recent AGM capacity coming online in Columbus, Georgia, we’re now
positioned for further penetration in multiple industrial applications
requiring basic AGM block batteries. We are under-represented in this product
offering with market share of 6 to 7 points less than our overall share
position. This incremental capacity will allow us to be more responsive with
respect to product needs and faster lead times.

Finally, our position in South America has been on an import-only basis to
date with mostly network power products. We are in the final stages of
establishing a partnership arrangement which we believe will position us for
further growth in industrial products in this region.

If you turn to Slide 13, you’ll see a summary of what we view as major issues
for our European business. With the next few slides, I’ll cover the strategies
and actions we have identified to address these issues.

Please turn to Slide 14. The chart reflects our current view of the OM
evolution to micro-hybrid batteries on a pan-European basis. This evolution
will potentially present a pricing and margin challenge for traditional
flooded batteries and a significant opportunity for those like us adding
capacity to meet the emerging micro-hybrid market. As demand for flooded
batteries diminishes we are taking aggressive cost reduction action to
mitigate price and margin erosion. More importantly, we are executing a well-
managed transition of flooded capacity to our MHF, or micro-hybrid flooded
product, to take advantage of this technology shift. At our Manzanares, Spain
plant, we are already transitioning from flooded to MHF by replacing 750,000
units of flooded capacity with MHF production. We are substantially complete
with our AGM capacity expansion in Romano, Italy and are well underway in
terms of adding more than 1.5 million units of AGM capacity in Poznan, Poland.

We are committed to continuing to invest in innovative solutions to meet our
customers’ evolving needs for these micro hybrid batteries. This will involve
not only technology development but also focused project management to ensure
customer approval (inaudible) this new capacity once online.

As you can see on Slide 15, transportation battery growth rates in eastern
Europe are expected to be significantly higher over the next several years
than in western Europe. This ongoing shift in demand by geography is causing
OEMs to move production east and they are encouraging their component
suppliers to do likewise. Our Poznan, Poland plant will support some of this
migration. To serve the CIS region and Russia, we have plans to expand our 75%
owned joint venture in Pinsk, Belarus. The planned investment will allow us to
meet demands of a major European OE as it expands car assembly into Russia.
The Pinsk expansion will take place over the next 24 to 36 months, supporting
CIS unit growth from roughly 500,000 in FY13 to approximately 1.5 million
units in FY16.

With Slide 16, I’ll focus on our actions to improve profitability of our
European industrial business. We’ve had some success with pricing in certain
targeted markets, but the vast majority of Europe remains very competitive.
With the economy softening in many countries, we expect the market to remain
in a competitive state. Driving profitability of the business continues to be
a primary focus. Through the use of lean six sigma and VAV initiatives, we are
seeing reduced product costs. At the same time, we are targeting capital
spending to allow greater productivity.

We are nearing the completion of an extensive project in our Lille, France
plant which will provide a more efficient production flow with reduced
indirect cost. We will be committing resources to redesign and approve network
power products, improving performance as well as extending the range of our
offerings. In Motive Power, our Tensor product has completed several
successful trials with many customers as we ramp production of this higher
margin product. We are also finding good success driving solution sales with
our more efficient high frequency chargers paired with Motive Power batteries.
Our service platform is being revamped to allow it to become a profit
generating activity. A reduction of our service technician population is
already underway and we intend to make our workforce substantially more
efficient using new automated service tools.

If you’ll turn to Slide 17, I’d like to recap our strategic focus for our
businesses. Starting with transportation Americas, we will limit growth and
continue to focus on return to profitability and cash generation. Limited
capital spending is anticipated with earnings improvement resulting from the
closure of Bristol, maximizing utilization of Salina and Manchester capacity,
optimized lead supply chain, and ongoing productivity initiatives. With
limited capacity, we will look to manage our customer portfolio for maximum
return on investment.

For transportation Europe, we are managing micro hybrid battery capacity ramp-
up carefully with demand. This will involve bringing innovative technology to
market for both advanced AGM and MHF solutions. We are carefully selecting the
right opportunities to meet growing demand in the CIS region, the Middle East
and North Africa.

For industrial Americas, we are re-deploying resources to allow this business
to grow profitably at a faster rate. We have great products with more new
offerings on the horizon. We’re in the process of adding more feet on the
street, including sales and service personnel, utilizing our existing branch
network. Additionally, we look to expand in South America via relatively small
investments to gain local content to serve this growing market.

In industrial Europe, we’ll be unrelenting in executing margin improvement via
pricing, new product introductions, and continued productivity initiatives. In
addition, we are in the process of exiting our small industrial business in
India as we focus on more attractive markets in Asia Pacific. Cash
restructuring charges to this will be fairly significant and we are finalizing
an impairment charge which will be recorded in our third quarter.

Please turn to Slide 18 for a brief summary and wrap-up. The fiscal 2013
second quarter was significantly impacted by continued high core costs
combined with lower LME lead-based pricing. However, as Phil mentioned this
morning, we began to have more adequate supply of spent batteries in late
September, and this has continued through October. We currently expect this
trend to continue as we enter the fall and winter battery season.

We continue to focus on improving profitability in all businesses, and the
completion of several new initiatives is in the near future, specifically the
closures of Frisco and Bristol and the idling of lead production in Reading.
Our targeted growth plans and actions in transportation Europe and industrial
Americas is underway and sets the stage for top line growth and improved
financial performance.

Today we mentioned several strategic changes in our business model and
corresponding footprint, shrinking in some, expanding in others. We believe
these important changes will allow us to more effectively target resources and
capital to drive improved returns in our business.

Thank you for your attention, and now we’ll open the call for your questions.
","
**Question and Answer Session**

**Operator**

Thank you. [Operator instructions]

Your first question comes from William Bremer of Maxim Group.

**William Bremer – Maxim Group**

Morning Jim, Phil. Good morning Carol. Did I hear you correctly, Phil, when
you said third quarter we’re looking for a restructuring charge in the
neighborhood of 4 to 5 million?

**Phillip Damaska**

It’d be 4 to 5 million for the Reading idling, and then as Jim indicated late
in our remarks, we’ll be formulating a charge for the closure of our
industrial business in India. The cash restructuring or severance related to
that will be fairly insignificant, certainly less than 700,000; and we’re in
the process of determining what, if any, asset impairment charge would be
associated with that.

**William Bremer – Maxim Group**

Okay. And as we look over the segments, how should we look at the back half of
this year for each one of them? I mean, if we look at, say, the transportation
Americas, you’ve seen very little growth top line first and second quarter
here. How do we look at the back half there, and then if we go into the
industrial side, a little bit in terms of the margins here on the Americas.
Year-over-year, we’re still down, pretty much flat-lining from the first
quarter. How do we look at it in terms of the operating metrics for these
segments going forward?

**James Bolch**

So Bill, let me try to take a crack at that one. To start with, if you look
year-over-year, we saw unit growth up in every segment except for
transportation Americas. Obviously there has been a currency and lead
escalator impact that suppressed the top line growth in the others.

As we look forward – and I’ll take them in the same order you asked the
question – transportation Americas, we saw this quarter down slightly, about
1.5%. We actually saw the OE volume up, but as we indicated on the call, we’re
looking to change that ratio and drive more aftermarket sales to OE. We’re
starting to see good demand as we move into the season. You’ll recall it’s a
seasonal business. We would expect much higher demand, although there is
certainly a weather component and you can probably predict the weather as well
as we can. But it looks like at this point we’re moving into somewhat of a
normal season. We also saw in this last quarter some attrition in the
aftermarket due to the pricing actions that we took in the market, and again
we’re working that side of the equation. We’re starting to see some of that
come back.

Moving to transportation Europe, again we saw pretty solid performance in the
quarter aftermarket unit sales, up about 4%. OE was up about 6. Certainly the
European market is a watch market. We believe this will be more impactful on
the OE side than on transportation. Again, the big indicator in Europe is
going to be the weather, and we’re seeing a strong start to the quarter.
October sales were quite robust there.

Moving to the industrial side, industrial energy Americas, we saw strong sales
in the quarter; and from what we’re seeing from a backlog there, we’re up 25%
year-over-year and continuing to see orders strong there. The most recent ITA
statistics in Motive Power, which tends to be an indicator, second quarter
shipments were up 4% and orders were up 5. The numbers that we have out of
September for us are saying that sales of electric trucks in the market are up
about 14% and our October orders continue to be strong.

All that said, with the fiscal cliff out there, the data we have today is good
but we’re certainly going to be very cautious here because I think this is a
place we’re going to have to watch our costs very carefully and we’re
monitoring inventory levels and costs very closely.

And then finally, industrial Europe – again, strong orders and backlog. Our
backlog in Europe and rest of the world was up about 37% year-over-year, and
although we’re seeing some signs of moderating in especially the Motive power
side – and again, I think this is a watch and see with the economic issues
that are in Europe today – we’re going to have watch the costs very carefully,
but at this point lines are still solid.

**Operator**

Your next question comes from Kelly Dougherty.

**Kelly Dougherty – Macquarie**

Hi, thanks for taking the question. Just wanted to see what you intended to do
with the—I think you said maybe up to $50 million you won’t have to spend to
upgrade Reading and Frisco. Is that cash you want to keep to bolster the
balance sheet or do you intend to plow that back into CAPEX in Tubular or
Start-Stop. How should we think about maybe CAPEX over the next few years,
given what you’ve outlined today?

**James Bolch**

Well Kelly, good question, and I’ve stated pretty consistently that this
company needs to spend around $100 million a year. That statement was based on
our prior footprint. Certainly I would expect the reduction of capital that
would have been required for both Frisco and Reading and the fact that we’re
going to have one less plant in Bristol, Tennessee that our going forward
spending certainly won’t be at that $100 million level. We’re evaluating the
fiscal ’14 budget at this point in time in terms of prioritizing capital
requirements.

You mentioned certainly the need to continue to invest in AGM and MHF. We’re
certainly going to continue to do that with respect to the projects that are
ahead of us – that’s Poznan, Poland and the conversion of MHF in Manzanares,
Spain. But in summary, I would expect to spend at levels lower than we’d
previously indicated as being required, so below the $100 million level.

**Operator**

Your next question comes from Craig Irwin of Wedbush Securities

**Craig Irwin – Wedbush Securities**

Morning everybody. I wanted to pick through the results of transportation
Americas a little bit more. So I noticed the gross margins in that segment
were up about 270 basis points sequentially, but when I look at the lead cost
metrics you’ve disclosed and the lead metrics trading on LME, the delta or the
gap between junk and LME – and junk being the number you disclosed – widened
from about 25% headwinds in your first fiscal quarter to around 35% headwind
in your second fiscal quarter, a very substantial deterioration but you still
came through with 270 basis points of margin expansion. Can you walk us
through really what’s having the most material impact there, and I know you
mentioned 50% increase in core purchases for your branches this quarter but
can you maybe give us a little bit more detail around that?

**Phillip Damaska**

I think the other piece that needs to be discussed is the pricing we did get
in the aftermarket. It’s about $5.5 million, and that’s kind of on the run
rate that we talked about a quarter ago, recognizing that volumes are going to
likely be stronger in the third and fourth quarter than the second quarter. So
the price that we were able to have stick in the aftermarket was beneficial.
You’ve probably seen, Craig, the purchase core cost, but as Jim indicated
we’ve had great success in terms of improving our captive core returns in the
industrial space. There’s a lot of lead in those industrial batteries. That
drives down the average cost of cores in our total lead equation.

So I would suggest that the aftermarket pricing of 5.5 million and the
improvement in captive core rates are what’s driving the improvement we’re
seeing.

**Craig Irwin – Wedbush Securities**

Okay, excellent. So when I look at core costs, to me – and this is my opinion
– it appears that you’ve really thrown a wrench in the machine of your major
North American competitor, disrupting the way they get their junk back and
influencing the market by your more successful procurement of cores through
captive recovery. Now, I had always expected that we would see a little bit of
hoarding of cores in the market going into this coming winter because we’re
going to see—or at least again in my opinion, it looks like we could easily
see a 10 or 20-year peak in unit demand given the prior very weak selling
season from the winter, and if we have some more favorable weather this
winter, and hoarding is a real impact when I talk to some of the people out
there.

Can you comment on whether or not you’ve seen hoarding of cores out in the
market and whether or not that’s influenced your ability to buy at prices that
you see as reasonable, and whether or not you see that as something that could
potentially come to an end?

**James Bolch**

So Craig, let me try to give you perspective this way. It’s obviously pretty
difficult for us to understand what our competitors’ core inventory levels
might look like. Certainly scarcity of cores through this year has been an
issue for us, not only in the price we had to pay for those purchased cores
but also from time to time we were running very thin, which has operational
issues – you have to have short cores in front of the smelters. What we are
seeing today, as we indicated on the call, is we have seen the market free up
a bit with cores. We now have an ample supply and we’re seeing better pricing
in the market. It could be that the overall market demand is down. It could be
we’re more effective in the way we’re going after it – likely a combination of
the two.

As we go into the winter peak demand season where we’re now ramping up
capacity, we feel very comfortable with our core supply situation right now
and what’s coming in. And I’ll reiterate – it’s incredibly important as we
change this mix going forward, once we are no longer having to supply the
third party lead sales and we have reduced demand for OE customers, just by
math our captive core rate will go up dramatically so there will be a lot less
pressure on us to go out and buy those purchased cores.

So in summary, I think we’re feeling pretty comfortable with our position
going into the winter season from core supply.

**Operator**

Your next question comes from Kirk Ludtke of CRT Capital Group.

**Kirk Ludtke – CRT Capital Group**

Hi, good morning everyone. You mention that the price of cores has softened so
far this quarter. If they stayed where they were, what kind of year-over-year
increase would you expect, say, in the second half of this fiscal year?

**Phillip Damaska**

Yeah Kirk, you’re aware we’re not providing guidance. That’s moving well into
that direction. All I would suggest to you is that if we see a normal winter
season, we ought to see some tailwinds, and as I said in my comments, if core
costs stay where they’re at today or improve and if LME stays where it’s at or
firms even further, certainly we’ll be positive on a sequential basis to our
second quarter. And that’s all I’m prepared to say at this point in time.

**James Bolch**

One point I would add there just to keep in mind from a timing standpoint as
we talk about lead escalator pricings, which tend to be a quarter in arrears,
a similar phenomena on input costs is if we saw the lead prices coming down
with about two months of inventory, it would be about a two-month lag before
we would see that in the income statement.

**Operator**

Your next question is from Sean Britain of Bayside.

**Sean Britain – Bayside**

Good morning. Wanted you just to talk about market share in the aftermarket in
the U.S. It looked like, looking at the BCI data, that the negative 1.5% you
guys realized in volumes kind of lagged a low single-digit market growth. I
also think your large competitor kind of posted positive numbers. In this
segment, do you have a sense if you are losing share, and if so, in terms of
what customers or what specific types of customers?

**James Bolch**

I think the numbers you stated are accurate, and as I said earlier, we did see
some attrition in the aftermarket predominantly in these independent battery
suppliers who tend not to be very loyal and are price-shoppers. So as we
increased prices, we saw some attrition in that segment. To counter that,
though, we are seeing ramp up in some of our larger customers. We talked about
Pep Boys last quarter and we’re now fully supplying them. As we move into a
two-plant scenario where we have Salina and Manchester, our intent is to be
very selective with customers. We want to fill those plants up, run then at an
optimal rate, but that will give us the opportunity to really pick the
customers that are most beneficial to us from a margin standpoint, and that
includes not only gross margin on the initial sale but core returns.

**Operator**

Your next question comes from Stan Manoukian of Independent Credit.

**Stan Manoukian – Independent Credit**

Good morning. Thank you for taking my questions. I have several questions
about smelters. I was wondering if you can tell me—and I’m trying to sort of
get this into one question in order to avoid standing back in the queue, what
is the capacity in your remaining smelters in Missouri, and what is the
capacity in your smelter in Pennsylvania that you are shutting down? And then
if I understood you correctly, the $50 million of CAPEX savings, is it only
related to Bristol or it is also 50 million included in Reading? And then
finally, how much you are paying now for junk batteries per pound, if I may
ask this.

**James Bolch**

Okay, let me see if I can take those going through. I think the best way to
describe the capacity in the smelting is on Slide 10 that we shared in the
prepared remarks. The combined capacity of Frisco and Reading was about
150,000 tons. That will be coming out by the end of this year once Reading is
done—in fact, Frisco is already in the process of ramping down as we speak.
Once that happens, we will then be below our internal demand which you can see
on that chart is something in the nature of 270,000 tons of demand, and we’ll
be buying about 20 to 25% of that outside.

The $50 million number that was referenced, that is the capital costs we will
not have to spend in the Reading and the Frisco plants to meet the new
stricter air emission standards. That has nothing to do with the Bristol
plant. Any savings from not having the Bristol plant would be incremental to
that going forward.

And lastly your question on pricing that we pay for purchased batteries, it’s
really a spectrum depending on the type of battery and the channel, and that’s
not a number that we typically disclose.

**Operator**

Your next question is a follow-up from Kirk Ludtke of CRT Capital Group.

**Kirk Ludtke – CRT Capital**

I was just curious – you talked about your strategic plan with respect to AGM
and MHF. Is that just in Europe or are you planning on rolling that
technology—I mean, what are your plans for that technology here?

**James Bolch**

Kirk, we’ve talked about this one pretty extensively on previous calls, and I
would tell you it remains pretty consistent with what we’ve disclosed in the
past. The market for transportation for these advanced batteries, for micro
hybrid or also called Start-Stop batteries, is much more robust in Europe
today than it is in North America. It’s actually still just beginning to
materialize in North America, so most of the volume today and most of the
capacity that we have put in place has been for that European market. I would
point out, though, that we very strongly believe, and it’s supported by what
our customers tell us, that it’s not a single solution; it’s not just AGM,
that there’s many applications that they prefer the MHF technology, which is
why we continue to pursue both.

In the case of North America, the capacity we brought online in our Columbus
plant is for the flat plate and we’re in the process of bringing online
Bristol, Tennessee for the spiral wound, is aimed at the transportation
market. In fact, we’ve launched it in the form of the Edge product for the
aftermarket, which is now starting to show up on store shelves around the
country. But we also are using that capacity to support increased industrial
production, especially in the flat plate side, these so-called AGM blocks; and
as we talked about in our call today, as this market matures in the U.S.,
which we believe is going to be much slower than in Europe, we can also
utilize that capacity to go into the industrial markets, which in many cases
is actually a higher margin proposition.

**Operator**

Your next question is from Michael Guarnieri of Nomura.

**Michael Guarnieri – Nomura**

Thank you. Good morning, folks. I had a couple of questions. One is coming
back to the question of margin, and there was a fellow earlier who was very
specific about transportation Americas, but would you be comfortable giving us
a view on what your gross and operating margin is by segment if you exclude
currency and lead? What I’m trying to get at is I think—we’ve done a back of
the envelope analysis, and it appears that we’re starting to see material
improvement, but we think our analysis is less than perfect and I was
wondering if you could just give us at least some indication and some thoughts
about margin by business, excluding the effects of lead and currency.

**Phillip Damaska**

So let me give that a shot, Michael. There are a lot of moving parts,
certainly; but as I look at the industrial energy Americas business, strong
growth, should have expected margins to improve as a result of that growth,
but $6 million of reduced lead margin – the definition of that being higher
core cost, lower LME – certainly impacted that business. That business has
historically been a business that’s generated mid-20s and higher gross
margins. It’s a business that’s historically operated at, call it 10% of
operating income or higher, and we believe that those are numbers that are
certainly attainable once we get this lead equation back in sync, and we think
we have the right strategy and right plans to accomplish that.

Transportation Americas business, certainly we’ve seen operational
improvements in that business; but the big evolutionary change of that is to
take a plant of excess capacity and take it out of the equation, and the 20 to
$25 million operating income improvement, we continue to confirm that. It’s a
number that we can now see on the near-term horizon with assembly being
transitioned between now and Christmas and then formation transitioning in the
next three to six months thereafter. That’s a business that we’ll see
operating income dip over the break-even point, and then as Jim indicated we
focus on continued productivity in a smaller footprint, we don’t focus on
growth. We focus on better management of our customer portfolio with the
intent of driving much higher return on investment than we have today. So
that’s a business that we think we have the right strategy in place. We’re
executing on that strategy, and again as I said, we see the light on the
horizon with respect to getting that business back into the positive and then
building on that as we move into ’14 and beyond.

Transportation Europe is clearly an invest-to-grow business. There’s an
evolutionary change in technology. We’ve committed to making that evolutionary
change. We’ve talked historically about AGM and MHF being higher price and
higher margin products. We expect to see that business return to much higher
profitability approaching, call it the high single digits on an operating
income perspective. And then industrial energy Europe rest of world is really
a tale of two tapes there. We’ve got a European business that has struggled
over the last 18 months or so. We think we have the right plan in place to
begin to enhance the operating margins and improve those to levels that our
industrial competitor enjoys, and you can see what they’ve reported most
recently out of their European business.

The other piece of that that we don’t disclose separately is our Asia Pacific
business. It’s an import-only business today. Those margins which have
historically been quite robust remain under attack from local producers and
the evolution that customers are taking to buy local product as opposed to
imported product from elsewhere in the world. We need to address the fact that
we are not a producer or manufacturer in that area of the world, and we don’t
have anything to report at this point in time but it’s certainly something
that we’re working on strategically as we move into fiscal ’14 and beyond.

That’s about as much color as I’m willing to give at this point in time.

**Operator**

Your next question comes from Max McGregor of McGregor Enterprise.

**Max McGregor – McGregor Enterprise**

How you doing? Thanks for taking my call. I appreciate it. I just had a few
questions basically about Pep Boys’ sales. How are sales going right now at
Pep Boys with that whole deal, and how soon do you think that’s going to
impact your overall profit revenue?

**James Bolch**

Well in terms of Pep Boys, we are now fully at run rate. As you recall, we
previously provided product to them for the premium lines through another
supplier, Bosch. We’re now supplying across the lines. We’re moving into the
winter selling season, so that’s really always the telling tale in this
business. We believe that Pep Boys has a good position there. They seem to
value the marketing firepower that we bring their business to help them grow,
so a lot of it will still come back to weather-dependent on the overall
aftermarket but that contract is running very good and we’re also continuing
to see high core returns in that particular customer, which is also very
beneficial.

**Operator**

Your next question comes from Joe Von Meister of Bennett Management.

**Joe Von Meister – Bennett Management**

Hi guys, thanks for taking the call. I don’t know if I got this right, but
lead gross profit in the first quarter was down 5 million year-over-year, and
38 million year-to-date. Is that correct?

**Phillip Damaska**

No, lead margin was down about 18 million in the second quarter, most of that
being in the Americas region, and it’s about $38 million globally on a year-
to-date basis.

**Operator**

Your next question is from Craig Irwin of Wedbush Securities.

**Craig Irwin – Wedbush Securities**

Sorry about that. Thank you for taking my follow-up question. So two questions
– first one is really a housekeeping issue. In the past, you talked about
environmental maintenance CAPEX being somewhere in the range of 30 to 35, just
for environmental; but you’ve brought down—well, Bristol is almost done.
Frisco and now Reading are on their way down. Can you talk about the
environmental maintenance CAPEX and then the rest of the maintenance CAPEX,
how you expect that to shake out? Is it still going to be in the sort of $60
million range, or is this going to bring it down as far as the base level of
annual spend that we should see in the business?

**Phillip Damaska**

Craig, let me try to take a crack at that. The 35 to 40 million of what I’ll
call replacement maintenance capital that we’ve historically talked about
included that for moderate environmental projects. It certainly didn’t
encompass all of the 50 million that we’ve talked about in terms of Frisco and
Reading. But taking the footprint from where it’s historically been at to
where it’s going to be, that 35 to 40 million of replacement maintenance
capital will come down. I don’t have a precise number to share with you today,
but it’s certainly a number that given a smaller footprint is going to come
down, and certainly as we finalize our fiscal ’14 budget and get a better
sense of what capital looks like for fiscal ’14, we’ll share that at the
appropriate time.

**Operator**

Your next question comes from William Bremer of Maxim Group.

**William Bremer – Maxim Group**

Yes. On the inventory levels, can you help us decipher a little bit of the
breakdown of the inventory that you’re carrying? I mean, given the events up
here in the northeast, I must assume that you’re going to have a significant
draw-down on both reserve and then follow up a little bit on the aftermarket,
given the events up here with Hurricane Sandy. Can you provide a little color
on that, please?

**James Bolch**

Well Bill, we don’t break out the product level. Certainly you can see by the
overall inventory positions for industrial Americas and the like. Let me maybe
just go to the hart of the question, which is around Storm Sandy. Certainly
it’s been a pretty horrific event. We have had a lot of inquiries already from
our customers, and interestingly enough it’s really come across all segments.
Network power is probably the most pressing one, and we’re looking to finalize
what that might look like. The most common discussion with those customers
right now is we’re going to need your help, and when we ask what kind and how
much, they say we don’t know yet – just get ready. So we are trying to really
guess what those inventory requirements will be, but we’re prepared to ramp up
production especially in our network power plants to meet that demand.

We would also expect to see some increased demand, though, on the Motive power
side. From a material handling standpoint, you can imagine there’s going to be
a lot of need to move goods and the like into that area. And then finally it’s
probably a little longer lag, but there’s been obviously a lot of damage to
the car park in the northeast and so we’ll expect to see some replacement to
not only components but even whole vehicles going to that area.

So it’s a little too early to tell yet what that demand is going to look like,
but I can tell you both from an inventory position but probably more
importantly as we’re trying to look at run rates and the capacities to spin
up, we’re going to be prepared there.

**Phillip Damaska**

Bill, let me just add some details around that. You’re aware of the seasonal
nature of obviously our transportation business. So we build inventory from
March to September. September is likely and historically been our peak period
of inventory. We’ve got about 80 days of inventory on a global basis. That
compares to 77, 78 a year ago, so very similar inventory position coming into
the winter selling season. Last year, we didn’t have one of those. This year,
we certainly have every expectation that we’re going to have a selling season
more normalized and would expect to obviously bring that inventory level down,
sell through, and then collect the receivables in the second half has
historically been the cash pattern of this company.

**Operator**

Your next question is a follow-up from Sean Britain of Bayside.

**Sean Britain – Bayside**

Hi guys, just a quick follow-up on the liquidity position. First, if you could
give me an approximation of the amount of your cash that’s in North America,
and the second part of the question relates to just your overall working
capital position. When I look at accounts receivable relative to this time
last year, relative to the balance of the year, it looks like your receivable
days had moved up. Is there any kind of change in the working capital profile,
or it is just kind of an anomaly in the numbers this quarter?

**Phillip Damaska**

Let me address the liquidity in the cash position. In terms of how much cash
is in North America, I basically look at cash between Europe and North
America, we can bring cash back and forth without much issue as a result of
intercompany lending that exists between the U.S. and Europe. The only amount
of cash that would have a cost to repatriate, if you will, would be about $20
million of cash that we have in China. At this point in time, it’s our sense
and our view that we’re going to use that to invest in China, but if push came
to shove we could get the cash back with a minimal amount of cost.

In terms of receivable days, certainly a bit higher than it’s historically
been. I think some of that is driven by customer mix change. As many of you on
the call are aware, these aftermarket automotive retailers, certainly part of
the price of entry is longer terms than we have seen with other customers like
the OEs. We certainly weigh that into—take it into account when we price the
product, so obviously the adding of Pep Boys has lengthened our days here.
Although with that said, I would say that our days sales outstanding in our
Americas business, particularly the transportation business, is a pretty solid
statistic vis-à-vis the overall aftermarket.

Certainly it’s something we’re looking at very closely. Obviously the economic
issues that we’ve faced in Europe provide potential credit risk, and we’re
keeping a very watchful eye on that. But overall, I’m not particularly worried
about the days sales outstanding, and we expect, as I said earlier, to sell
through and collect a significant amount of our receivables in the third and
fourth quarter as we historically have.

**Operator**

Your next question comes from Randy Gaulke of Muzinich.

**Randy Gaulke – Muzinich**

Yes, hi. Just going back to the chart on Page 10 and your decision on exiting
the capacity, as you looked at this and as you looked at the possibilities—I
mean, for the last little bit we’ve had the core costs that the mismatch,
shall we say, of core prices and LME prices. But under what scenarios does
your decision to reduce this capacity and rely on external supply not work, or
when does that move against you, so to speak, if we get a recovery or if we
get a change in some of this relationship?

**James Bolch**

Randy, let me take a shot at that one. Part of the answer to this is you have
to look at where the company has been historically. We’ve had quite a bit of
recycling capacity in this company, and because of where it came from
historically and what’s happened with the markets, actually more than we need
internally. If you were to look at the competitors in our space, the major
competitors anyway, we believe their internal recycling capacity goes from
none at all to perhaps something like 50%. After this change, assuming that
Reading were to stay idled, we would still be at 80%, so we would be as a
percent of our internal demand still the most highly vertically integrated of
anyone in our space, at least certainly of the major players.

If you can imagine when could it go against us, well, if in the future I
suppose this core price to LME ratio was to go back down to very low levels,
at that point this external lead sales business could again become a
profitable, steady business. At this point, we believe that’s not our core
business. I mean, our core business is to make and sell great batteries to our
customers and drive margin there. And if you think about what the investment
decision looks like, they would say we would have to go invest these very
large amounts of capital to go into really a speculative third party metals
business, and we’ve decided that that’s not the best place to put our capital
today if we want to be a great battery company.

Having this 20 to 25% dependence on the external market actually gives us some
very interesting abilities to go optimize our supply chain. Certainly from a
tolling standpoint, there is still excess capacity in the industry right now.
That tends to make for competitive tolling rates, and should we choose to also
go buy some of that from a primary metal supplier – that is virgin lead – over
this past year, we’ve actually seen situations where that could be less
expensive than recycled lead. So we actually feel very good about this
position in terms of deployment of capital and as well as our ability to
optimize our cost structure.

**Operator**

Your final question comes from the line of Scott Vogel of Davidson Kempner.

**Scott Vogel – Davidson Kempner**

Does your Q3 free cash flow guidance include the sale of Frisco?

**Phillip Damaska**

No, the Frisco proceeds, as I attempted to indicate, aren’t going to be
accessible until mid-calendar 2013. They’re in escrow at this point in time.
There’s a number of steps that have to transpire to get that money out of
escrow, and ultimately we expect to have those proceeds, call it in the July-
August time frame.

**Operator**

And that concludes the question and answer session. I’ll now turn the call
back over to management for closing comments.

**James Bolch**

Thank you. I’d like to just thank everyone for their time on the call this
morning. Hopefully the format that we’ve chosen this morning has been helpful.
We really wanted to, as Phil said at the outset, convey not only the what but
the why we’re taking the actions that we are. We believe that we’re moving
this company toward a position of improved financial performance, but it
involves a lot of hard work and we believe we’re on the path. Again, thank you
for your time this morning.

**Operator**

Thank you. That concludes today’s conference. You may now disconnect.

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10,100060-velocity-express-corporation-f4q08-qtr-end-06-28-08-earnings-call-transcript.html,Velocity Express Corporation,VEXP,industrial-goods,2008.0,,regular,"October 15, 2008",9:00 am,2008-10-15T13:00:00.000Z,31674,19665,12009,3,2,"['John G. Nesbett - Institutional Marketing Services', 'Vincent A. Wasik - Chairman of the Board & Chief Executive Officer', 'Edward W. Stone - Chief Financial Officer']","['Robert Schwick - Berham', 'David Campbell - Thompson, Davis & Company']","**Operator**

Welcome to the Velocity Express fourth quarter and year end results conference
call. (Operator Instructions) I now would like to turn the meeting over to
John Nesbett of Institutional Marketing Services.

**John Nesbett**

On the call today we have Vince Wasik, Chairman and Chief Executive Officer
and Ted Stone, Chief Financial Officer. After prepared remarks we will host a
question and answer session. Now, let me take a moment to read the Safe Harbor
statement. Certain statements made on this call by or on behalf of the company
may constitute forward-looking statements within the meaning of the Federal
Securities laws.

Statement regarding future events and developments and the company’s future
performance are not historical. Non-historical facts as well as management’s
expectations, beliefs, plans, objectives, assumptions and projections about
future events or future performance are forward-looking statements within the
meaning of these laws.

Forward-looking statements include statements that are proceeded by, followed
by or include words such as believe, expects, anticipates, plans, estimates,
intends and similar expressions and include statements about our ability to
release routing efficiencies and control driver pay, our ability to generate
revenues and profits from potential customers in our pipeline, our ability to
be successful in our new franchise strategy and our ability to comply with the
new financial covenants in our revolving credit facility.

Forward-looking statements are only predictions and are not guarantees of
performance. These statements are based on beliefs and assumptions of the
company’s management which in turn are based on currently available
information. These assumptions could prove inaccurate. Forward-looking
statements are also affected by known and unknown risks that may cause the
actual results of the company to differ materially from any future results
expressed or implied by such forward-looking statements.

Many of these risks are beyond the ability of the company to control or
predict. These and other risks are indentified in the section titled risk
factors in the company’s annual report on Form 10-K for the year ended June
30, 2007 as well as in the other documents that the company files from time-
to-time with the Securities & Exchange Commission.

Management believes that the forward-looking statements contained in this
release are reasonable however, undue reliance should not be placed on any
forward-looking statements contained herein which are based on current
expectations. Further, forward-looking statements speak only as of the date
they are made and management undertakes no obligation to publically update any
of them in light of new information or future events.

With that out of the way, I’d like to turn the call over to Vince.

**Vincent A. Wasik**

Despite the current depressed economic conditions, Velocity earned $2.1
million EBITDA in the June ‘08 quarter. The company will be EBITDA positive in
the September quarter. From our perspective, we’re very excited about some of
the developments but from our perspective obviously there’s still some
challenges ahead.

The major challenge obviously is the economy and the reduction in a number of
the account delivery volumes that we have experienced. However, saying that
because of the route efficiencies from a driver perspective and purchase
transportation, because of the continual reduction of G&A and direct labor
costs, we really have been able to continue the efficiency that we experienced
in the June quarter and we will continue that as I said in the September
quarter.

Ted will give a few more highlights but one of the key points I’d like to
really provide to everyone is in the last four months alone because of the
FedEx independent contractor action we’ve spent over $800,000 in legal
expenses and we’ve now petitioned to consolidate all of those in to one
jurisdiction. There are 11 different class action lawsuits that have been
filed and we are vigorously defending these because we feel that we are
exactly the opposite of what FedEx has done with their independent contractor
owner/operator model.

So from our perspective we’re still very, very positive that we will win. In
fact, we continue to win state by state in a number of these actions but we
believe that the best thing to do is to consolidate so that we reduce the
legal costs. As I mentioned, we’ll be EBITDA positive in the September quarter
despite almost $1 million in legal costs.

With that, let me turn it over to Ted and then I’ll come back to give some
other key business highlights.

**Edward W. Stone**

Although the 10-K we filed last night is of course the annual report for the
full fiscal year of 2008, I’m going to focus my remarks today on the fourth
quarter results because that’s how we really measure our progress. The short
story for the June quarter is, as Vince just said, we had a good quarter
despite a poor economy. Now, fourth quarter revenue was $79.3 million compared
to $82.2 million in the third quarter of fiscal 08 and $98.6 in the fourth
quarter last year.

Revenue declined from 2007 because of our planned exit from uneconomic
customer contracts acquired with the CD&L merger, the loss of a significant
bank customer in the second quarter of 2008, continued migration of banking
customers due to the Check 21 scanning technology, some volume declines from
continuing customers due to the slowing US economy and you heard Vince mention
that as well. Then, what we will refer to as unplanned customer service stops.

These changes were partly offset by new revenue from customer start ups of
$7.5 million and $2.5 million of volume growth from other continuing customers
that are less affected by the slowing US economy, primarily customers in the
healthcare area. If we compare revenue to the March quarter it’s down $2.9
million, a third of that is getting out of uneconomic contracts. Over half of
it is volume declines from continuing customers because of the slow economy.

There is another $2.5 million that is unplanned customer service stops but
then $2.5 million of new customer starts benefitting revenue in the June
quarter. That level of unplanned service stops continues to trend down. That’s
just one more indication that the integration of the driver forces and the
databases that we use to manage them are now behind us. In fact, these
unplanned service stops in the first three months of fiscal 2009 are down to a
quarterly rate of $1.5 million, better actually than where Velocity was before
the merger.

Turning to gross profit, our gross profit before depreciation for the quarter
was $22.8 million, that’s 28.7% of sales, a little bit better than we had
projected it was going to be when we were on this conference call back in May.
That compares to $20.9 million or 25.4% of sales in the March quarter and
26.9% of sales for the June quarter a year ago.

That year-over-year change reflects a 330 basis point improvement in driver
pay margin which was partially offset by the absence of a non-cash benefit
last year that totaled 1.8% of revenue because of the fiscal year end purchase
accounting adjustments that had to be recorded in cost of services. Driver pay
margin increased because of improved driver pay management and route
engineering made possible by integrating the customer and route management
databases.

In fact, the average weekly settlement paid out to our independent contractor
drivers actually increased by more than 3% year-over-year while the revenue
per driver rose by more than 7%. This is the triple win that you heard us talk
about in past calls. Fewer drivers making more stops and therefore making more
money driving fuller trucks on well designed tighter routes that permit better
service to customers.

We compare to the March quarter, gross margin improved by 330 basis points
almost entirely because of the driver margin improvements that I just
described and then some smaller cost savings in the other areas of direct
costs. Importantly, both of those comparisons would have been even better had
we not experienced the substantial increase in the cost of fuel you heard us
discuss back in May.

We need to adjust the settlement payment we make to our drivers every week
because they literally need the money to fill their gas tanks. At the same
time, the typical adjustment period for those customers that have fuel index
provisions in their contracts is monthly, a few are bi-weekly, some are even
quarter so there’s a disparity there. In addition, as we discussed on our
earnings call in May, there were a number of customers with fuel index
provisions that either didn’t exist or they were simply to divorced from
today’s reality to be useful and we had to renegotiate.

That’s been completed but during the June quarter, those disparities cost us
more than $1 million in the quarter of further margin improvements we could
have achieved. If we move down the P&L to operating expenses those expenses
included in adjusted EBITDA for the quarter, as we showed in the press release
were $20.6 million or 26% of sales compared to $22.6 million which is 27.5% of
sales in the March quarter and $24 million which is 24.1% of sales in the June
quarter a year ago.

Our operating expenses compared to last year decreased in proportion to
revenue in basically every expense category except the cost of our warehouse
and cross dock facilities where we have purposely expanded to meet the needs
of our growing retail store replenishment business.

If we want to compare to the March quarter, operating expense declined in
dollar terms and as a percent of revenue due to reductions in G&A, salaries
and nearly every other category of G&A expense with the exception of legal
expenses as Vince mentioned, in connection with the class action lawsuits
related to the employment status of our independent contract drivers and the
Office Depot legal action.

Now, during the quarter as you have all seen, the company reported a non-cash
goodwill impairment charge of $46.7 million based on our determination of the
fair market value of the company compared to the book value of all of our
assets and liabilities. As you all know, the major portion of our goodwill
asset rose in connection with the CD&L merger. Net interest expense in the
quarter moved up from $5 million in March and June a year ago to $7.3 million.

That is due to an increase in the interest rate on the senior secured notes
due 2010 and an increase in the non-cash amortization of the debt discount
associated with the debt restructuring that we announced on May 19th. The
result of all those puts and takes is an adjusted EBITDA for the quarter was
$2.1 million. That compares to $2.8 million from a year ago but, please
remember that last year’s adjusted EBTIDA number included a $1.5 million non-
cash benefit from those purchase accounting adjustments.

You can therefore look at our $2.1 million of EBITDA this quarter as a nice
increase from what it was June a year ago and of course a very nice turnaround
from a $1.7 million EBITDA loss in the March quarter. Now, we can’t move on
from the financials without also talking about another element of the press
release and that of course is the opinion of our accountants. When we filed
our Form 10-K last night it contained a going concern qualification from our
auditors.

Now, this announcement does not reflect any change or amendment to the
financial statements or any reclassification of debt to short term. The
opinion of our accounting firm is based on our history of losses which has
resulted in negative working capital and a net deficiency in shareholders’
equity. Now, as you saw me say in our press release this morning, obviously
we’re not happy about a going concern opinion but we do believe we are making
good progress in replacing our current revolving credit facility.

If we’re successful doing that, that may permit us to reevaluate our position.
We have executed a letter of intent with the US subsidiary of a major European
bank. We finished the due diligence despite all the turmoil in the credit
markets we got credit approvals up until and including the credit staff at the
parent bank two and a half weeks ago. Unfortunately, shortly after September
25th the events in the global credit markets really accelerated and that
simply slowed down the approval process beyond yesterday’s filing date for
year end financials.

As of yesterday, our financing partners in the US subsidiary remain optimistic
that final approval is in process and that we’ll be able to start
documentation and closing in the very near future. Now Vince, I think that
covers the most important financial figures that we needed to go over so I
would like to turn the call back to you.

**Vincent A. Wasik**

In fact, I’d like to talk a minute about what Ted just said about the
accountant’s opinion. Currently, with our current lender we have a number of
covenants and we made the monthly profit covenants so that is really not a
problem. But, we have a driver pay covenant and as Ted mentioned with any
spike in fuel it is very difficult because we pay the drivers weekly and in
many instances we don’t get the fuel surcharge for a month.

Therefore, what we really have because of this basic lag in customer receipts
in certain weeks we do not meet the bank covenant or have not met the bank
covenant for driver pay purchase transportation even though as I said, we did
achieve the monthly profit covenant in every month. As a result of this
structural disparity what we really have on a going forward basis is we can’t
show the auditors and we can’t get a future waiver because it is in the credit
agreement so our only choice is really to replace the overall credit
agreement.

From our standpoint, we really believe that you cannot have a driver pay
purchase transportation covenant even though it is the largest expense
category because from an overall perspective you will have week-to-week
changes. Obviously, if it had been a monthly covenant it really wouldn’t have
been a problem but our current lender really wanted to see week-to-week
progress and that’s not the way to measure this business.

From our perspective as Ted mentioned we really thought that we would have the
lender replaced but when the credit market basically just tightened up it was
impossible to get it completed before the audit. Even though I have to say,
that we tried like hell to get it done and we thought we might have had it
done but rather than not file the 10-K timely we decided we would file the
10-K with this going concern which we believe is from our perspective
something that we’re going to be able to rectify in the near future.

Now, what I would like to do is I would like to talk for a couple of minutes
about some of the various questions that a number of people have asked and I
have been, unfortunately because we were in this period where I couldn’t
comment I’d like to try to give an overview in terms of some of the things
that are going on within the company.

First of all, we continue to diversify our mix of business. As we announced
previously, we did sign a multiyear $30 million plus contract with a
significant retailer and because of that contract we’ve just been awarded a
number of other major customers for an additional $8 million of annualized
revenue. With the planned diversification of our business mix, we now believe
that we are not vulnerable to any one business sector.

In fact, the financial institution sector is now less than 10% and it is
interesting that a number of the financial institution that recently either
declared bankruptcy and/or have been taken over where major financial
institutions that we no longer had from a year ago. It was all part of the
planned diversification process. In retrospect, we loss that revenue but it
probably wasn’t so bad because there’s no more business for that particular
account or they’ve disappeared.

From our perspective we’re very excited about the diversification. A lot of
that is in the retail and healthcare sectors. In fact, I just returned last
week from a major conference in Denver with Jack Duffy, the former Senior VP
of Strategy of UPS. It was a counsel of supply change management
professionals. It was interesting that one of the original founders, a
distinguished professor of supply chain management at the University of
Tennessee, Dr. Mentzer also happens to be a board member of Stage Stores, the
major account we signed.

It was interesting because between him and Mr. Grubbs who is the senior
executive of Logistics of Stage with 150 some odd people in the audience
really said, “The partnership with Velocity Express has worked so well that
other retailers ought to be looking at the line haul infrastructure, the
delivery infrastructure that Velocity has.” Because we have been able to do
such a phenomenal job with the start up that we really began in July and
August that Ted referred to.

Mr. Grubbs has given tremendous recommendations to a number of other retailers
and that’s one of the reasons why we’re able to report an additional $8
million that is annualized that is going to be starting here very shortly.
From our perspective we’re very excited about the diversification because
we’re not at risk in any one category and we believe that with what we’re
doing from a number of our strategic initiatives that we’re going to be able
to be extremely strong in a number of key sectors from a growth perspective.

One of the key points that I talked about previously was our V-Trac 50
Scanning. We have continued to increase our investment in the V-Trac 50
scanners and in fact all 3,500 of our drivers will be using V-Trac 50 scanners
by March. Currently 35% of our drivers have 50 scanners with our other drivers
using the older V-Track 30 model. But, we have an aggressive roll out schedule
to meet our March objective and our latest version of the 50 is GPS tracking
capabilities which in our test have increased driver productivity by an
additional 2%.

As a result, we’ve made the decision that once every driver has a 50 scanner
we’ll replace even the initial version of the 50 beginning in March. Another
strategic initiative that I’ve talked about on previous calls is the global
alliance partnership. I should highlight here that we have NDAs from all of
our bond holders and we also have NDAs from the key preferred shareholders
which control the votes in each of the various classes. We have revealed to
them who we are in discussions with from a global alliance perspective.

We don’t believe that this is going to happen within the next few weeks but we
believe that everything that we have been working on, on a going forward basis
really points to the fact that with our extensive US ground delivery network
and the line haul infrastructure that we can offer a lower cost alternative in
the United States for both European and potential Asian partners. Over the
course of the last two months I’ve been in China and also have been in Europe.
From our standpoint, we’re very, very excited about some of the opportunities
that exist there.

Ted mentioned that we continue to have a strong pipeline in the retail and
healthcare sectors. What we’re seeing is a lot of retailers and in the
healthcare continue to look for savings. Savings both from their current fleet
that they may have that they want to outsource and their current providers.
From our perspective although the economy is depressed, although we’re seeing
less deliveries in terms of volume from each of our existing customers which
in some cases is fairly significant we believe that by adding a number of
these potential opportunities that from our perspective we can continue to
grow the revenue.

Tough economic times but we really believe that there’s a significant
opportunity. With that, I’d like to open it up for any particular questions
that anybody might have.

","**Question-and-Answer Session**

**Operator**

(Operator Instructions) Our first question comes from [Robert Schwick –
Berham].

**[Robert Schwick – Berham]**

With the stock trading at this price there’s going to be another issue of
being delisted from NASDAQ I believe. Could you tell us how you’re planning to
handle this?

**Edward W. Stone**

There is a process that we will go through with NASDAQ on three counts now,
the minimum share price, the minimum net worth, the now negative shareholders’
equity in which we will explain to them some of the things that Vince has
alluded to both in terms of our improving operating results which we would
expect to show up in the value of the company in the stock market as well as
that our role within the global alliance as it comes together. We believe that
in our conversations we’ll be able to maintain our listing until there is a
definitive event.

**[Robert Schwick – Berham]**

In other words you don’t think that the December 4th deadline is going to be
affective for delisting?

**Edward W. Stone**

Obviously we can’t commit to what NASDAQ is going to do but we understand what
the appeals process is, if you will, going through hearings with the NASDAQ
Hearing Commissions as they set them up. We’ve got a pretty clear idea what
our story will be to them and believe it will be persuasive. Of course, we
can’t speak for the hearing panel.

**[Robert Schwick – Berham]**

In doing that are you making any forecasts of what your bottom line operating
results might be for the following fiscal year? The 12 months ended June 30th
’09?

**Edward W. Stone**

We have not given the economy where it is we’re pleased to say that we have
been profitable continuously since March of this year and expect to remain so
but aren’t about to start making forecasts. You know, detailed forecasts of
our earnings per share and specific dollar amounts of EBITDA by quarter or
worth for the full year.

**[Robert Schwick – Berham]**

You don’t have to do that Ted for the NASDAQ listing issue?

**Vincent A. Wasik**

Well, I think there are two things with the NASDAQ listing that will be
similar to what we’ve done with bond holders and the preferred shareholders.
We will obviously be revealing some of the confidential information plus the
fact that we will also be providing to them the forecast of exactly which
customers we have signed, when their start dates are and the opportunity that
we see on the going forward basis to reverse even with the economic climate
some of the perceptions out there.

One of the key points I think I’ve mentioned on previous calls is that no
retailer starts the business after August and the reason for that is because
obviously with the Christmas season. But, we have a fairly good idea of what
is going to happen right after the Christmas season with a number of our
accounts and obviously we’re factoring that in to some of our opportunities
that we have on a going forward basis.

We’ll make the case. We hope to get an extension. We’re very confident that
the case will be very persuasive but, as Ted mentioned, we can’t predict what
a government organization will do, as we witnessed over the course of the last
30 days from the United States government and all of our top officials.

**Operator**

Our next question comes from David Campbell – Thompson, Davis & Company.

**David Campbell – Thompson, Davis & Company**

I just wanted to ask, normally you do have some statements about where you
think the gross profit percentage will go. I know that you were targeting, or
believe you were targeting 28% for the June quarter which you earned and even
higher than that at the end of the quarter. Where was it in the September
quarter and why won’t you give us any objectives for fiscal ’09?

**Vincent A. Wasik**

I think from our perspective is what we’re looking at is there are two key
factors in the gross margin. Obviously, the first is the revenue coming in and
the second, the major cost area obviously is in the driver pay and purchase
transportation. From our perspective we’re very confident that we’re going to
continue to show improvements in the gross margin but one of the key points in
terms of the deliveries is that if we are priced per stop we really do
extremely well.

If the customer has it on a price per package which is similar to what UPS and
others are experiencing, if the package volume goes down that is extremely
hard to predict and from an overall perspective if you’re averaging roughly
3.8 packages per delivery and you’re paid on a per package, and you suddenly
are getting 2.8 or 2.5 obviously that driver is looking and saying, “Excuse me
I have to make that stop and my fuel, my lease cost, etc. is lower.” The way
to handle that is through more efficient route engineering as Ted pointed out.

The key to this is I think some of our accounts have been absolutely
flabbergasted by the decline. In fact, as Ted knows we’ve signed NDAs with all
of our accounts but if I were in the financial investment business and knew
what I know in terms of the shorting the stocks I probably would be an
extremely wealthy individual taking that information. Because, we have been
flabbergasted by the decline in some of the accounts and so have they.

So, from our perspective we think that achievement of that 28.7%, 29% margin
is probably a fairly, fairly good achievement and unless the economy
stabilizes we’re going to be playing catch up week-to-week, month-to-month.
Even though we think that we should be able to get over the 30% I’m probably,
and I’m usually the most optimistic guy, I’m very cautious at this stage
because I know how difficult it is to basically reroute on a weekly basis.

Normally, we’re rerouting on a monthly basis but to reroute on a weekly basis
is a horrendous task in 100 plus cities. And, most of our accounts are in
multiple cities and we’re seeing that decline from our existing accounts.
We’re able to put new accounts on, obviously that has a tremendous positive
impact especially if we can do multiple customers on the same truck.

**David Campbell – Thompson, Davis & Company**

Then you mentioned the problem in the driver pay vis-à-vis fuel surcharges.
With fuel surcharges going down but apparently lagging the pay it hurts you on
the way up but doesn’t it help on the way down as it has been going down since
June?

**Vincent A. Wasik**

You have to look at where it was last year and where it is now. It is still
$0.80 to $1.00 more than it was last year. So, you’re correct about the lag
and we do feel that we will gain some advantages on that but each one, and
this is where you have an independent contractor – an independent contractor
has a contract and with our independent contractor settlement analysis
calculator the fuel is really baked in based on the miles that the individual
is driving.

But, he has a contract so you have to sit with that individual so you’re
talking about 3,500 drivers that your city managers have to sit with and each
one is in individual discussion of you received x cents per mile, you are now
going to receive x minus cents per mile. From our perspective you’re
absolutely correct there will be a benefit and we think we will see that
benefit but we haven’t seen it in the September quarter. We think we’ll see
that in the December quarter.

**David Campbell – Thompson, Davis & Company**

You mentioned the problem of the new credit agreement, it was not quite clear
if that was caused by the credit crunch or the end of temporary decrease in
availability of credit or the time to process it? It seemed like it was more
the time to process it. What is the status of the credit markets? Are they
perfectly okay now in terms of getting new agreements or does it still take
longer to get them, or just what is going on?

**Edward W. Stone**

I can’t speak to the overall credit markets but I can speak to the specific
European bank with whom we’re working. We went to their credit committee
literally the day after Black Monday the 29th of September and they, like I
suspect every other financial institution in Europe and the United States was
furiously wondering, “Can we stay in business? Can we keep lending money?”

Now, they took some time to make a primary basic decision of, “Yup, we’re
going to stay in this game.” And, this particular institution wants to
increase their asset deployment in the United States and revalidate that
strategic decision. They came back and did that. That’s a big strategic
decision, they didn’t do it in 24 hours, they did it in a week. Now, as they
kind of recrank they are simply being more cautious than what the pace of
approvals would have been six months ago.

In this particular case, I repeat, they have said, “We’re in this game.” Their
particular government is among the European governments that has come to the
rescue and that’s obviously helped them make the decision. They’ve reconfirmed
their decision to grow in the United States. They’ve been back to their credit
committee with, “Okay, we get this.” That’s not a final approval and they’re
being more cautious than they have in the past but it is still moving forward.

**David Campbell – Thompson, Davis & Company**

The last question is, the Office Depot legal action you mentioned, can you
explain that a little bit more?

**Vincent A. Wasik**

We’re in depositions with Office Depot in the lawsuit. We are aggressively
pursuing the lawsuit. I was the first individual deposed, it was seven hours
and I probably have another 10 hours. One of the key executives from Office
Depot that is going to be deposed happens to be one of the individuals that is
disclosed in their SEC documents. He doesn’t want to be called whistle blower
but was one of the individuals that is key to the SEC investigation in to
Office Depot.

So, from our perspective we are pursuing aggressively. We believe that we have
a substantial case. There have been five other depositions thus far, they
continue every week and from our standpoint obviously it’s a fairly
significant legal bill but we really believe it’s a very significant and good
lawsuit on our behalf.

**David Campbell – Thompson, Davis & Company**

But it sounds like you’re spending $1 million a quarter is going to be, if you
are successful, it’s going to be more than that.

**Vincent A. Wasik**

Well, the legal cost I said were for the class action lawsuit not for the
Office Depot. No, the Office Depot lawsuit is not costing us that much money.
These are the defense of the IC model. I’m sorry if there was any confusion on
that.

**Operator**

Currently we have no other questions registered so I would like to turn the
meeting back over to management.

**Vincent A. Wasik**

First of all, I want to thank everybody for coming to the discussion today.
Obviously, we believe that there’s still a lot of work to do with the company.
We’re pleased with where we are and the progress that we’ve made thus far but
we’re not confident that this is as far as we can go. We think that there are
substantial improvements that we can still make. My objective still is to
exceed a 30% gross margin. We believe that is on the horizon.

We also believe that with the international delivery market being in excess of
a $20 billion industry with 2.1 million shipments daily and projected annual
growth rates of over 10% that there is a significant opportunity because the
US is the largest retail market for both Europe and obviously for China. So,
from our standpoint we believe and I know some individuals have questioned why
would we be looking at this global alliance partnership and we believe it is
going to substantially increase the value of the company.

But, we also think it is going to substantially increase the overall revenue
and profitability of the company. With that, I want to thank everybody for
coming on the call. Obviously, from our standpoint we’re hoping to see a
little bit better economic news but we know that we’ve got to continue to
reduce expenses and continue to show a value proposition to our customers.
Thank you very much and have a good day.

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11,100063-heritagecrystal-clean-inc-f3q08-qtr-end-09-06-08-earnings-call-transcript.html,"HeritageCrystal Clean, Inc.",HCCI,industrial-goods,2008.0,,regular,"October 15, 2008",10:30 am,2008-10-15T14:30:00.000Z,25913,7816,18097,2,4,"['Joseph Chalhoub President, Chief Executive Officer', 'Gregory Ray Chief Financial Officer, Vice President of Business Management']","['Randy Hugen Piper Jaffray', 'Jeff Germanotta - William Blair', 'Craig Bell - SMH Capital', 'Jeffrey Cooley - Foster']","**Operator**

Welcome to the HeritageCrystal Clean Inc. third quarter 2008 earnings
conference call. (Operator Instructions)

Some of the comments we will make today are forward looking. Generally, the
words ""aim,"" ""anticipate,"" ""believe,"" ""could,"" ""estimate,"" ""expect,"" ""intend,""
""may,"" ""plan,"" ""project,"" ""should,"" ""will be,"" ""will continue,"" ""will likely
result,"" ""would"" and similar expressions identify forwardlooking statements.
These statements involve a number of risks and uncertainties that could cause
actual results to differ materially from those anticipated by these
forwardlooking statements. These risks and uncertainties include a variety of
factors, some of which are beyond our control. These forwardlooking statements
speak as of today, and you should not rely on them as representing our views
in the future. We undertake no obligation to update these statements after
this call.

Please refer to our SEC files, including our registration statement on Form S1
as well as our earnings release posted on our website for a administer more
detailed description of the risk factors that may affect our results. Copies
of these documents may be obtained from the SEC or by visiting the investor
relations section of our website. Also, please note that certain financial
measures we may use on this call, such as earnings before interest, taxes,
depreciation, and amortization, or EBITDA, are nonGAAP measures.
Reconciliations of nonGAAP financial measures to GAAP financial measures are
included in our press release and may be obtained by visiting the investor
relations section of our website, of www.crystalclean.com.

With us today from the company are the President and Chief Executive Officer,
Joseph Chalhoub; the Chief Financial Officer and Vice President of Business
Management, Gregory Ray; and the Chief Accounting Officer, Ellie Chaves. At
this time, I would like to turn the call over to Joseph Chalhoub.

**Joseph Chalhoub**

We are pleased to report on our third quarter of 2008. Last night, we issued
our third quarter press release and posted it on our website on our investor
relations page for your review. Today, we will discuss the financials and our
operations in the third quarter and respond to questions you have relating to
these results.

We are pleased to report that our third quarter results were quite good,
consistent with our previous report. We achieved sales growth of 22% over the
same quarter in 2007. Our pretax income for the latest quarter was $2.8
million, which reflects an improvement of 55% compared to the year ago
quarter.

We operated 54 branches at the end of the latest quarter, an increase of 6
from a year ago. Of these branches, there were 47 that were in operation
throughout both of the third fiscal quarters of 2008 and 2007; and these
contributed same branch sales growth of $4.1 million or 20%. Our daily sales
are now approaching $440,000, up 22% from one year ago. In the third quarter,
our sales team performed admirably as demonstrated by our growth in the face
of the slowing economy.

Our [distillation tower] for solvent recycling continues to positively impact
our business for the third quarter of 2008. This system, commissioned in late
2007, recycles used solvent using clean recycled solvents that we blend and
resupply to our customers. During the latest quarter, our recycling throughput
increased, helping us to reduce our accumulated stock inventory.

In contrast to our solvent recycling program, our reuse program captures used
solvents, which we sell to industrial firms that manufacture roofing products.
This is historically a somewhat seasonal market. During this third quarter,
reuse sales were not as strong as the previous quarter and reuse inventory
remains relatively flat.

Because the solvent that we buy is produced from crude oil, our unit cost for
solvent continued to increase in the latest quarter. However, the fact that we
cover most of the value of the used solvent through our recycling and reuse
programs partially mitigates these cost increases.

While our total volume of solvent products in inventory decreased during the
quarter, increasing pricing during the quarter led to an overall increase in
the value of our current inventory. For much of the quarter, we continued to
experience increases in all our energysensitive costs, driven by higher crude
oil prices within the cost of sales line in our financial statements. The cost
increases on the solvent we purchased were more than offset by higher margins
for our reused solvent sales and recycling program.

As we benefited from the FIFO inventory accounting, so more reused product
[inaudible] recycled solvent that had been carried in our inventory at
historically lower value. While we have enjoyed the benefits of appreciating
inventory values for the past two quarters, we don't anticipate that this will
continue. If solvent prices decline further, we would likely need to record a
reduction in the value of our solvent inventory. Although lower solvent prices
would also lead to lower cost of sales for the company, that would translate
into improved margins provided that pricing was stable.

In our operating expense line, again, we experienced high cost, both for
vehicle fuel and thirdparty transportation costs during the quarter. The
additional fuel surcharge to customers and selective price increases on
certain customers implemented in the second quarter have partially mitigated
these increased costs.

We are pleased with our report card for the third quarter, including the
performance of our employees and the continued patronage of our customers and
the support of our shareholders.

Our chief financial officer and vice president, business management, Mr.
Gregory Ray, will now further discuss the financials and then we'll open the
call to your questions.

**Gregory Ray**

Again, I am very happy to be with our investors today for HCCI's third
earnings conference call since becoming a public company. During the latest
quarter, I met with many of our shareholders or prospective shareholders; and
I am proud to continue to tell our story.

Our SG&A expense in the third quarter increased to 16.7% of sales, up from
15.6% of sales in the third quarter of 2007. This increase includes
approximately $370,000 of costs associated with being a publicly traded
company that we did not incur in the year ago quarter, including director
compensation and insurance, incremental legal and accounting fees, and
SarbanesOxley consulting.

Our interest expense for the third quarter was only $24,000, down from more
than $300,000 in the third quarter of 2007 reflecting the paydown of our debt
with proceeds from our IPO.

Taxes, for the third quarter of 2008, were $1.2 million. In the prior year, as
a limited liability company, we were not subject to federal or state corporate
income tax. In our financial statements, we have reported our net income and
EPS in both GAAP and pro forma presentations. Where the pro forma is
calculated as if we had been a C corporation during 2007 and paid state and
federal income taxes and which also adjusts our share count to reflect our
March 2008 reorganization. For your reference, we have posted on our company
website the historical pro forma information for all quarters of 2007.

Our operating income for the third quarter was $2.8 million, compared to $2.1
million in the third quarter of 2007. Our earnings per share both on a basic
and diluted basis was $0.15 per share, an increase of 67% compared to the pro
forma EPS in the year ago quarter. On these financial measures, we believe
that we exceeded analyst's expectations for our performance. I share Joe's
satisfaction with our financial results for the quarter, and I thank you for
your continuing interest in HeritageCrystal Clean.

At this time, I will turn control of the call over to our operator, and she
will advise you of the procedure to submit your questions.
","
**QuestionandAnswer Session**

**Operator**

(Operator Instructions) Your first question comes from Randy Hugen Piper
Jaffray.

**Randy Hugen Piper Jaffray**

It was good to see the samebranch sales continue to move up. Could you go into
some of the drivers behind the increase? Is it largely a function of the
surcharges?

**Joseph Chalhoub**

Well, the sales increases that we experienced this quarter and last quarter,
there are a lot of factors that go into sales increases. The surcharges are
only a very, very small piece of that increase. The majority of the increase
is organic, different lines of businesses, and price increase, including the
surcharge, is not a big factor in that increase.

**Randy Hugen Piper Jaffray**

So it's not a big driver of the continued increases in your samestore sales
metric?

**Joseph Chalhoub**

Definitely not the surcharge, definitely not.

**Gregory Ray**

On a longterm basis, when we think about samebranch sales growth, and you have
seen our statistics over several quarters now where we've been running at the
doubledigit rate for samebranch sales growth. Typically, on a yearoveryear
basis, that statistic almost always has in it one regular price increase.

Over the last several years, while we've raised parts cleaning prices a little
bit more than other services, the average blended price increase has probably
been in the neighborhood of 5%, plus or minus 1% across the board. The
remainder of that would be volume growth in samebranch sales. I think that in
the latest quarter it's possible that because of the surcharge, we could have
picked up another 1%. I am just shooting from the hip here, but it wasn't a
big number in terms of driving a higher rate of samebranch sales growth.

**Randy Hugen Piper Jaffray**

Could you remind us how this industry overall has faired during previous
recessions? And then also comment on if you have seen any impacts with your
clients from the economic slowdown?

**Gregory Ray**

Historically, the industry through recession has been resilient. As you know,
our management team has been in the industry for 30 years now. We don't recall
having seen substantial negative impact on our business when the general U.S.
economy has been in a slowdown mode. That may partly be a factor of serving
many small customers. There's a significant turn rate in that customer base.
But we've never seen major impacts from that.

Certainly, at HeritageCrystal Clean, where we've got this high growth rate for
us in the last several years, we don't expect there to be a major impact due
to a kind of modest U.S. recession. I am sorry, your second point? I forgot.

**Randy Hugen Piper Jaffray**

****

Just if so far you have seen anything in your current operations that might
suggest any sort of change among your clients because of the recession.

**Gregory Ray**

No, I think the two things that we pay attention to closely are revenue growth
yearoveryear and our accounts receivable, with the thought that accounts
receivable could be an early indication of financial or economic trouble on
the part of our customer base. We have not seen any erosion in our day sales
outstanding statistic over several quarters, but we keep watching that with
the thought that it could be a leading indicator. We're not finding any new
renewed difficulty in securing new customers at this point.

**Joseph Chalhoub**

To some extent, a slowdown in the economy affects all businesses. Some more
than others. For a company like ours, and in particular our company, where
we've grown about 20%, our ability to grow at that rate is going to be a
function of how much resources we put in to grow our different businesses. How
many new routes, branches, head count of people. The piece that is impacted by
the economy is really a much smaller piece compared to the variables that we
have in our control to continue to expand our business.

**Operator**

Your next question comes from Jeff Germanotta William Blair.

**Jeff Germanotta William Blair**

I would love to understand a little bit deeper the sources of that 20%
samebranch sales growth, in particular how much of that is new customer
derived versus rising average, if you will, average revenue per existing
customer.

**Gregory Ray**

We still don't really manage our business with those distinctions. We do
monitor customer growth in total, and it continues to grow. We're reporting
the statistics on customer count on an annual basis rather than quarterly, but
I can tell you we're continuing to see growth in customers.

But we have not measured how much of our revenue growth quarteroverquarter is
coming from brand new customers versus crossselling of services to existing
customers. I think that, historically, we haven't made a big distinction
there. Sometimes, depending on the types of service, the customer crossselling
is a very integrated process, where we're really intentionally cross selling.

As you understand, some of our services and routes are done by different reps
on different trucks. From the point of an oil rep out calling on new accounts,
he may be selling to somebody that he doesn't really care whether it's an
existing Crystal Clean parts cleaning customer or not. He just wants to grow
the line of business that he's responsible for with them. It might be
interesting information. I don't have it at my fingertips to share with you,
and we don't use that measure to kind of run or grow our business. We're
really focused on both new customer acquisition and crossselling and our
people are equally incentive for those activities.

**Jeff Germanotta William Blair**

My next question then is with oil prices falling, what customer pushback are
you seeing in terms of price and what will be the forward impact of fuel
surcharges?

**Joseph Chalhoub**

We haven't seen any customer pushback because of the price of crude reduction.
Our solvent cost and diesel fuel, as we sit today, is still much higher than
where it was the same period a year ago despite the recent reduction of the
price of crude. If the price of crude stabilizes and the solvent price comes
down and diesel fuel price comes down, then first we don't expect customer
pushback. On the other hand, we may give back some of the surcharges.
Something that we would decide internally.

Historically we have had price increases for a variety of factors, including
energy. So any price increase is not just driven by the cost of energy. Again,
historically, we haven't had a customer pushback when these things happen. We
haven't gone in and put a full price increase when the price of energy first
was a factor for us. We were able to move that to later during the year. So we
don't expect that. We may give some of the fuel surcharge, but it's relatively
a smaller piece of our total price increase.

**Gregory Ray**

If I can add to that. When Joe talks about giving back some of the fuel
surcharges, it's a marketing strategy that drives that more than customer
pushback. We have now implemented our typical annual price increase in the
fourth quarter. We were a little bit more aggressive this year with that than
we have been in some prior years because of the greater cost increases.

So tactically, what we typically would do is make that price increase
implemented and if crude prices stay down where they are, or even move down
further, we would probably then go back out to customers and slightly adjust
or reduce the fuel surcharges with the thought that longterm, it would be our
desire, if energy prices were stable, to have all of our pricing built into a
single charge and not have fuel surcharges. One way to get there is keep
raising our list price and diminishing the fuel surcharges.

**Joseph Chalhoub**

The benefit of a lower cost of crude and really the product will way surpass
what surcharge factor is. We have significant benefits if the price of energy
and solvent come down from where they have been and where they are right now.

**Jeff Germanotta William Blair**

My last question. You guys are obviously proven veterans of this industry.
Based on your experience of past soft patches in the economy, what's in the
playbook or tool box at HeritageCrystal Clean for how to manage through those
periods?

**Joseph Chalhoub**

We would look at the daytoday new business obtainment for us and all of the
factors that we have. New customers and each line of the business as we
regularly manage, and to the extent we want to push the growth at the higher
level, we would do that by putting more resources. On the other hand, we are
sensitive about cost factors and, as we do these things, we're attempting to
maintain and improve our margins.

But we do have several variables in our control to mitigate any losses due to
the slowdown in the economy.

**Gregory Ray**

If I could add, when we talk about slowdown in the economy, again, this is
anecdotal rather than statistical information, but there are certain aspects
of some of our customer base which we think helps us in a weak economic
environment. I don't want to oversell that so you.

For example, on the vehicle segment side of our service business, we generate
revenue from servicing automotive repair establishments that work on vehicles.
If Americans are buying fewer new cars, they're often driving old cars longer
and that may increase the service workload in the small shops of America that
we count as customers. Additionally, I think as you know, we've often talked
about how our service offers allow us to have a lot of pricing flexibility
because they're very small ticket items to our typical customer.

Handinhand with that is the reality that for certain accounts out there that
we want to penetrate, it's not worth their time to even allow us to make a
competing bid. Because a manufacturing plant that has a $5 million annual
spend, they might be spending $2,000 a year on parts cleaning. And we want to
come in there and help them have a better program and save $20 a year, they
don't want to give us the time of day. Sales guys sometimes will remark that
when there's a little bit of economic pressure, they find those purchasing
managers out there more willing to schedule appointments and listen to
competitive proposals, because suddenly they're more interested in possible
cost savings than they have been historically in strong economic times.

Those may be some reasons why we have not, as an industry, seen declines when
the economy has been softer. It speaks a little bit to Joes point about how
we're going to be able to plan our sales programs to maintain good growth by
keeping a lot of people in front of customers making a lot of sales calls.

Then obviously, I remarked earlier about AR. That is one thing we will watch
more closely in these economic times. If we start to see some deterioration
there, I think we just get more aggressive about holding customers to terms
and chasing them more vigorously in the event that they're starting to get a
little bit delinquent.

**Operator**

Your next question comes from Craig Bell SMH Capital.

**Craig Bell SMH Capital**

****

I just wanted to circle back on the surcharges and your pricing. If I
understand how you guys do it, when you implement, like this year for example,
the price increase. Some of that will be then leading to a reduction in the
surcharge, but the net effect for you guys would be a positive. If we continue
to see fuel costs going down, shouldn't that benefit you going forward?

**Gregory Ray**

Yes, I think you understand the dynamics well. The price increase that we do
typically in the fourth quarter of the year is a bigger or more significant
number typically than what we try and recover through temporary fuel
surcharges. We implement the price increase; we can afford to give back some
of the fuel surcharge and still be net positive on pricing across the board.

If energy prices stay down or come down further, we will have a longterm
benefit in terms of some margin expansion compared to the yearago level.
Having said that, we did also remark in the script here and will remind you
that if we have a substantial decrease in pricing of our commodities,
particularly solvents, we could be forced to on a onetime basis take a charge
to the inventory value. But our view is that as long as pricing stays in that
direction, we would quickly, over a matter of two, three, four months, recover
that inventory charge in terms of improved margins and profitability.

**Craig Bell SMH Capital**

Looking at economic picture again, if we're in a recession here, does that
have any impact on what your expansion plans are or do you press ahead with
your planned branch expansions in the face of thinking that you can take
business as you said earlier.

**Joseph Chalhoub**

This economic slowdown we're going through now is going to affect us.
Basically we will continue to expand our businesses. We are confident of
wanting to do that. We've done that historically by keeping an eye on our
margins. That's going to be a factor. Our cost factors are going to be as
important as our top line growth to make sure that we maintain decent margins
as we continue to expand the business.

**Operator**

Your next question comes from Jeffrey Cooley Foster.

**Jeffrey Cooley Foster**

If I could just ask a question about the impact of FIFO on the gross margins.
Incremental gross margins over last year were about 88% and about 1,000 basis
points over the total gross margins. I don't know how you want to answer this.
What was the impact of FIFO or maybe we could take a look at the difference
between cash flow and net income?

**Gregory Ray**

I am not sure where you're going. If you would like to try and follow either
of those lines of questioning, maybe we can get in better.

**Jeffrey Cooley Foster**

One of the reasons given that the gross margins improved was that you're
eating through inventory that has been booked on a lower cost basis than you
would be buying in a spot market now. Theoretically, that's not a cash flow
impact, that's more of a GAAP income impact. So there could be difference
between the cash flow you generated versus the net income growth you
generated. That's basically the source of my question.

**Gregory Ray**

I will try and give you some color on that. I guess first to respond to the
FIFO issue, I want to clarify, I think you probably understand it. I just want
to make sure we're talking about it the same way because you were talking
about buying things on a spot market. Really, the biggest source of that FIFO
benefit, if we talk through that for a minute, is that we have got inventory
of reused solvent. And it's accounted for on a FIFO basis.

In a stable price environment, we would pick up the used solvent from our
customers, value it when we put it in inventory. Sometime later when we sold
it, we would take it out at that same value; and the difference between what
we carried it for in inventory and the selling price would be a modest
differential, but we book that into income.

In this rising price environment, with FIFO accounting, we're accumulating
these layers in our tank, theoretically. We put it into the tank at the old
value. It appreciates in value over the six months that it takes to get to the
end of that pipeline, on average. When we're selling it, we're then selling a
low historic cost product at current market prices. So that's the source of
improved margins there.

So there's not really case where we're buying something on spot, there really
isn't neatly a spot market for this used solvent, it's all stuff that we're
just generating internally and then reselling to customers.

**Jeffrey Cooley Foster**

What that argues, though, if we return to a stable or declining price
environment, that your margins would be hurt in that scenario. Am I right
about that?

**Gregory Ray**

That's right. Let me help you understand how we viewed this six months ago.
Because I think putting it in the context of what we were trying to do with
our business in terms of a marketing and pricing strategy it's important. We
shared this with some analysts and talked about it briefly on earlier calls.
It bears repeating.

When prices for our commodity, chemicals, solvents and fuels, hydrocarbon
started to go up early this year, there was a certainly an argument that that
would have been the right time to have raised our prices across the board with
customers to mitigate or get them to absorb those cost increases. We chose not
to do that.

The reason we chose not to do that was from a marketing perspective. It's our
preference, if we can, to defer our price increases and just do them at the
end of each year. We think our customers prefer that. Now, the slight nuance
there is we did implement some fuel surcharges. As I said earlier, relatively
those were minor compared to a normal price increase.

The reason that we thought we could defer our price increase until end of the
year was that we knew we had this inventory, and we knew we were going get
this FIFO benefit. So we were playing a balancing game for the last two
quarters. Knowing we were picking up this benefit and hoping that it would
last long enough that we could get to the point in time when we felt
comfortable doing our typical yearend price increase. We've gotten there.
We've done an increase there quarter. As inventory values come down, you're
correct that that impact by and of itself will diminish our gross margin. But
it's not in a vacuum, it's occurring at the time we hoped it would, where we
have now got the benefit of otherwise improving margins from our price
increase and we'll have to see over the next couple of months how those two
factors balance out.

**Joseph Chalhoub**

Outside of what you just said. There's also the fact that a lower price for
the solvent and fuel will also benefit us on an ongoing basis because these
are costs of doing business. So we will have a shortterm inventory cost
correction, but we'll have a much bigger longer term benefit if the price of
these commodities drops.

**Jeffrey Cooley Foster**

I agree with that. I am just trying to figure out much of a payback there will
be on the margin front now that it looks like prices are falling or
stabilizing.

**Operator**

There are no further calls and this will conclude the conference.

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16,100070-lufkin-industries-inc-q3-2008-earnings-call-transcript.html,"Lufkin Industries, Inc.",LUFK,basic-materials,2008.0,,regular,"October 15, 2008",10:00 am,2008-10-15T14:00:00.000Z,30479,18496,11983,4,4,"['Jack Lascar - DRG&E', 'John F. Glick - President, Chief Executive Officer, Director', 'Christopher L. Boone - Chief Financial Officer, Vice President, Treasurer', 'Angela McCarthy - Corporate Controller']","['Collin Gerry - Raymond James', 'Byron Pope - Tudor Pickering & Co. Sec.', 'Terese Fabian - Sidoti & Company', 'Eric Mintz - Eagle Asset Management']","**Operator**

Welcome to the Lufkin Industries third quarter earnings conference call.
(Operator Instructions) I would now like to turn the conference over to Jack
Lascar of DRG&E.

**Jack Lascar**

With me this morning are Jay Glick, Lufkin’s President and CEO, Chris Boone,
Vice President and CFO, and [Angela McCarthy], Corporate Controller. Before I
turn the call over to Jay, I have a couple of housekeeping items. If you would
like to be on our email distribution list to receive future news releases or
if you experience a technical problem and didn’t get one this morning, please
call us at 713-529-6600.

If you would like to listen to a replay of today’s call, it will be available
via webcast by going to the earnings conference call section of Lufkin’s
website at [_www.lufkin.com_](http://www.lufkin.com) or via recorded replay
until October 22. This information was also provided in this morning’s
earnings release. The information reported on this call speaks only as of
today, October 15, 2008 so be aware that time sensitive information may no
longer be accurate as of the time of any replay.

Also please be aware that today’s conference call may contain certain forward-
looking statements. The assumptions of from which these forward-looking
statements are based are beyond the company’s ability to control or estimate
precisely and may in some cases be subject to rough estimate material changes.
Actual results may differ materially.

With that I will turn the call over to Jay Glick.

**John F. Glick**

As you saw in this morning’s news release we had a very good quarter
particularly in the oilfield division and this was against the headwinds of
Hurricane Ike which impacted our factory operations in Lufkin and Houston for
several days in September.

For the third quarter we reported net earnings from continuing operations of
$25 million or $1.66 per diluted share. This compares with $18.3 million or
$1.21 per diluted share from continuing operations in the third quarter of
2007. Sequentially earnings from continuing operations increased by 17% from
$1.42 per diluted share in the June quarter. Two items impacted this in the
third quarter: Our LIFO inflation rate adjustment and the lost revenue due to
Hurricane Ike. Together these items reduced earnings by approximately $0.20
per diluted share compared to our third quarter forecast. Chris will provide
more details in a moment.

I want to give a lot of credit to our employees who worked very hard after the
hurricane hit under some extremely trying circumstances to get us up and
running again quickly. Many were without power or phones or even water at
their homes for many days. In spite of their difficult personal circumstances,
they returned to work to help the company fulfill its commitments to
customers. The impact on Lufkin could have been more severe were it not for
their dedication.

Despite the negative impact of the LIFO charge and the hurricane, we still
came in a penny above our EPS guidance range of $1.55 to $1.65 per share, and
as a result we have raised our full-year guidance from our previous range of
$5.50 to $5.70 to a new range of $5.65 to $5.85. This would put our fourth
quarter guidance in the range of $1.51 to $1.71 per diluted share.

The oilfield division was our biggest driver of the strong results this past
quarter. Oilfield bookings increased by 135% year-over-year and by 28%
sequentially to $256 million. International orders particularly Latin America
were the main drivers of the sequential bookings growth with bookings up 62%
while US bookings were up 17% sequentially.

We saw slightly lower bookings from our power transmission division, which I
will discuss more in a moment.

Company-wide bookings at September 30 were up almost 20% sequentially. The
total order backlog for Lufkin at September 30 was $413.9 million which is a
125% increase year-over-year and a more than 33% sequential increase. Most of
the increase in backlog was in the oilfield division. Power transmission was
off a little on a sequential basis but up year-over-year. I’ll come back to
these in more detail in a minute.

We have ramped up production and shipments dramatically over the course of
this year in response to strong energy prices and a surge in customer orders.
Despite the pullback in oil and gas prices we saw in the third quarter, we
expect our manufacturing plants to be very busy for the rest of this year and
into 2009 based on our current backlog.

Our cash flow was strong in the third quarter and we continue to maintain a
strong balance sheet. With so much trauma in the credit markets today the
choices we have made over the years in terms of capital structure and
liquidity were clearly the right ones for Lufkin.

We can’t predict what the financial markets are going to do or how that will
affect our customers’ access to credit or how a deep downturn in the broad
economy will impact energy prices. We will continue to watch the markets very
carefully and stay close to our customers. Based on current feedback from
those customers, the current oil price levels will support continued E&P
CapEx.

Our poll of customers suggests that most 2009 budgets that they’re developing
are assuming an economic hurdle rate on a per barrel basis in the range of $60
to $70 and somewhat lower in more mature basins. However we recognize that if
events in the broader economy affect either energy demand or access to credit
might well alter this picture. Based on information we are getting we believe
that the majors and large independents will have a strong cash flow and will
be well positioned to maintain their development programs into 2009. We will
monitor the pulse of the small and medium independents carefully.

We also expect that a few of the resource plays may come under greater
scrutiny at gas prices under $7.00 per mcf. Fortunately we’re strongly
leveraged to oil. Last quarter for example about 4/5 of our new bookings in
the oilfield division were oil projects and 1/5 natural gas projects. So on a
company-wide basis we are less sensitive to changes in gas-related activity
than oil.

In addition it’s worth noting that many of the natural gas wells we supply and
service are shallow US onshore gas projects, and since these wells are low-
cost development wells that don’t require the large upfront capital
commitments necessary for a deep water gas project, we believe these projects
will proceed because of the incrementally lower risk profile and the
flexibility to quickly scale up or down should the energy price environment
suddenly shift.

How much the credit crunch could impact some of our customers’ plans is
unknown. My hunch is that the strong cash flows that our larger E&P customers
are realizing today should sustain continued capital investment in any MP
projects if the global energy demand forecast remains strong.

In power transmission where most of our customers are original equipment
manufacturers as opposed to end users, we could be a little bit more exposed
but so far we have seen no indications of credit-related interruptions.

The equity markets have steeply discounted the oil services stocks because of
commodity price declines in recent weeks and it could be argued that those
discounts are overdone, although we will leave the forecasting of share price
moves to those of you on the other end of this call.

Our M&A efforts however may benefit from the reduction in valuations. We spent
a good bit of time looking for attractive acquisitions over the last couple of
quarters but we were unable to close any of those due to what we believe were
unrealistically high expectations by the sellers, which we believe subsequent
events have borne out.

A couple of more items before I get into the detailed operations discussions.
Last week we signed a new three-year labor agreement with our three unions.
The new contract is not expected to impact our guidance for the remainder of
the year which we have raised this morning and the terms are in line with our
expectations over the life of the contract.

Now let’s look at the divisions in a little bit more detail, starting with
oilfield. No matter how you look at it we had a great quarter, not only in the
pumping side of the business but automation was also extremely strong last
quarter. New orders for the oilfield division totaled $256 million which is up
135% versus the third quarter of last year and up 28% from the second quarter
of 2008. Of that, 69% was domestic and 31% was international.

Domestically we saw continuing strong orders from customers operating in the
Bakken Shale in North Dakota and from heavy oil areas in California and the
Permian Basin in West Texas. We also had very strong activities from both
Latin America and Canada. Our oilfield backlog at September 30 was $279.8
million which was up 64% from the second quarter and up 335% year-over-year.
The US backlog was up 66% versus 60% for international.

As I mentioned a moment ago, we have ramped up production dramatically in
oilfield and our third quarter shipment rate was up 45% from the first quarter
rate. We are continuing to optimize our manufacturing through the applications
of lean processes and new capital equipment to keep up with customers’ demand
and maintain the short lead times that have been a competitive advantage for
us for many years.

Looking at the fourth quarter, which is typically a strong revenue quarter but
can be a weak quarter for bookings, we are projecting a moderating level of
new orders for the division. Both the second and third quarters were marked by
large international project bookings that are not assumed in our fourth
quarter projections.

Last quarter we highlighted a big upward spike that we’ve seen in steel
prices. Efforts to offset those increases through price adjustments and
aggressive supply chain management have prevented the erosion of our margins.
We continue to keep a watchful eye on commodity prices and believe that steel
price increases have moderated for the moment.

Future raw material pricing will depend on the steel producers’ ability to
reduce or maintain prices by reducing output. In any event we will continue
our efforts to improve our steel sourcing and procurement practices to
minimize our costs and manage the volatility in our raw material cost
structure.

The real driver of improved gross margins came from greater leverage on our
fixed assets associated with the higher factory utilization which was driven
by the ramp up in manufacturing activity to meet the higher levels of demand.
Chris will speak to the margins in more detail in just a moment.

Looking now at the power transmission division, [lead orders] totaled $43
million which is down 10% from the third quarter a year ago and 12% versus the
second quarter of this year. This decline is mainly related to capacity and
scheduling issues with our marine customers based on shipyard capacities. Also
some new orders that we expected to book have slipped from the third quarter
into the fourth quarter.

Timing issues also affected power transmission’s revenue in the quarter.
Shipyards delayed in taking delivery of new equipment that was scheduled for
completion in the third quarter. In addition we experienced similar delays on
several large oil and gas and power generation projects that involved high-
speed units. In those cases customers did not want to take delivery until the
fourth quarter.

Backlog in power transmission increased by 12% from a year ago to $134.1
million but declined 3% from the second quarter. Oil and gas and power
generation projects continued to be the most active sectors for the business
in power transmission. Demand from those sectors is expected to remain strong
in the fourth quarter and into next year.

Hurricane Ike has also created some business opportunities for us from the
petrochemical and refining sector along the Gulf Coast. Our after-market group
is inspecting and reconditioning gear boxes damaged during the storm. We
expect that work to continue into 2009.

We are expecting a slight increase in revenue during the fourth quarter and a
recovery in the rate of bookings as projects delayed from the third quarter
are placed during the fourth quarter.

Looking ahead we see continuing growth opportunities in oil and gas, power
generation and the marine business. One of the benefits of the power
transmission side of our business is the greater market diversification that
that division offers. We are not so linked to the volatility of oil and gas
prices and it offers opportunities in general industrial applications as well
as alternative energy plays.

To sum it up again, a great quarter. Our growing backlog combined with the
continued strength in demand in both segments of our business and the ongoing
improvements we’re making in our manufacturing operations have increased our
full year earnings outlook for 2008. We remain cautiously optimistic as the
impact of the economic situation is tough to call, but early indications would
suggest a solid 2009.

Now I’ll ask Chris to give you a more detailed review of Lufkin’s financial
performance during the third quarter.

**Christopher L. Boone**

Just a quick reminder that we’re providing results from continuing operations
in our financial statements because we closed our trailer operations in the
second quarter. All of our prior period financial information has been
restated to reflect this change.

To briefly recap third quarter financial results, third quarter net income
from continuing operations was $30 million or $1.66 per diluted share. This
compares to $18.3 million or $1.21 per diluted share a year ago and to $21.2
million or $1.42 a share in the second quarter of this year.

For the third quarter we saw a $0.20 per share impact from non-cash additions
we made to LIFO reserves for continuing operations, about $4.5 million
compared to the third quarter last year. These LIFO reserves were about $2.5
million greater than originally forecasted for the third quarter or $0.11 per
share higher than expected. This was due to continued inflationary impact of
raw material prices versus a year ago.

Hurricane Ike cost us about a dime of EPS for missed shipments and plant
downtime.

Looking at sales and gross margin results by division. Starting with oilfield,
third quarter revenues increased $147.1 million which was a 52% increase year-
over-year.

Breaking those revenues down by product line: $92.9 million was from new
pumping units, which is up almost 70% from the third quarter of ’07. Services
contributed $27.4 million, up over 26% from a year ago. Automation contributed
$19.2 million, which is up nearly 54% year-over-year. Commercial castings
generated $7.5 million, which was off just a little, 1.6% from a year ago.

Comparing those same numbers to the second quarter of 2008, revenue from new
pumping units was up more than 17%. Services revenues were up over 14%
sequentially. Automation sales increased 9% and founder revenues were up 31%
from higher raw material surcharges.

Gross margin for the oilfield division was 28% in the third quarter versus
26.1% in the second quarter of 2008 and 26.9% a year ago. This increase
reflects the combination of higher volumes and the catch-up we’ve been able to
achieve following a rise earlier this year in steel costs. The non-cash
additions we made to LIFO reserves were $3.2 million higher in the third
quarter of this year than they were in the same quarter last year. That
reduced gross margin for oilfield by 2.2% points.

Turning to power transmission. Revenue was $48 million for the third quarter,
which is up over 17% from a year ago and roughly flat with the second quarter
of 2008.

Breaking that down by product line: New units contributed $36 million, which
is up almost 16% versus the third quarter of last year and down about 3% from
the second quarter. Repair contributed $12.1 million, which is up more than
22% versus a year ago and about 11% from the second quarter of this year.

Gross margin of power transmission was 30.4% versus 34.2% a year ago and 30.8%
in the second quarter of 2008. Non-cash additions to LIFO reserves were $1.3
million higher than they were in the third quarter of last year. This reduced
our margin by 2.8% points.

On a consolidated basis, overall gross margin for the third quarter was 28.6%
versus 27.4% in the second quarter and 29.2% a year ago.

Looking at some of our expense items for the third quarter. Third quarter SG&A
expenses from continuing operations increased to $17 million, which is up 24%
from a year ago but flat sequentially. We expect SG&A for the fourth quarter
to be on trend with the third quarter. As a percent of revenues third quarter
2008 SG&A expenses decreased to 8.7% compared to 9.7% in the second quarter.

Depreciation and amortization from continuing operations in the third quarter
was $3.9 million. We expect D&A in the fourth quarter to be about the same or
slightly higher.

EBITDA from continuing operations in the third quarter was $43.2 million or
22.2% of revenue as compared with $32.4 million or 23.5% for the third quarter
of 2007.

We ended the third quarter with $110.2 million in cash and cash equivalents
versus $95.7 million at December 31, 2007, up $15 million. Working capital for
accounts receivable and inventory net of accounts payable was $209.1 million,
an increase of about $49 million during 2008 due to higher sales volumes and
strategic steel purchases.

Capital expenditures from continuing operations in the third quarter were $7.6
million. Year-to-date we spent about $18 million and we expect capital
spending in the $25 million to $30 million range for the full year of 2008.
This slightly lower range than previously provided reflects the fact that the
approval of certain large capital projects took a few months longer than
previously planned and we’re also seeing longer lead times in getting delivery
of new machine tools. That will push some of the expected 2008 spending into
2009.

Also during the third quarter of 2008 the company paid dividends of $3.7
million or $0.25 per share.

In early October we bought $3.5 million worth of Lufkin common shares, which
completed the outstanding repurchase authorization. We bought about 52,000
shares at an average price of $67.53.

The company ended the quarter with no short or long-term debt and we continue
to have access to a $40 million credit facility with J.P. Morgan Chase that is
scheduled to retire on December 31, 2010.

The third quarter tax rate from continuing operations was 35.8% which was in
the range of what we had expected, and we expect a tax rate of 35% to 36% for
the fourth quarter.

That concludes the financial overview, so I’ll turn it back to Jay.

**John F. Glick**

We’re now ready for questions.

","**Question-and-Answer Session**

**Operator**

(Operator Instructions) Our first question comes from Collin Gerry - Raymond
James.

**Collin Gerry - Raymond James**

In the past we’ve talked about lead times being one of your competitive
advantages and being closer to the customer. Are there any capacity
constraints that you all are running into as this demand really exceeds what
we’ve seen in the past?

**John F. Glick**

Our lead times have gone out by more than we’d like to see them go out, which
reflects the fact that we’re not able to ramp up the output as rapidly as we
would like.

I would point out we’re continuing to bring on more resources from both the
power transmission division domestically as well as activating some resources
with our operation in France to supplement the domestic capacity. The capital
investments that we have coming in will also let us get back to lead times
that are more in the range of what we would like to see, which would be
something more like four to six weeks on units. We are bumping up against
capacity constraints temporarily but I think we’re going to be able to deal
with those going forward.

One of the other things that we continue to see with the bookings though is
that customers are actually reserving capacity further out. So while we had
the glut of business come in in both Q2 and Q3, which we were delighted to
see, it wasn’t all requesting immediate delivery. A lot of this extends out
into the first part of next year. We clearly have the fourth quarter covered
for oilfield and PT with backlog matching the revenue projections we’re
giving; perhaps more than matching them. But we have oilfield backlog
extending out into next year because again customers requested dates were out
that far.

**Collin Gerry - Raymond James**

Visibility now with the backlog goes out six months or maybe even nine months
in some cases?

**John F. Glick**

That in PT. It’s probably more like four to five months in oilfield.

**Collin Gerry - Raymond James**

Just to follow up on some of the drivers that we’re seeing in terms of demand,
internationally I saw that bookings really picked up. Could you just speak to
regionally where that’s coming from, what specifically is driving that, and
what’s changed over the last year in those particular regions?

**John J. Glick**

We picked up some share in certain markets in Latin America and I think part
of that’s due to the fact that we now have a station fully equipped to support
the [Mur Cuissure]. We’re seeing some benefits from that. We’ve also seen
customers expanding field developments in that part of the world in ways that
were not in place a year ago so clearly that’s been a big driver year-on-year.
We’re seeing Canada pick back up a little bit. The [Nivaucan] development is
clearly a major issue domestically. It was a big source of where our new
bookings came from on the US side.

**Operator**

Our next question comes from Byron Pope - Tudor Pickering & Co. Sec.

**Byron Pope - Tudor Pickering & Co. Sec.**

I wanted to get your thoughts. You talked about based on your customer
feedback $60 to $70 per barrel being the pain threshold if you will. As we
look at some of these plays domestically, you mentioned the Bakken and you
mentioned West Texas and California for the heavier oil, are those the three
primary reasons we should be looking at from a rig count point of view in
terms of thinking about when we might start to see some softness in the oil
directed rig count as it relates to demand for pump jacks for you guys?

**John F. Glick**

Yes, I think so. Those are the areas we’re clearly watching. Mid-Continent is
another area we’re fairly busy in but if you look at Permian and you look at
California and you look at the Bakken, so far as our domestic US business goes
those are the areas. Barnett Shale we’re seeing some business pick up there
recently and Haynesville we’re all kind of holding our breath to see what
happens there as oil prices weaken a little bit.

**Byron Pope - Tudor Pickering & Co. Sec.**

Based on your commentary, it sounded like you’re fairly confident that among
your customer base that the oil majors and the large independents will
probably power through in terms of demand for pump jacks, but is it fair to
think about watching the private E&P operators as kind of the X factor in this
whole equation?

**John F. Glick**

I think that’s fair. That’s certainly what we’re going to do. Again we’re
getting ready to go to our sales meeting this afternoon. Chris and I are
leaving for that. We’ll know a little bit more after that but we had a
discussion last week and the feedback we’re getting from most of our major
customers suggests that they’re going to power through as you said. It’s the
small independents we’ll keep an eye on just to be sure they have the cash
flow to carry on with the plans they gave us.

**Byron Pope - Tudor Pickering & Co. Sec.**

On the power transmission side, historically that mix has been fairly balanced
between oilfield and non-oilfield. Has that mix shifted much? I recall one of
the drivers there is general industrial plant and utilization is something we
should be watching for on that side. Is that a fair way to characterize it?

**John F. Glick**

65% or so of what PT does is typically energy related and in that group we
have the power generation sector as well as the oil and gas sector and the
refining sector. We’re not seeing the weakening in the industrial part of that
business which would be the 35% that’s left over. That is still there to come.
What we are seeing is a pretty significant pick up in the power gen area so
we’re counting on that. We’ll be talking about that probably at the end of our
fourth quarter call. So far PT seems to be, from an order intake perspective,
staying kind of in the same mix that we’ve seen the last several years.

**Operator**

Our next question comes from Terese Fabian - Sidoti & Company.

**Terese Fabian - Sidoti & Company**

You had a nice pick up in your oilfield service segment revenue growth. Can
you talk a little bit about that? Where is that coming from? Is that because
of new additions to your service facilities or expansion thereof?

**John F. Glick**

A lot of it was domestic pick up in service. Our international service
continues to grow as well. California was clearly busy; the same areas we just
spoke to Byron about. West Texas was busy. We had good weather in spite of the
hurricane in this part of Texas. West Texas had pretty good weather, which is
a factor. We’ve tried to ramp up the capacity of that group and will continue
to build that going forward. So I think it’s just a combination of active
markets in areas that we traditionally are strong in and no weather
interruptions. Canada came back recently strong as well.

**Terese Fabian - Sidoti & Company**

Getting back to your backlog, you say that you sort of see a breakdown between
the majors and large independents with access to cash than the smaller
independents. Do you have any breakdown on who your customers are between
those two groups?

**John F. Glick**

Yes. That was a question we anticipated. If you look at our oilfield backlog
at $270 million or $280 million, the $90 million that is international is all
either majors or very large independents. Of the $180 million that is the
domestic market, probably 15% to 20% would be small independents in that
group.

**Terese Fabian - Sidoti & Company**

Another question you may have anticipated is in your pump jack backlog, can
those orders be canceled probably for the international for the most part, but
what about the others?

**John F. Glick**

We’ve beefed up our cancellations going back a couple quarters ago in
anticipation of what things would be like if they weakened, and essentially
we’ve not seen any significant cancellations come through. Our cancellation
policy gets more onerous as we approach the delivery date.

The other thing we’re trying to do is if we have something that we’re
concerned about, we’re trying to check with people before we commit materials
to the shop to be sure we’re working on the right things. Part of that’s in
response to making sure our capacity supply to the customers that need the
equipment most, but it also has the additional advantage of checking against
customers who may be reconsidering their development work.

**Terese Fabian - Sidoti & Company**

I know it’s hard to see into the future, but going back into the fast maybe I
think you were somewhat surprised by the level of your backlog numbers in
oilfield services. Did the third quarter numbers sort of come as a surprise to
you also, and what do you see going forward?

**John F. Glick**

If you remember our second quarter call, our bookings in oilfield were about
$200 million in Q2 and I made the comment that we didn’t expect that to repeat
at that level, and lo and behold we booked $250 million or something in Q3. We
were surprised. I think the biggest issue though was several large
international projects came in that we had not expected timing wise to book in
Q3 and in addition to that we saw some strength in our domestic markets that I
think came as a little bit of a surprise in the US markets.

**Terese Fabian - Sidoti & Company**

Your diluted share count at the end of the quarter?

**Christopher L. Boone**

Right around 15 million to slightly over 15 million.

**Operator**

Our next question comes from Eric Mintz - Eagle Asset Management.

**Eric Mintz - Eagle Asset Management**

Last quarter we talked a little bit about operating efficiencies and getting
more out of the plants. I’m just wondering where we are in the phases and
obviously you had some good op margin expansion this quarter. I guess there’s
more to come in Q4 and should we expect to see continued margin expansion in
’09?

**John F. Glick**

I don’t want to project too much into ’09 at this stage. We’re hoping that we
can see some pullback in raw material prices. I would hasten to add we have
not seen that yet and I think that’s going to be a challenge to forge through
but our sourcing group will be working hard on that.

The labor efficiency issues and just kind of the lean payback on investment in
training and other things that we’re doing, I would hope we’ll see more of
that in ’09 for sure. We put a lot of effort into that. We found a lot of
seeds, and overall the workforce has embraced the concepts. So I think we will
see some improvements there. I’m not sure I could quantify those this morning
but certainly that’s where the push is going to be.

**Eric Mintz - Eagle Asset Management**

Just to use a baseball analogy, is it fair to characterize it as still early
innings on those initiatives?

**John F. Glick**

Yes. It clearly is early innings but again there’s a lot of momentum. It’s one
of these things that has snowball downhill characteristics that once you get
the thing rolling and success is visible to other areas of the factory, the
momentum increases and more people want to jump on board.

**Eric Mintz - Eagle Asset Management**

You mentioned I think you said a significant pick up in power gen. Would that
be related to wind energy?

**John F. Glick**

A lot of what we’re seeing right now is related to gas turbine power gen, but
we are working on some things that we may want to talk about in future calls
on wind energy both in our operations in Europe and our operations here. We’re
making some capital investments to position ourselves a little bit more
strongly for those sectors. There is going to be that in the future but my
reference was more to the gas turbine sector.

**Operator**

Management, I’m showing that there are no further questions. I’ll turn it back
to you for closing comments.

**John F. Glick**

Again we are very pleased with our third quarter results and we expect a
strong fourth quarter as well. We think we’re well positioned to manage our
business through this uncertain economic period. We appreciate you joining us
this morning. If you have any follow-up questions, please talk to either Chris
or Jack by phone. Thanks very much.

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22,100081-rli-corp-q3-2008-earnings-call-transcript.html,RLI Corp.,RLI,financial,2008.0,,regular,"October 15, 2008",11:00 am,2008-10-15T15:00:00.000Z,25149,10772,14377,4,6,"['John Robison - Treasurer', 'Jonathan Michael - President and Chief Executive Officer', 'Joseph E. Dondanville - Senior Vice President, Chief Financial Officer', 'Michael J. Stone - President, RLI Insurance Company']","['Matthew Carletti - Fox-Pitt, Kelton', 'Bijan Moazami - FBR Capital Markets', 'Mike Grasher - Piper Jaffray', 'Michael Phillips - Stifel Nicolaus & Company, Inc.', 'DeForest Hinman - Walthausen & Company', 'Ron Bobman - Capital Returns']","**Operator**

Welcome to the RLI Corp. third quarter earnings teleconference. (Operator
Instructions)

Before we get started let me remind everyone that through the course of this
teleconference RLI management may make comments that reflect their intentions,
beliefs, and expectations for the future. As always these forward-looking
statements are subject to certain risk factors which could cause actual
results to differ materially. These risk factors are listed in the company’s
various SEC filings, including in the annual Form 10-K which should be
reviewed carefully.

The company has filed a Form 8-K with the Securities and Exchange Commission
that contains a press release announcing second quarter results. RLI
management may make reference during the call to operating earnings and
earnings per share from operations which are non-GAAP measures of financial
results.

RLI’s operating earnings and earnings per share from operations consist of net
earnings after the elimination of after tax realized investment, gains or
losses. RLI’s management believes that this measure is useful in engaging core
operating performance across reporting periods, but may not be comparable to
other company’s definitions of operating earnings.

The Form 8-K contains reconciliations between operating earnings and net
earnings. The Form 8-K and press release are available at the company’s
website at [_www.rlicorp.com_](http://www.rlicorp.com). At the request of the
company, we will open the conference up for questions and answers following
today’s presentation. I will now turn the conference over to RLI’s Treasurer,
Mr. John Robison. Please go ahead.

**John Robison**

Joining me for today’s call are John Michael, President and CEO of RLI Corp.,
Joe Dondanville, Senior Vice President and Chief Financial Officer, and Mike
Stone, President and Chief Operating Officer of RLI Insurance Company.

We will conduct this call as we have in past quarters. I’ll give a brief
review of the financial highlights and discuss the investment portfolio. Mike
Stone will talk about the quarter’s operations, then we’ll open the call to
questions and John Michael will finish up with some closing comments.

Our third quarter operating earnings were $1.12 per share. Included in this
quarter’s earnings are $21.9 million in pretax favorable development and prior
year’s loss reserves. The favorable development came from our Casualty and
Surety’s book to business. In addition, we reported pretax net losses from
both hurricanes of $21 million, roughly $5 million from Gustav and

$16 million from Ike.

The combined ratio for the second quarter was 88.3, resulting in underwriting
income of

$15.2 million. The soft market continues to impact our top line. Our total
gross written premiums are down quarter over quarter 8% to $173 million.

Turning to the investment portfolio, it’s certainly been an interesting time
in the capital markets. Our investment income declined 3% quarter over
quarter. A large portion of our cash flow in 2007 and 2008 has gone to fund
the share buyback program and short term rates are lower today than this time
last year as a result of several Fed interest rate cuts.

Other comprehensive earning shows a loss of $24.1 mill for the quarter. This
is a result of market fluctuations and reflect the net change in market value
of our $1.8 billion investment portfolio. Net losses on investments for the
quarter was $24.2 million pretax. The majority of these losses were classified
as other than temporary impairment charges. Most of these losses stem from our
preferred stock portfolio for we held securities in the financial sector. Of
that amount, $8 million represents losses not yet realized through sale.

Obviously the events leading to a market decline are well documented. Fannie
and Freddie taken into new conservatorship; Lehmans filing for bankruptcy;
Bank of America acquiring Merrill Lynch; the U.S. government stepping in to
save AIG; money market funds breaking the buck; three month treasury bill
touching 0% yield; and Washington Mutual becoming the largest bank bankruptcy
in history. Our portfolio is well diversified, but not immune to market
corrections. We will compare favorably too many indices that cannot escape the
fear that has spread across the capital markets.

Our total portfolio return was -2.1% for the quarter, and -2.7% year-to-date.
Our fixed income portfolio has an overall credit quality of double A, and a
duration of roughly 5.

Given the turmoil in the capital markets today, I wanted to provide additional
insight into our investment portfolio. We have not significantly changed our
asset allocations since last quarter, with the exception of our preferred
stock portfolio. At June 30 we had approximately $40 million or roughly 2% of
our invested assets in preferred stocks. The changes in the marketplace and
the fact that these issues were dominated by financial issuers has led us to
substantially reduce our preferred portfolio. Today we have less than $16
million in preferred securities.

Again the majority of our other than temporary impairment charges have come
from the preferred stock portfolio. To provide additional color on our
portfolio, I want to give you our investment allocation at 9/30. Roughly 15%
are in corporate bonds; 12% in mortgage backed securities which are all Fannie
Mae, Freddie Mae, Jennie Mae triple A rated; 18% is in straight agency debt
triple A rated; 3% is in commercial mortgage backed securities triple A rated;
2% is in asset backed securities with an overall rating of triple A.

Our mortgage and asset backed securities are all senior tranches. We have 27%
in municipal securities with an overall rating of double A; 3% is in a high
yield muni bond mutual fund; 17% in equities; and 3% cash. We do not have any
direct credit to fault swap exposure or derivatives in our portfolio. We have
been purchasing equities in the down market but not aggressively. In fact, our
allocation to equities remains less than our normal range of 20%.

We manage this exposure in relation to our overall insurance risks. We do not
want to take excessive investment risks that will prohibit us from writing
insurance business. When we look at our direct exposure to the financial
sector, bonds, stocks and preferred stocks, this represents approximately 6%
of our portfolio. I’m of course excluding Fannie and Freddie senior debt and
mortgages from this total.

Obviously October has been very volatile in the capital markets. Through
yesterday the markets were down 14% for the month, 31% year-to-date. Our
portfolio has a lower beta than the S&P 500 and tends to outperform on the
down side. We expect to see continued volatility in the markets but believe
that over the long run, our diversified portfolio will provide strong
protection to policy holders while supporting book value growth for
shareholders.

Turning to our share repurchase program, during the quarter we repurchased
42,600 shares of RLI stock at an average cost of $54.26 or nearly $2.3
million. We have roughly $37.8 million of remaining capacity from the $200
million repurchase program approved in 2007. During the quarter, we suspended
the repurchase program in response to the developing market turmoil.

Since January of 2006, we have returned over $300 million to shareholders in
the form of dividends and share repurchases. Despite this and the volatility
in the markets, our statutory surplus has remained at roughly $700 million.
For the operations highlight, I will now turn the call over to Mike Stone.
Mike.

**Michael J. Stone**

Overall very good underwriting quarter, 88 combined ratio in a very volatile
environment, a major hurricane, at least one major competitor very distressed.
Now maybe we can even call it owned by us. Equity and credit markets turmoil.
Through all this the insurance market was fairly steady. There was a slight
blip during the AIG uncertainty but it quickly returned to fairly steady
overall.

Overall insurance prices down, but it now does appear that the rate of decline
is slowing and we’re starting to see some signs of stability and maybe a turn,
certainly in the D&O arena, the directors and officers arena, prices are up
and the AIG instability is probably fueling that. [Inaudible] gross written
premium for the quarter down 12%. Some of our products, GL, primary liability
product, our largest product off 20%; rates off about 12% for the quarter;
competition coming from all areas, including particularly the standard lines
companies.

However, I would say there are some signs of optimism. On the rate front we
saw in Texas during the month of September rates actually flattening and New
York in the northeast rates have declined, slowing considerably. I would
expect fourth quarter, first quarter of next year actually to be flattening
out there so some signs of optimism there. Obviously the question of what the
recession will do to the top line is in question at this point.

In our personal umbrella product gross premium was up 4%, our growing policy
count and getting a little bit of rate in that product. D&L I spoke to a
little bit. We’ve not been a market for financial services. Rates are moving
up in this area 10% or more and we’re seeing more and better opportunities
given the instability of a number of the markets in that arena. Risk managers
and D’s and O’s are starting to question some of our major competitors and
letting them have large limits, taking our large lines on the D&O programs. So
we’re optimistic that we’ll participate in this change.

Property gross written premium off 7%, quarter dominated by hurricane losses
as John mentioned earlier. However rates in the Kat arena still off 10 to 12%,
fire off a little bit less about 5%. I would expect to see some fallout from
the major competitor instability. I haven’t seen it yet. I would expect some
front rate firming due to hurricane losses, not seeing that yet either. But
again I don’t think things stay flat, I think they turn and we’re more
optimistic now than we certainly were last quarter.

In the marine arena we’re still growing out that business. It’s up 35% in the
quarter. They’re still continuing to execute on their business plan and we’re
starting to see some progress there.

On the Surety front good story, written premium up 17% in the quarter. All
segments are participating. Obviously we’re going to be very careful as this
economy slows in our contract in our commercial arena, but we feel like we’re
very strong here with underwriters well experienced that have been through
these markets in the past and we think we’ll perform well through this period.

We started up a Fidelity operation in the third quarter, would expect to see
some production in the fourth quarter from that product segment. Overall we
believe a very good underwriting quarter in this tough environment. John.

**John Robison**

We’d now like to open the call up to questions.

","**Question-and-Answer Session**

**Operator**

Your first question comes from Matthew Carletti – Fox-Pitt, Kelton.

**Matthew Carletti – Fox-Pitt, Kelton**

Looking back to the first quarter casualty you bumped up the accident year
loss ratio kind of given pricing trends and what you saw in lost costs and
since then it’s been kind of a slow but steady improvement it seems both in 2Q
and 3Q to slightly better accident year loss ratios. Could you just comment on
what you’ve seen over the past six or nine months that has led you to bring
that ratio down? What’s gone on with loss costs?

**Joseph E. Dondanville**

It’s basically favorable development because there’s nothing that you can do
as far as making up the deterioration and the losses on price other than
looking at our historical performance and that the base that we’re building
off of our loss picks has continuously improved beyond what we originally
estimated.

**Matthew Carletti – Fox-Pitt, Kelton**

So in other words it kind of lowered the bar, prior years are better than you
thought and it lowered the bar for current business?

**Joseph E. Dondanville**

Yes.

**Operator**

Your next question comes from Bijan Moazami – FBR Capital Markets.

**Bijan Moazami – FBR Capital Markets**

This question is for Mike Stone. I’m trying to get an understanding of exactly
what happened during last quarter. On one hand a lot of brokers were saying
that AIG were cutting rates as much as 40% in the wholesale brokerage market
and now it seems that that has somewhat cut back into normal. On the other
hand, I’m a little bit worried about any increase in unemployment rate what
the impact of that would be, what the impact would decrease in the stock
market. Will it be under D&O losses?

And also with the November election, with Democrats probably taking over would
that increase the probability of some of the regulation going the wrong way?
I’m just trying to understand the dynamic of the pricing in the context of
what you guys think about loss costs going forward.

**Michael J. Stone**

Bijan I’ll try to answer that multi-part question the best I can. I think
certainly on the AIG front it’s been a bit of a mixed bag I think from that
perspective. We’ve seen them be very competitive in some areas and not as
competitive in some other areas. I think they’re certainly being competitive
in the surplus lines arena. But they have been competitive for the foreseeable
past, so it’s really not any great change there. But it’s certainly not seeing
them increase rates.

Certainly in the D&O arena we will see some more opportunities and I think
rates will move up given what’s gone on in the equity markets. We’re a fairly
small player overall and even more of a small player when it comes to all
clause D&O we’re more of a player in the side A clause one, which is basically
bankruptcy coverage. So we’re a little more insulated from the dips in the
equity markets and the strike suits that come from that.

So we think we’re going to see more opportunities there as a number of the
competitors including AIG are being more questioned by risk managers as we go
forward. Certainly the recession will have, it might have a salubrious effect
on loss costs. Who knows? But it certainly will, probably will have an effect
on top line in a negative fashion. So I think that’s a bit of a mixed bag
there.

**Bijan Moazami – FBR Capital Markets**

So you think that the industry will be able this time around to act relatively
quickly to the dynamic of the loss costs to get the prices up? Because the
last cycle just took such a long time before the industry reacted.

**Michael J. Stone**

Bijan, if you listen to the management talk they talk about how disciplined
they’re going to be this time. I do think that I’m not so sure that I buy that
completely, but I do believe that information is better. I think governance is
stricter. I think what they’ve seen over the last month should give everybody
a bit of religion about price instability. And I think we will react quicker.

**Operator**

Your next question comes from Mike Grasher – Piper Jaffray.

**Mike Grasher – Piper Jaffray**

On the Surety business up 17% in the quarter, any benefit realized from the I
guess one of your competitors as you’ve stated a couple times, just the
uncertainty around them?

**Michael J. Stone**

I don’t think so Mike. They’re not a big player in the markets that we’re in.

**Mike Grasher – Piper Jaffray**

So this all came from the markets that you’re in and not necessarily going
outside?

**Michael J. Stone**

Yes that’s correct. Yes. We’ve had an emphasis on Surety over the last couple
of years. We’ve spent quite a bit of effort over the past couple of years on
building our Surety and rebuilding the contract area specifically and have
added underwriters and have added new geographies. So we’re adding exposure
there but in new geographic territories so we feel pretty good about that
starting to come online.

**Mike Grasher – Piper Jaffray**

And as you look forward at the opportunities that are out there would you move
into sort of a new I guess or would you have a different appetite for risk on
a larger scale by bringing in a successful team of underwriters from one of
your competitors?

**Michael J. Stone**

We’d certainly have the appetite if we could find the right people and I would
suspect that we’ll see opportunities as we move forward. I mean I do think
that there’s quite a bit of instability out there, so I would expect that
we’re – as we indicate in all of our advertisements and relationships with
people is we’re a good place for underwriters and underwriters that want to
make a difference and have a bit of an entrepreneurial zeal. So we’re a place
for that.

**Mike Grasher – Piper Jaffray**

Moving on then to your capital position I guess what is A.M. Best saying given
the environment? I mean certainly in John’s opening comment you pulled back on
the share repurchase and on paper you look to be under levered but is there
any concern from the agency itself?

**Joseph E. Dondanville**

The only questions that we’ve had so far from A.M. Best is collecting
information regarding cat losses and exposure to the financial crisis. I don’t
think we’re anywhere near the top of their list of companies that they’re
concerned about from a financial standpoint. We have not been in any
discussions about capital adequacy with them.

**Mike Grasher – Piper Jaffray**

So certainly quite a bit of flexibility remains.

**Joseph E. Dondanville**

Yes.

**Mike Grasher – Piper Jaffray**

And then just a question as we look ahead to the elections and that. If
there’s a change in tax policy on dividends does that create a change in your
view on either paying a dividend or growing that dividend?

**Jonathan Michael**

We’ve had a history of paying increasing dividends for a long time, 30 some
years and so we would tend to want to continue that policy. But obviously if
tax policy changes and such that dividends aren’t rewarded then we might have
to reconsider that. So I guess I’d say I don’t know. We’ll have to see what
happens.

**Mike Grasher – Piper Jaffray**

I guess the magnitude of change would drive it?

**Jonathan Michael**

Yes I think that’s right.

**Mike Grasher – Piper Jaffray**

And then just with regard to Maui Jim can you walk us through the accounting
on that? I think you had a $4 million dividend that came through and is that
basically the change in the carrying value of Maui on the balance sheet?

**Joseph E. Dondanville**

Well the way the dividends work is our approach to accounting for Maui Jim is
a long as an investment and as such we anticipate that the realization of the
value in Maui Jim would be through capital gains of which it would be 35%. Now
they’ve sporadically have paid dividends over the last few years and when we
receive a dividend then we get the dividend received deduction that applies
and that brings the tax rate on the actual dividend down to 7%. And at the
time we receive the dividend or they declare the dividend is the point in time
we recognize that tax differential as a benefit.

**Operator**

Your next question comes from Michael Phillips – Stifel Nicolaus & Company,
Inc.

**Michael Phillips – Stifel Nicolaus & Company, Inc.**

Please comment on what you’re seeing in terms of changes and pressures for
commission rates in the wholesale business.

**Michael J. Stone**

There hasn’t been a lot of pressure on commissions. I’m not saying that there
isn’t pressure on an individual account or it may be an individual product.
But we’re not seeing any pressure on commissions at this point. At least we’re
not responding to that pressure.

**Michael Phillips – Stifel Nicolaus & Company, Inc.**

John you mentioned the suspension of your share repurchase. Is that still in
effect?

**Michael J. Stone**

Yes it’s still in effect. John this is Michael.

**Operator**

Your next question comes from DeForest Hinman – Walthausen & Company.

**DeForest Hinman – Walthausen & Company**

We’ve had two weeks in October go by so far still a lot of volatility. You
said the investment portfolio had been making some changes there. Have we
taken further impairments or realized losses in the first two weeks of October
that we should be aware of?

**John Robison**

No we have not. Markets have obviously been pretty volatile. We monitor it
very closely and look at our holdings throughout the day but we have not taken
any additional impairments at this time from 9/30.

**DeForest Hinman – Walthausen & Company**

From a portfolio management strategy going forward, how do we look to position
the portfolio based on our take on the market right now, what we’re seeing?

**John Robison**

Well we’re fortunate to be a pretty strong cash flow company so as cash flow
comes in we look at our long term allocation and the opportunities that are
available in the marketplace and determine where we ought to put those funds.
As I said in my opening comments we have been buying some equities, very
limited on big down days in the market. We see some spread opportunity
obviously in the bond market which will enhance our yields.

But we’re playing it pretty safe. We’re not taking aggressive risks in any one
area or looking to increase the risk exposures substantially that we have
right now.

**DeForest Hinman – Walthausen & Company**

And a question on the Maui Jim. We mentioned a currency impact in the press
release. Can you quantify that?

**Joseph E. Dondanville**

Okay I’ll elaborate a little more on that. Maui Jim does hedge a little bit on
their inventory purchases on which they had owned some yen and when the dollar
went up they lost a little bit of money there. But the larger portion of the
losses, they do not hedge their receivables from foreign operations and that’s
where the bulk of it is. And our share of the foreign exchange losses is
roughly about $1.5 million in the quarter.

**Operator**

Your next question comes from Ron Bobman – Capital Returns.

**Ron Bobman – Capital Returns**

I just had a couple of questions. One the buyback suspension was the primary
motivator for that the ambition that the capital would be hopefully soon be
better put to use supporting better underwriting terms and conditions, etc.,
sort of a hardening market concept? Or something else?

**John Robison**

It was to support a hardening market or better insurance environment. We
thought we could put that capital to better use than actually buying our
shares back in the current environment.

**Ron Bobman – Capital Returns**

And then if you could remind us do you manage your own investments or do you
outsource that? And if you outsource it who do you outsource it to?

**John Robison**

We manage approximately 50% in house and it’s what we consider lower credit
risk items, lower credit risk before 9/15 of course when Fannie and Freddie
were taken over. But we manage about 50% in house. It would be the municipal
bond portfolio and U.S. Treasuries and Agencies. And we outsource our equity
portfolios and some of our corporate bond portfolios and spread product type
things. We use Conning as an investment manager. We use David Vaughan
Investments as our equity manager. We have Security Capital as a [reap]
manager. Those would be the primary managers that we use.

**Operator**

It appears there are no further questions. I will now turn the conference to
Mr. Jonathan Michael.

**Jonathan Michael**

Thank you very much for listening. It’s certainly an unprecedented time for
our country and for the world. We’re in the throes of a capital and credit
crisis that requires immediate and decisive government intervention by a lame
duck, Republican president. We’re about to elect a new administration which
regardless of who gets in office will undoubtedly lead to more regulation,
change in tax policies, etc.

I think we all believe that recession is upon us. The property and casualty
insurance market is probably at a point where prices should at least not
soften any more. Capital in the marketplace just from what’s happened through
the credit crisis have fallen a great deal. And then on top of that, we’ve
probably had as much as $20 billion in hurricane losses for Gustav and Ike.

In fact, I believe that some of the signs point to a firming environment and
that especially the fact that capital is down and that we have insurance
buyers who, I believe, will not be willing to put all of their eggs in one
basket so to speak with the revelation that one of our largest competitors,
AIG, had to be taken over by the federal government. I believe that risk
managers will be reticent to put all those eggs with one company again, which
means that we should see more opportunities.

Now we haven’t seen that firming price firming yet but our company RLI we’re
very well positioned in terms of our production plant and our systems to take
full advantage if and when that happens. Until then we’ll maintain our
underwriting discipline as is a hallmark for RLI and continue to build our
capabilities and look for opportunities.

On the investment side as John indicated we do have a very well diversified
portfolio. By the way, I will point out that the asset allocation of that
portfolio is determined internally. And we believe that our risk management
and conservative nature bodes well for us in the investment area as well.

I want to thank you for attending and your attention to our conference call
and we look forward to a good fourth quarter. Thanks.

**Operator**

This concludes our conference for today.

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Good morning, my name is Darla and I would like to welcome everyone to the
Alltel First Quarter 2006 Release. All lines have been placed on mute to
prevent any background noise. After the speakers remarks there will be a
question and answer session. If you would like to ask a question during this
time, simply press star then the number 1 on your telephone keypad. If you
would like to withdraw your question, press the pound key. Thank you. Mr.
Thomas you may begin your conference

**Tony Thomas, Vice President Investor Relations**

Thank you Darla. Good morning everyone, welcome to Alltel’s first quarter 2006
conference call. My name is Tony Thomas and lead Investor Relations for
Alltel. Thank you for participating in this discussion of our first quarter
results this morning. Today’s conference call was preceded by our first
quarter 2006 earnings release. This press release has been distributed on the
newswires and is available from our website at www.alltel.com. Today’s
conference call should be considered together with our press release and
related financial information.

Today’s conference call should be considered together with our press release
and related financial information. Today’s discussion includes statements
about expected future events and future financial results that are forward-
looking statements within the meaning of the Private Securities Litigation
Reform Act of 1996. Forward-looking statements are subject to uncertainties
that could cause actual future events or results to differ materially from
those expressed in such statements. Other factors that could cause actual
results of Alltel to differ materially, many of which are beyond the control
of Alltel, include but are not limited to the items listed in the Safe Harbor
statement contained in our fourth quarter 2006 release.

Additionally, today’s discussion will include certain non-GAAP financial
measures. Again, we refer you to the Investor Relations section of our website
where we have posted our earnings release and supplemental materials which
contain information regarding these non-GAAP financial measures, including a
reconciliation of each such measure to the most directly comparable GAAP
measure. Note that a live webcast of this call is available on our website. To
access the call, go to the Investor Relations section and click on the live
webcast link.

During our call we will make reference to performance on a pro forma basis
which reflects the Western Wireless merger as if it was completed on January
1, 2005. These pro forma wireless financials are included in the supplemental
material.

Participating in our earnings discussion this morning are: Scott Ford, Alltel
President and Chief Executive Officer, Kevin Beebe, Alltel Group President
Operations, Jeff Gardner, Winscreen President and Chief Executive Officer,
Sharilyn Gasaway, Alltel Executive Vice President and Chief Financial Officer.

At the end of the call we will take a few questions. With that, here is Scott
Ford.

**Scott T. Ford, President and CFO**

Thank you Tony and welcome to your first conference call. I think we’ve got a
real contender for the Rob Clancy Award for reading disclaimer language. Good
morning everybody. I appreciate you joining us today. This morning I would
like to briefly like to discuss a few financial highlights and then give you
an update of several strategic initiatives. As usual, Kevin will then talk
about the operational highlights of the business from the Wireless business
and then Jeff Gardner in what we hope will be his swan song performance on
this call, will give us strategic and operational highlights review of the
Wireline business, followed by Sharilyn Gasaway who will go over the
financials and try to give some clarity to all of the things that we’ve talked
about.

For the first quarter of 2006 we achieved $0.77 of fully diluted earnings per
share on a GAAP basis. This reflects the impact of Western Wireless
integration activities, Wireline separation expenses, a net gain in
discontinued operations in non cash charges related to the Wireless
acquisition amortization.

Sharilyn will cover all of these things with you in detail in a few moments.
Excluding these items, we achieved full diluted earnings per share of $0.82
for wire business, which is down 6% year over year on a per share basis
primarily due the increase share count related to both the equity unit
conversion and the Western Wireless merger.

On a consolidated basis, this quarter we generated $504 million of equity free
cash flow, an increase of 49% year over year. In addition, consolidated
revenues and operating income from current businesses grew 19 and 18%
respectively. On a pro forma basis, both consolidated revenues and operating
income grew 7% and pro forma equity free cash flow was up roughly 40%.

In our wireless business, service revenue and operating income grew 29 and 25%
respectively. On a pro forma basis, service revenue grew 9% year over year,
while segment income was up 5%, equity free cash flow was up roughly 45%.

We added 165,000 customers in the first quarter, driven by our lower churn
rate, strong sales of our new pre-pay wireless service UVIRA and our continued
commitment to be competitive in the post pay marketplace.  
Kevin will discuss each of these items with you in a few moments.

On the strategic front, an important step in the spin off our Wireline
business was completed in April. The new Co. has a name, that is Windstream.
We expect the separation of Windstream in the July time frame. Jeff will go
through all of those details with you in a moment as well too.

Finally, we are pleased to announce that last week we closed on the sale of
our Austrian asset Telering to T-Mobile for $1.6 billion or $1.1 billion after
tax. In addition, last week we closed on the sale of our wireless property in
Haiti. We expect the closing of the properties in Bolivia and Slovenia to take
place sometime in the second quarter. In aggregate, international assets will
provide pre tax proceeds of roughly $2.3 billion.

Moving closer to home, we purchased wireless partnerships from Palmetto Mobile
Net and LP that covers approximately 2 million pops in North and South
Carolina. We just recently closed on the purchase of First Cellular of
Southern Illinois which added 485,000 pops. We’d like to welcome the First
Cellular employees and their customers to the Alltel family.

Finally, we continue to work towards closing our proposed mid-West wireless
transaction which we expect to close in the second half of the year at this
point.

Post spin the wireless business will have a capital structure that allows for
optimal financial and strategic flexibility. We remain committed to our plans
for a $1 billion debt reduction and an aggressive $3 billion share repurchase
program beginning immediately after the spin closes.

From an overall strategic perspective, we are encouraged about the
opportunities that exist for our wireless business. We believe that both voice
and data minutes will continue to migrate to wireless networks. Thus, we have
plans to capitalize on that growth through network expansion and evolution.
The Alltel brand continues to evolve and become even more relative to existing
as well as potential customers, evidenced by our lower churn rate and higher
gross adds.  
With that, let me turn the call over to Kevin to discuss wireless operations.

**Kevin T. Beebe, Group President of Operations**

Thank you Scott and good morning everyone. First I’d like to review some
quarterly highlights. Wireless gross customer additions were 805,000 for the
quarter, that’s up 2% in year over year on a pro forma basis. Net adds were
$165,000 which included the loss of 18,000 customers due to our decision to
discontinue a western wireless service plan called “Talk Watch.” We made that
decision on January 1, 2006. Talk Watch is a post pay rate plan initially
designed with real time spending limits. At the end of the first quarter, we
had about 49,000 remaining Talk Watch customers, which expect to attrite off
over the remainder of this year.

Excluding Talk Watch, we added 72,000 net post pay customers and 111,000 net
pre pay customers in the quarter. Our 72,000 post pay net customers additions
were driven by post pay churn of 1.66%. Our total churn was 2%. Both of those
metrics improved year over year as well as sequential.

Our strong pre pay results were driven by the launch of U-Wireless, our new
pre pay product introduced in January and the continued strength of Simple
Freedom which is our phone in the box pre pay service sold primarily through
Wal-Mart.

We were very pleased with our results this quarter. We do expect seasonally
lower sales of our pre pay offerings in the second quarter. Our cost per gross
add was 15% higher year over year to $352. That was driven by larger subsidies
for higher end handsets by Razor and a higher mix of dealer sales within corp.
Offsetting the higher cost per gross add, our cash cost per customer declined
to its lowest level in three quarters. We continue to grow ARPU year over year
on both an as reported as well as a pro forma basis. Average revenue per
customer increased to 4%; year over year to $50.90. On a pro forma basis,
average revenue per customer increased 1%. These increases are the result of
data revenue growth and improvements in BTC revenues.

Data revenue per customer was $2.86, that’s an increase of 59% year over year,
representing over 5% of total ARPU. We were successful in selling existing
data products and applications such as text messaging, application downloads,
enterprise messaging, and during the quarter we launched an ABDO Blackberry
device. Also, we launched several new data applications including access
radio, which offers 40 channels of commercial free streaming music, exclusive
ring tones from several artists and office sync which allows users to send and
receive emails in real from their Palm, OS, or Windows mobile devices.

We will continue expanding data applications and products throughout the year
to leverage our growing EDDO coverage. This quarter was also filled with
integration and conversion work. We successfully converted our support systems
within the former Western Wireless markets. This includes the conversion of
the Western Wireless billing system and point of sales systems. This
conversion was a key step towards realizing, towards the realization of our
synergy targets.

In addition, we’ve completed the conversion to a new pre pay service platform
that expands pre pay features and substantially reduce our cost. Today both
our U-Wireless and Simple Freedom products build on this new platform.

Finally, to begin the current quarter, we have launched My Circle, giving
customers the ability to select up to 10 numbers connected to any wireless or
wireline network and add thee numbers to their mobile to mobile plan. In
essence, it expands their mobile to mobile service the people they call the
most regardless of the network. My Circle is available on any service plan
priced at $59 or above. Early sales results have been very encouraging. With
that, let me turn the call over to Jeff to discuss our Wireline operations,
Jeffrey.

**Jeffrey R. Gardner, President and CEO, Wireline Operators**

Thank you Kevin and good morning everyone. First I would like to review some
Wireline operational highlights and then provide an update on the pending spin
off and merger with VALOR. This quarter we added a record 44,000 broadband
customers bringing our broadband customer base to 441,000, a penetration rate
of 15% of total access lines.

At the end of the quarter we were capable of offering download speeds of 3
megabyte to nearly 60% of total access lines. In addition, we recently
launched a 6 megabyte service offering which is currently available to nearly
20% of our total access lines.

Broadband is a very important part of our business and we plan to continue
upgrading our network to reach more customers as well as deliver faster
speeds.

Future revenue per eligible line increased 2% and coupled with our broadband
revenue growth, lead to average revenue per wireline customer of $66.77. This
quarter we lost 23,000 access lines, primarily the result of wireless and
broadband substitution, bringing our year over year loss to 4%. This 4% year
over year decline is an improvement sequentially and represents the first
sequential improvement in year over year access line losses in 7 quarters.

We believe our continued emphasis on selling broadband services coupled with
our new bundled satellite video offering is having a positive effect on access
line losses. Recall that in the fourth quarter of 2005 we launched our dish
network TV offering and to date have been very pleased with our sales results.

Looking at broadband customers and access lines together, or total customer
connections, we added 21,000 total customer connections this quarter driven by
the record broadband add.

Turning to the upcoming spin off and merge with VALOR, several weeks ago we
announced a new company would be named “Winstream Communications.” Winstream
Communication built on our 60 year history as a reliable communication
provider and customer ally with fresh innovative thinking and technology to
deliver the information, entertainment and personal connections that customers
need. Over the past few weeks, our leadership team visited with roughly 5,000
employees in 9 locations to introduce the new name and our employees were very
enthusiastic about the name and our future opportunity. We believe our company
will be the premiere rural local exchange company in the industry in terms of
scale, and cash flow generation capability. And, we will have a strong balance
sheet that affords us financial flexibility.

In terms of transition activities, we have team within Alltel working on
detailed plans to separate the shared services functions within Alltel and we
also have teams at Alltel and VALOR working on the integration process.

We are very pleased with the progress we are making on both fronts and
continue to believe that the merger with VALOR presents an opportunity to
achieve approximately $40 million in annual net synergies.

In terms of the regulatory process, we have received approval from the SEC,
the FTC, and several State public utility commissions. We also recently
received a favorable ruling from the Internal Revenue Service on the tax free
treatment of the spin transaction and the merger with VALOR.

At this time, we have 5 State approvals remaining and we hope to complete the
entire approval process in time for a mid-year closing. This quarter we also
announced the appointment of Keith Paglusch as Chief Operating Officer. Keith
has over 25 years of telecom experience and we are all very pleased to have
Keith on our team.

In summary, our Board and senior management team is largely in place. We are
very eager and excited to begin our new journey together. With that, I now
turn the call over to Sharilyn to discuss the financial results.

**Sharilyn Gasaway, Alltel Executive Vice President and Chief Financial
Officer**

Thank you Jeff and good morning everyone. In the first quarter we achieved
$0.77 of fully diluted earnings per share on a GAAP basis which includes the
following items: $20 million of pre tax expense related to the integration ad
re-branding of Western Wireless property and transaction consulting and
employee benefit costs for the pending spin off of our Wireline business. $18
million of net gain from discontinued operations which includes the various
international businesses held for sale and the domestic divestitures required
in connection with our recent acquisition And $45 million of wireless
amortization expense related to intangible assets recorded in connection with
previous wireless acquisitions. Excluding these items, we achieved $0.82 of
fully diluted earnings per shares from current businesses which includes a
fully diluted weighted average share count of approximately $390 million.

Under Alltel’s previous presentation of operations from current businesses
that included wireless and tangible amortizations, the fully diluted earnings
per share would have been $0.75. For the quarter, our wireless business
generated $1.64 billion of service revenue, an increase of 29% year over year.

On a pro forma basis, service revenue increased 9% year over year driven by a
9% lift in both retail and wholesale revenues. The primary driver of our
retail revenue growth continued to be our focus on quality customer growth,
data revenue improvement and ETC revenues.

For the quarter we received approximately $57 million of ETC revenues. As
Scott mentioned earlier, we generated $356 million of wireless segment income
an increase of 25% year over year. Included in the results this quarter is
stock option expense of $5 million associated with the adoption of VAS 123R.

Pro forma segment income grew by 5% year over year driven by (inaudible) and
pre pay customer growth. Of course, these customer additions were associated
with the higher sales costs that Kevin discussed earlier.

Wireless cash costs per customer excluding selling and marketing expenses were
$23.40 and increase of 3% year over year, driven principally by additional
data expenses. The sequential decline of wireless cash costs, up 4%, was
driven by improvements in bad debt and lower system expenses.

Turning now to our Wireline business. We generated $575 million of revenue, a
decrease of 3% year over year and EBITDA of $330 million which also declined
3% year over year.

Segment income for the quarter was $227 million, an increase of 6% year over
year driven by lower depreciation expenses as we’ve linked in the depreciation
loss of certain assets that are expected to be in service longer than
originally anticipated. Communication support services produced $251 million
in revenue and $21 million in segment income. This quarter, capital
expenditures totaled $221 million and we generated $504 million of equity free
cash flow, an increase of 49% year over year ending another quarter with a
strong balance sheet in credit metrics. Our capital expenditures will calm
significantly in the coming quarter.

Turning to the balance sheet. Our net debt balance at the end of the quarter
was $5 billion, which will be impacted in the coming quarters by the $1.2
billion after tax proceeds from the sale of the international assets just
received, the $4.2 billion de-leveraging from our spin off of Wireline, the
purchase of Mid-West Wireless for $1.1 billion, the recently announced
purchase of First Cellular of Southern Illinois for $140 million and the $130
million after tax proceeds from the liquidation of the Rural Telephone Bank.
Our pro forma net debt following all of these transactions will be $680
million before the benefit of free cash flow earnings over this period. The
Rural Telephone Bank liquidation payment once received in April and will
result in a one time pre tax gain of approximately $175 million in the second
quarter.

Finally, we expect to be within the first and second half 2006 guidance that
we provided on February 1st. With that, we will now take a few of your
questions. Operator, please review the instructions and open the call to
questions, thank you.

","**Question-and-Answer Session**

**Operator**

Thank you. At this time I would like to remind everyone if you would like to
ask your question, press star and the number 1 on your telephone keypad. We’ll
pause for just a moment to compile the Q&A roster.

Your first question comes from Tom Lee with JP Morgan.

**Thomas Lee**

Guys, can you hear me? Good morning. I’m not going to ask you questions on the
spin off, because I know someone else will. I wanted to ask you really some
longer term questions on your wireless business. You know clearly we had a
nice rebound in wireless growth, but what I’m curious about is, when I look at
the wireless numbers, I’d say that one thing I notice was that wholesale
revenues from roaming cells sequentially. Now I know they’re up year over
year, but at $151 million we saw about a $20 million drop off sequentially, so
my first question just relates to you know, A) can you talk about if this was
seasonal factors, if there were step downs behind that and longer term EBITDA
margins – I kind of originally was kind of conceptualizing 40% is being that
long-term target for Alltel, if you could talk about what you feel comfortable
with what long term margins are and kind of related to that is just data
revenues? I know data is really exploding with you guys, I’m just curious if
data is proportionately doing more capacity than its revenue contribution?
Thanks.

**Scott Ford**

Hello Tom, this is Scott and Kevin will have a few things to say too, but, if
you go through it sequentially, just if you look at roaming, we are currently
in negotiations with basically every roaming partner that we have. There are a
lot of puts and takes going on around those sets of discussions. It’s really
not right at this point to be talking about it publicly, but suffice it to
say, there is a lot of jockeying going on around the track right now.

If you look at the long-term margin issue, we’ve not gotten into the business
of forecasting margins. We’re going to specifically stay out of that right
now. But we are in a transition period both in terms of the wholesale
business, the network as we start to build out the data network and we start
to take the expense of building that data network, but you know you have to
build the expense in before you get the revenues. And also, the jockeying that
takes place on any quarter in terms of the gross adds side of the business.
Kevin, you fill in anything more on that, that you’d like and one of you take
the data stuff as well.

**Kevin Beebe**

Hey Tom. I think on margins, here’s what I offer up to give you some
perspective on what happed in Q1, and then obviously you’ll sort through it as
you always do in a good way. We did a couple of things in the first quarter.
One is, because of the movement on pricing around higher end funds that we
saw; we chose to subsidize all higher end phones to a larger degree than we
had planned. Market reaction, there were a lot of dynamics around higher end
phones in Q1 and we chose to really follow the market there. So I think those
higher subsidies had an impact. We continue to price higher end phones at the
same level or same price if you will that we did in the first quarter. Of
course, we’re working hard with our suppliers to make them understand that
additional volume should result in lower costs. That’s an interesting
conversation as I know you know.

We also incented towards the end of the quarter, we incented the dealers to
sell Alltel because of some share shift we had seen in the dealer channels. We
were very pleased with the results of that, but that caused higher costs. We
have removed those incentives at this point, but we’ll be mindful of whether
or not that’s something we need to do in the future. We expect the second half
of the year to have some improvement in terms of the synergies from Western
Wireless. I mentioned we did the conversions 1Q that should begin to have an
impact on our run rate. And then of course, whenever we can close Mid-West
we’re working through regulatory approval right now, everything is progressing
well, it’s just taking time. They’re operations are really exceptional. The
Dennison Team have done a great job so did Terry Atakin and team at First
Cellular of Illinois. So we think those are some of the positive things going
forward.

On the data revenue side, we got the 5% and the 59% growth is exceptional,
although in looking at some of the other carriers who have reported, we know
that we are known at the levels that others are. I think we need to continue
to deploy applications. We’re working hard to get those out as fast as
possible. We also need to expand and improve our high speed network, we’ve
announced earlier this year our plans to cover 60% of our pops with DO, we’re
working through that. 1Q was a slower start than we expected simply because we
were doing some other things (inaudible) conversions quite frankly. So our
engineers are after it right now and we expect to do some catch up beginning
in 2, 3 and 4 Q and that’s why I think you’ll see a pop in our CAPX expenses
as the year winds.

Hopefully those things help.

**Thomas Lee**

Yeah, very helpful, thanks guys.

**Kevin Beebe**

You’re welcome.

**Operator**

The next question is from Michael Rollins, Citigroup.

**Michael Rollins**

I’m curious if you could talk a little bit more about the pace of integration
on the Western side. And maybe talk more specifically about if you got any
specific cost benefits in the quarter and maybe just an update on the
quantitative side of how that should ramp through the year? And then just
backing up with a more philosophical question on just the subscriber
environment that’s out there today, and what are you seeing as you look at the
newer markets that you’ve acquired versus some of the existing markets and are
you seeing significant ramp in the new markets as you launch your new
marketing message and get that systems conversion fully up and running?
Thanks.

**Kevin Beebe**

Hey Mike, this is Kevin. Why don’t I take a shot at that then Sharilyn and
Scott can certainly add on if they see fit. But in terms of integration.
Really in 1Q there were more costs than we’ll see because of the integration
activity, because of the work we did around the conversions, expenses, etc.,
so as the year proceeds, we should begin to see some pick up in the synergies.
Sharilyn might have something she wants to add.

In terms of customer growth in the lesser markets, while we stop reporting
Heritage and Western, because when we converted to our systems in mid-quarter,
we converted pence, we don’t see those operations as different any more. We
certainly know what’s going on at a market level but I think it’s time to just
report at Alltel at this point and continue to give you some pro forma looks
which I think should help to get at our real run rate revenues and other
things.

We’re very pleased with the post pay pick up in Western markets. I think
that’s the result of the launch of our rate plans, our name, which really just
happened in 1Q. We just launched the Alltel name as well as all of our handset
and pricing. We’re also working through broadening the launch of our data
applications in those markets. A lot of that has to do with the network and
making sure it’s ready before we launch the applications. The engineers have
made great progress there. So we couldn’t be more pleased. What are we seeing
in those markets? It’s certainly than Phoenix and Tampa and Cleveland in terms
of the growth opportunities and I think the competitive realities are we feel
better to be lucky and good, right? We feel very fortunate to have a strong
competitive position in those markets.

**Sharilyn Gasaway**

And Michael, I’ll just add on a little bit. As Kevin mentioned, we are on pace
to achieve the synergies related to Western. We don’t fully realize those
benefits until the back half of the year. For example, like with the billing
system that we have, even though we’ve converted many of our customers, we
still are keeping that billing system providing transition services to those
markets that we divested of. So we’ll really see those benefits come in the
late back half of the year.

**Operator**

Our next question is from Jonathan Atkin, RBC Markets.

**Jonathan Atkin**

Yes, RBC Capital Markets. I was wondering, just can you talk more about some
of the changes you saw in the overall level, the mix between different
technologies and carriers this quarter? And the My Circle rate plan, what kind
of take away have you seen among your new customers versus perhaps your
upgrade or renewal customers?

**Kevin Beebe**

Hey Jonathan, Kevin. On roaming, we saw growth across the board in terms of
minutes, CDMA and GSM. Of course, the GSM growth was helped by the fact that
last first quarter we didn’t have Western and fully baked in, in terms of the
GSM activity. We haven’t expanded any GSM capability to our existing markets.
We’ve talked pretty openly about our desire to do that but as Scott mentioned,
we’re still working through conversations with some of the GSM providers in
the business. But feel good about that going forward. We did see some more
build from some of the national carriers. That certainly had an impact on our
revenue, but we expected that quite frankly as some of them have picked up
additional licenses.

**Jonathan Atkins**

Was that over build mostly GSM or GDMA?

**Kevin Beebe**

GDMA. My Circle – our early results, very early, so – early results suggest
the activity around new customers coming to us as a result of what we think is
My Circle, of course there’s a lot of messaging in the marketplace from Alltel
right now. The phone price service is great, blah, blah, blah. Not to imply
that none of those are bad, some are very good and we don’t put blah, blah,
blah in our ad, or should we? But a lot of messaging. So the best we can tell,
the people signing up and choosing for My Circle, are generally doing what we
expected, that is buying up on the $59 rate plan. That’s good news. The
percent of our gross adds right now that are at $59 and above are better than
they had been historically. The results, don’t know that it’s going to show up
any time soon. All of those caveats apply. I think that’s good news.

In terms of existing customer base, we’ve had a good amount of upgrade
activity, but we’ve had some down grade activity as people have sorted
through, just as we know customers would, the amount of minutes they think
they need as a result of My Circle. Too early to tell how it’s all going to
wash out, but it’s about half/half 50% up, 50% down in terms of the base.

So, encouraged by the results, encouraged by how simple it has been, how it’s
been received in the marketplace. I think we’ve done a great job in
communicating what it is, not only customers, but also as you all know, the
challenge at times is to make sure your retail reps understand what they’re
selling. And in this case, we’ve done a great job on the training end too,
internally. We also have offered it through the web and been very encouraged
by our web sales results which, of course, is a much lower cost channel than
anything else we have.

**Jonathan Atkins**

On Western real quick -- is there a concerted effort to equip the customer
with Alltel phones and rate plans or is that migration happening more on pace
with the typical upgrade cycle?

**Kevin Beebe**

More on pace Jonathan because they were CDMA. So nothing different there in
terms of big expense to get new phones in people’s fingers

**Jonathan Atkins**

Thank you very much.

**Operator**

Your next question is from David Barden, Bank of America Securities.

**David Barden**

Hey guys thanks a lot. Just a couple of questions. First is, thanks for
reiterating the guidance Sharilyn. I was wondering if you could give us as we
look a the first to second quarter ramp, the kind of maybe 1,2, 3, things are
going to change in the revenue cost equation. If it’s not going to be the
Western integration numbers that’s going to kind of get us to the guidance
range in the second quarter?

The second thing would be if you could just give us a sense as to the
magnitude of the costs that were integrated into the Wireline business this
quarter from the expected separation?

And then, last question, strategically, I know you guys are sensitive to this
but you know, it’s kind of a central theme to your strategy – as you look at
the carriers over bill plans, and as you were in negotiations with them on
roaming, are you guys comfortable, pleased with your kind of strategic
positioning to be the kind of roaming partner of choice? Is this looking to be
a good strategy or is it leading to some brinksmanship in terms of threats of
overbuilding? I’m just trying to get a sense of where that’s really playing
out right now. Thanks.

**Sharilyn Gasaway**

Okay David, I’ll take the first couple. In terms of some of the things that
we’re looking at in terms of the margins, and some of you kind of hinted
around, 1Q is more seasonal and so we see declines not only at wholesale from
a seasonal basis, but also from a usage standpoint. And so we expect to see
that ramp up some. We’ll get some of the synergies associated with the
conversion of our billing systems both on the pre pay and the first pay side
and so those are a few things and we’ll also continue to be mindful of our
cash cost per unit. We continue to watch that as you saw sequentially that was
down from 4Q.

In terms of separation costs – I think we’ve provided that there would be
about $20 million of synergy costs in a wireless business and now I’d say that
we’re probably on track to have incurred $7-$10 million of that. On the
Wireline side, we didn’t separately disclose how much we thought that would
be. But certainly we’ve had ramp up in terms of duplicate functions from
executive teams and are ramping up the head count that the company’s are going
to need on both sides of the house in order to run those businesses on a stand
alone basis. They have not hired fully and are continuing to do that over the
next several months.

**Scott Ford**

David, this is Scott. On that topic. This is a quarter of immense change and
actually we’ve got another one still ahead of us. In trying to glean too much
of what’s really going on in the operations from all the noise that are in the
numbers right now, I understand that can be difficult. I would imagine that it
could be more misleading trying to grapple with too many details of trying to
forecast the run rate of what the two businesses will see in long term because
there is a lot of duplicate of calls. And frankly, a lot of just management
talent and focus on that issue and that’s one of the reasons we need to get on
it.

Long term, you talk about roaming. The question about roaming. I want to turn
it a little bit around this way. 90% of our business is retail; retail is
where we spend 90% of our time. Roaming is a nice revenue add. With every
revenue dollar that you add though, you incur some requirement to build
networks. You incur additional expenses and you spend a lot of management time
sorting through the relative changes in the contracts and changes in the day
to day operations at that group level. So, it’s great to have, we love to have
it, but that is not the purpose of the business. It’s not the primary focus of
the business. Where we see over build is where you would expect to see it.
It’s in high traffic volume areas where the incremental return for another
carrier saying well rather than send the roaming tractor to Alltel, at X rate,
I’d rather just over build it because return on capital or the margin impact
is positive for us.

So you can imagine, we’re constantly arguing about volume or constantly
arguing about rate. Some carriers are very easy to deal with and sit down at
the table and are very constructive and some like to hammer and play back and
forth in the longer term. Hash out, shall we say – and we’ve got some of that
going on right now and that’s probably all we need to get into.

**David Barden**

Alright guys, thanks for sharing. I appreciate it.

**Operator**

Your next question, David Janazzo with Merrill Lynch.

**David Janazzo**

Discussion on the CETC topic has been increasing in the recent weeks and
months. What is your view on the prospects and timing of changes, if any in
that area?

**Kevin Beebe**

Hey Dave, this is Kevin. It has been in the most recent bill proposed by I
think Senator Stevens Inue from Hawaii. We feel it positive in terms of
attempting to sort through and establish some requirements. We would certainly
be very interested in the opportunity to get additional ETC dollars as you
know for broadband deployment. We are planning on deploying EBDO and certainly
we’re going to deploy most of that EBDO capital in places where the volume is
there to recover the investment that just makes good business sense. Under the
current bill, which we haven’t studied in full, it’s a pretty lengthy
document, because it includes other things, but under that proposal, it would
seem that there’s a proposal would change the opportunity for return if we
invest in certain areas. And certainly if that what ETC is all about.

You know, the other thing I comment on is there is this significant difference
between State regulators, legislators are viewing that whole topic and the way
we hear about it at the Federal level.

The State regulators, legislators we have had great working relationships in
all the States where we’ve received support. We continue to have very open
dialog with regulators on the areas that they’re most interested in us
deploying technology and the potential return down the road in exchange for
additional funding. So we welcome that kind of dialog at the State level. We
continue to work at the federal level to make our opinions known.

**David Janazzo**

Thank you.

**Operator**

Your next question is from Simon Flannery from Morgan Stanley.

**Simon Flannery**

Hi, this is Jessica Yell for Simon Flannery.

I was wondering what your latest thoughts are on the wireless spectrum auction
that’s coming up. Any willingness to participate? Also what are you seeing on
the M&A front other opportunities to buy other wireless players?

**Kevin Beebe**

The two don't go together right now as you can appreciate. The Spectrum
Auction has basically brought to a halt any discussions that might have been
going on, on the M&A front. I think that there was some reasonable non
activity on the M&A front that was possible this year when the Spectrum
auctions were scheduled to be placed in the middle of the summer. I think most
of that stopped.

Our own thoughts about, so you know, we’ll see what happens in the fall, what
everything looks like in the fall when we start over.

When you look at the Spectrum auctions, we are still thinking about it. We
have been through a number of discussions with several parties that we looked
at participating with. We have not been able to get those lined up exactly
like we would all like them to get lined up. It is important to remember that
the license is the cheapest part of the exercise. And building it is the
second cheapest part. You then have to put customers on the network and have
to underwrite the losses on the network, and so any new build in the modern
era is expected to be extremely expensive and this is not the best spectrum
for looking at things like that. So, while we might still go to this one, we
are leaning towards not going to this auction and are taking a hard look at
those things that are scheduled to come down over the next two or three y ears
because that’s much better spectrum for building out networks that have voice
at the core of them.

**Jessica Yell**

The question about M&A environment. What do you see there?

**Kevin Beebe**

Well most of the discussions that you would expect to be taking place at this
point, I have halted because of the auction rules that say nobody can talk and
so at this juncture M&A has dried up for all intents and purposes and probably
will stay that way until maybe the back quarter of the year. And then what
happens at that point we’ll have to see what ends on the auction, what prices
are, value, what relative trading comparisons are. A lot can be sorted out at
that time.

**Jessica Yell**

Great. Thanks.

**Operator**

Your next question is from Tom Sykes with Lehman Brothers.

**Tom Sykes**

Most of my questions have been answered, but just a couple of quick ones.
Could you talk about that Western Service Plan that was discontinued? I think
you said that there were maybe like 50,000 total customers on it. Does that
mean that we’re going to get a churn off of 30,000 next quarter kind of
impacting our net add forecast? Or is it going to kind of dribble off from
here?

**Kevin Beebe**

You’ve got another one. This is Kevin. We have about 50,000 left actually. So
about 18,000 disconnect in the first quarter. We’ll continue as has been our
tradition. When we eliminate service plans like we did a few years ago with
Boomerang, instead of adjusting the customer base, which some carriers choose
to do, we just report it to you like we did this morning and it will certainly
impact the reported net number but we think it’s important that you know how
many customers that there are in that net number that have left. In this case
it was 18,000 in one queue. We discontinued the service plan. We still offer
the service plan but new customers can’t get it. We’ve never really
discontinued a service plan in terms of taking it out and force migrating a
customer. In fact, we still have about 1,000 or so boomerang customers that
are active today that continue to replenish, which is fine. But we do expect
as it relates to Talk Watch that those customers will continue to attrite off
as we don’t offer the service any more and they move to something that’s more
competitive.

Hopefully, now that our full suite of plans is in the marketplace, and we have
the new U wireless pre pay plans, they’ll get a sense that there’s a better
offer from Alltel today. But we won’t force migrate them. We do expect them to
attrite off over time, probably the rest of the year. It may never go to zero
though. I don’t want to mislead you. That 49,000 may never go to zero.

**Tom Sykes**

Okay. And just on the you know State regulatory approvals, are there any, I
mean without getting into the discussions that are happening, is there any big
hurdle that you see, I mean are you at all worried about slippage from a July-
ish split?

**Jeff Gardner**

Tom, this is Jeff Gardner We are spending 100% of our time, a couple of us are
on the landmine side of the business on the regulatory process and we’ve been
making a lot of progress. It’s about convincing the State public commissions
that this transaction is in the public interest. So, we’re focusing on things
like we’re 100% focused on landmines and driving broadband addressability.
We’re talking about our capital structure. The fact that we’re going to be the
largest (inaudible) in the State with what we believe some of the best cash
flow characteristics and we’re focusing them on the management team that we
think is capable of leading this business for several years to come. So, we’re
feeling very good about the process. We’re 100% focused on it. Scott made a
great point earlier that we really believe it’s in the best interest of both
businesses to get this done. And we’re taking very seriously our talks with
each State to make them feel as good as possible about this transaction. In
the last two weeks we’ve had a lot of momentum.

**Tom Sykes**

Okay. Thanks.

**Tony Thomas**

Darla, this is Tony, we’ll take one more question.

**Operator**

Your final question is from Phil Cusick from Bear Stearns.

**Phil Cusick**

Hi, good morning, this is Com Rowsky for Phil. I was just wondering if you
could comment on the net add situations. You guys have seen over 100,000 pre
paid net adds and about 80,000 (inaudible) how do you see that mix going
forward and how has the national carrier, the competition from them affected
you.

**Kevin Beebe**

Sure, this is Kevin. I feel good. In 1Q we lead what we thought was consensus
on post pay, so that was good and again, pre pay has been incremental growth.
Given that incremental growth has come at a much lower cost because of our new
structure, our new systems, our new infrastructure. We feel really good about
that pre pay. I do believe that pre pay activity is always seasonally higher
in 1Q and hence I would expect to see a drop of that. But you know, we’re
continuing to push post pay growth as our primary way of doing it. This Simple
Freedom product in the Wal-Mart has been exceptional these last few quarters.
Battle for Wal-Mart shelf space is just that. It’s always a battle. They’re
the world’s largest retailer, but we continue to position our product very
well there. So I feel good about the continued growth of both. On the national
front, you know the market is obviously very, very competitive. It continues
to be and we’ll be mindful of that and balancing everything we need to in
terms of our position in the marketplace.

**Com Rowsky**

And just one question on the roaming. Are you guys seeing any loss from the
recent Verizon over builds as far as roaming is concerned?

**Kevin Beebe**

I think I commented earlier that we’ve seen some over builds from some
carriers in the first quarter, that was a level of what we expected.

**Com Rowsky**

Okay. Thank you.

**Kevin Beebe**

You’re welcome.

Just to wrap up the call. On February 1st, when we had our analyst day, we
tried to lay out what we hoped to execute over the next 12 months which was a
very complicated set of integration work and then separation work on the
Wireline business. The team has just done a remarkable job and I know a lot of
them listen to this call and so if you’re just a shareholder and you don’t
really care about all of this stuff you can hop off, but to the team, I want
to say, just how proud we are of the job that you’ve done. You have worked
nights, weekends. You have worked weekends in a row. You’ve done a fantastic
job of going above and beyond on every front. Jeff Gardner, we appreciate your
leadership. We wish you well in the new Wireline business. And we’ll miss you
and your ring tone phones here on these quarterly calls.

If you’ve got any questions and want to follow up, Tony will be manning the
phones today at 501 905-8991 in Investor Relations. Thanks very much. You all
have a great day.

**Operator**

This concludes today’s conference call you may now disconnect.

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29,10010-jds-uniphase-corporation-f3q06-qtr-ended-mar-31-2006-earnings-conference-call-transcript-jdsu.html,JDS Uniphase Corporation,JDSU,financial,2006.0,,regular,"May 3, 2006",5:00 p.m.,2006-05-03T21:00:00.000Z,52443,24016,28427,3,10,"['Jacquie Ross - Director of Investor Relations', 'Kevin Kennedy - CEO', 'Dave Vellequette - CFO']","['John Harmon - Needham & Company', 'Dayle Hogg - JMP Securities', 'Paras Bhargava - BMO Nesbitt Burns', 'Brantley Thompson - Goldman Sachs', 'Arnab Chanda - Lehman Brothers', 'Jeff Evenson - Sanford Bernstein', 'Subu Subrahmanyan - Sanders Morris', 'Ajit Pai - Thomas Weisel Partners', 'Ehud Gelblum - JP Morgan', 'John Anthony - Cowen & Co']","**Operator**

Good day, ladies and gentlemen, and welcome to the JDSU fiscal 2006 third
quarter earnings conference call. (Operator Instructions). I would now like to
turn the presentation over to your host for today's call, Ms. Jacquie Ross,
Investor Relations.

**Jacquie Ross**

Thank you, Colby, and welcome to JDSU's fiscal 2006 third quarter conference
call. Joining me on the call today are Kevin Kennedy, Chief Executive Officer
and Dave Vellequette, Chief Financial Officer.

As always I'd like to remind you that this call is likely to include forward-
looking statements about the future financial performance of the Company.
Forward-looking statements are subject to risks and uncertainties that could
cause actual results to differ materially from management's current
expectations.

We encourage you to look at the Company's most recent filings with the SEC,
particularly the risk factors section of our Form 10-Q, filed for the quarter
ended December 31, 2005, and 10-K filed for the year ended June 30, 2005. The
forward-looking statements, including guidance, provided during this call are
valid only as of today's date, May 3, 2006, and JDSU undertakes no obligation
to publicly update these statements as we move through the quarter.

Our comments today will include non-GAAP measures. A detailed reconciliation
of these non-GAAP results to our GAAP results, as well as a discussion of the
usefulness and limitations of these non-GAAP measures, is included in today's
news release announcing our results, available on our website at www.JDSU.com.

Finally, and as a reminder, this call is being recorded and will be available
for replay from the investor portion of our website, at
www.JDSU.com/investors. I would now like to introduce JDSU's Chief Executive
Officer, Kevin Kennedy.

**Kevin Kennedy**

Good afternoon. Thanks for joining us today. Our fiscal third quarter results
are characterized by four important accomplishments:

  1. Revenue in the top-half of our guidance range; 
  2. gross margin improvement amid dramatic mix shifts; 
  3. double-digit sequential growth in the Optical Communications segment; and 
  4. A book-to-bill greater than one in all segments. 

It has been one year since we first shared with you our specific plans to
build a JDSU that was capable of delivering improved probability. While our
journey is not yet complete, I'd like to take a moment a recap the scope and
status of the underlying initiatives.

First, we have initiated our manufacturing consolidation program targeted to
reduce the number of North American Optical Communications sites from seven to
two. We remain on plan to see the full benefit of these activities after the
end of the calendar year.

Second, and in support of this consolidation program, we are executing an
aggressive program of product transfers from North America to either our own
Shenzhen facility in China, or to one of our contract manufacturing partners.
To date, we have transferred 13 product lines.

Next, seven product lines have been divested or discontinued in order to
support our gross margin objectives. Relative to the third quarter of fiscal
2005 ended March 31, 2005 approximately $20 million per quarter of revenue was
deliberately removed in pursuit of improved probability.

Next, we met the cost-saving targets that we shared with investors a year ago,
achieving quarterly cost savings of at least $4 million in fiscal Q1 '06, $9
million in fiscal Q2 '06, and $17 million in fiscal Q3 '06, as compared to our
fiscal Q3 '05 results. In fact, we have pulled in some savings ahead of
schedule, bringing the cumulative total to more than $18 million. These
savings have contributed to improved gross margins and operating margins in
our Optical Communications and Commercial and Consumer business.

During the last 12 months, we launched 34 new Optical Communications products
developed internally, highlighting our continued commitment to innovation and
to meeting our customers' needs. As a result, Optical Communications revenue
has increased more than 25% in the last year, and we believe that JDSU is
gaining market share.

Finally, we welcomed approximately 2,000 employees from four acquired
companies, demonstrating our continued commitment to extending our opportunity
in growing profitable markets. The integration of Lightwave, Photonic Power,
Acterna and Agility has been completed or is being executed on or ahead of
schedule.

As I said, this remains a work in progress, but we believe our third-quarter
results further illuminate the path for an emerging JDSU business model.

Now some detail on our fiscal Q3 '06 results. Non-GAAP revenue of $315.5
million was flat from last quarter as growth in Optical Communications and
Commercial and Consumer more than offset a $20 million seasonal ebbing in our
Communications Test and Measurement segment.

Compared to our year-ago results, revenue was up 90% from $166.3 million.
Excluding our Communications Test and Measurement business, which was not
included in last year's results, and adding back instrumentation revenue which
was transferred to the Communications Test and Measurement segment, revenue
was up 16% from the same quarter a year ago.

Non-GAAP gross profit was $118.3 million, or 37.5% of revenue, our highest
margin in five years. The bulk of this quarter's improvement reflects the
impact of our cost-saving initiatives in our Optical Communications and
Commercial and Consumer segments, although we also benefited from a favorable
mix in our Commercial and Consumer and Communications Test and Measurement
segments.

While we expect our non-GAAP gross margin to fluctuate on its path to greater
than 40%, we believe that our actions today have created a floor around the
35% level. Non-GAAP EBITDA was once again positive at $7.9 million, which was
roughly flat from last quarter and compares to non-GAAP EBITDA loss of $19.8
million in the year-ago quarter.

On a non-GAAP basis, pre-tax income was positive for the first time since June
2001. However, higher taxes resulted in an overall net loss of $2.8 million, a
slight improvement from last quarter's loss of $3.5 million, and an
improvement of $20 million from the year-ago quarter. On a per-share basis, we
were once again slightly below breakeven.

Finally, book-to-bill was once again greater than one for each of the
operating segments. This quarter our served markets were generally favorable
relative to a year ago, although variability existed across customers.

Moving now to our business segments. Led by JDSU's Agile optical products, our
Optical Communications revenue increased from $109.6 million last quarter to
$127.5 million in the third quarter, an increase of 16% from last quarter and
25% from the year-ago quarter.

Growth in our Optical Communications segment was almost entirely driven by our
Agile optical network, or AON, products, including ROADMs, optical switches,
blockers and tunables. The Agile optical network components, modules and
subsystems are key elements of next-generation optical networks that allow
service providers to manage changing traffic demands remotely, supporting the
cost-effective acceleration of new service deployment.

JDSU's Agile optical portfolio was on display and well-received by customers
at OFC. Customers choose JDSU's Agile product portfolio because of our
technical leadership in this area. Our wavelength selective switch, or WSS,
for example was carrying live long-haul and metro traffic today. And in the
[wavelength] ROADM market, we believe that JDSU currently has more than 60%
market share.

In terms of the optical communications industry, we continue to believe that
the overall market is growing in the region of 5% to 10% per year, possibly
better. JDSU's stronger performance this quarter was driven by the industry's
transition to newer technologies that are enjoying higher growth rates than
the industry as a whole. ROADM, for example, are expected to grow more than
40% annually, according to Ovum-RHK.

At the same time, our Optical Communications revenue was still reliant on a
relatively small number of large orders from a limited number of customers.
This means that our Optical Communications revenue will continue to fluctuate
from quarter to quarter and be heavily impacted by the timing of deployments
and orders, and our ability to manufacture and ship those orders.

Our operations team continues to execute solidly in an environment of ongoing
transition, enabling a greater than $17 million ramp in Optical Communications
revenue during this quarter.

Highlighting the positive impact of our cost reduction initiatives, Optical
Communications operating contribution improved from a loss of $10 million last
quarter to a segment operating income of $2.2 million in the third quarter.
This represents the first time in five years that that segment has made a
positive contribution, and marks a very important milestone for this
particular business.

Our Communications Test and Measurement business grew more than 10% from the
year-ago quarter. As anticipated, the market seasonality in this business was
clearly visible in our results, with revenue declining from December's very
strong $146 million to $126.8 million this quarter.

Even without the benefit of year-end carrier budget spend, we continued to
strengthen our position as the supplier of choice for broadband triple play
test and measurement solutions, partnering with BT's 21st Century network, and
realizing double-digit revenue growth quarter-over-quarter in our MTS platform
designed to support the deployment of fiber-to-the-home networks.

During the quarter our Communications Test and Measurement segment introduced
a number of new products and enhancements designed to enable the efficient
delivery of triple play services and reliable deployment of FTTx and digital
cable networks.

New products in our Smart Class handheld series, for example, introduced a
range of high-value, high-performance instruments for dark fiber installation
and troubleshooting. Additionally, our pending acquisition of TestUm further
establishes JDSU as a leader in the growing home networking test and
measurement market, and gives us a unique ability to offer solutions from the
core network to the customer premise.

We are also seeing momentum in our test systems business. During the quarter
we launched and received our first order for NetComplete broadband tools, a
new software tool for broadband network management and performance monitoring.

The product, developed in collaboration with AT&T, will provide DSL network
capacity planning support for a major U.S. service provider. We also received
our first order for our recently introduced digital video monitoring system.

Our Commercial and Consumer business contributed $61.2 million, up 3% from
last quarter's $59.4 million, despite our exit from the front surface mirror
business which was completed during the quarter. Reduced revenue from front
surface mirror was more than offset by solid performances in our laser and
flex groups. Year-over-year, the segment was down 5%, highlighting the impact
of our series of product phase outs. Our segment operating contribution
improved slightly at $8.2 million, or 13% of revenue, which compares to an
operating income of $1.3 million, or 2% a year ago.

During the quarter our flex group launched an authorized partner program
designed to extend the reach of our SecureShift technology. By partnering with
Nosco and CCL, JDSU intends to broaden the reach of our anti-counterfeit
products without compromising the security of the supply chain.

JDSU's family of SecureShift products enables consumers to immediately verify
branded merchandise as authentic. Branded owners in turn recognize that
SecureShift inks and labels offer a cost-effective anti-counterfeit measure.
More than 40 well-known pharmaceutical brands are protected by JDSU, for
example, as well as a very well-known brand of printer consumables, and most
recently, one brand of cell phone batteries.

Our laser business continues to gain recognition for its high-power, high-
performance precision lasers. The introduction of the telecom class single
emitter diode laser in January, for example, demonstrates our ongoing
commitment to innovation. With in-house manufacturing now consolidated, the
business is well positioned to build on its growth this quarter with a very
strong portfolio of lasers that supports the industry's transition to solid
state.

Our coated optics team completed the divestiture of the front surface mirror
assets during the quarter and received its first $1 million order for custom
optics built using a new semiconductor class of precision coater, mentioned on
previous calls.

Moving to corporate developments, and consistent with our objective to recruit
additional talent to support and guide the management team, we welcomed
Openwave CFO Gal Covert and former Sun executive Masood Jabbar to our Board of
Directors during the fiscal third quarter. 40% of JDSU's board members have
joined us within the last 14 months, allowing us to benefit from a wealth of
sales, finance and operations experience in the turnaround context.

Finally, and just a reminder that stockholder authorization for reverse stock
splits remains in effect until December 1, 2006. The exercise of this
authorization remains a matter of ongoing review by our Board of Directors.

Before I hand the call over to Dave, I will just share with you some of our
areas of focus going forward. First, we will continue to execute our program
of cost reduction and gross margin improvement initiatives to realize
previously identified cost savings.

Second, we must decrease our operating expenses as a percent of revenue.

Third, we will continue to be focused on improving our manufacturing supply
chain yield and capacity metrics to ensure that we are able to meet the demand
and customer quality and performance expectations.

Fourth, we continue to strengthen our finance team and streamline processes.
We have made 28 new hires in the finance department in the last nine months,
including eight CPAs.

And finally, we will continue to invest organically and inorganically to
enable optical and broadband innovation. I'd now like to invite our CFO, Dave
Vellequette, to discuss the financials in greater detail.

**Dave Vellequette**

Thank you, Kevin. GAAP revenue for the third fiscal quarter of 2006 is $314.9
million. Non-GAAP revenue of $315.5 million includes $600,000 of revenue
associated with acquisition accounting, in addition to the first full quarter
of revenue from our acquisition of Agility Communications, which closed at the
end of November.

When comparing our revenue to the year-ago quarter, you should recall that our
top line has been impacted by four acquisitions, as well as the sale or exit
of seven product lines over the last 12 months.

Non-GAAP gross margin improved from 36.3% last quarter to 37.5%, as the
incremental savings from our cost reduction initiatives more than offset
downward pressure on gross margin caused by the seasonal ebbing in our test
and measurement business.

In terms of our cost reduction programs, we were able to pull in some of our
scheduled cost savings, and therefore exceed our targeted $8 million of cost
savings for this quarter. This brings the cumulative cost savings total to
over $18 million when compared to our third quarter results of fiscal 2005.

Our target for incremental cost savings in the fourth quarter is therefore
approximately $4 million, which would bring the cumulative total to $22
million, or $88 million on an annualized basis.

As a percentage of revenue, non-GAAP operating expenses of 39.7% increased
from 38.1% last quarter, reflecting our first full quarter of Agility-related
operating expenses, as well as higher SG&A expenses associated with selling,
integration and finance support. The majority of these SG&A increases were
associated with our Communications Test and Measurement segment.

Operating expenses as a percentage of revenue will be impacted by the
seasonality of the Communications Test and Measurement segment. Overall, we
continue to target 35% to 38% of revenue as a desirable range, which we expect
to achieve during the next fiscal year, which, as you know, starts in July.

Non-GAAP net loss narrowed to $2.8 million from a net loss of $3.5 million
last quarter, and compared to a net loss of $23.5 million a year ago. Non-GAAP
earnings per share for the third quarter was slightly below breakeven, flat
from last quarter and compared to a net loss of $0.02 on a per-share basis a
year ago.

A detailed reconciliation of our non-GAAP results to our GAAP results is
available in today's press release.

In addition to the deferred revenue adjustment noted above, our non-GAAP
results exclude a $37.7 million gain on sale of investments reflecting the
sale of our remaining investment in Agere; amortization of intangibles of
$16.3 million; an $8.8 million charge for restructuring and nonrecurring
expenses relating to exiting our former headquarters location and to the sale
of our Ottawa manufacturing facility; and a $4 million charge related to
stock-based compensation.

Including these items, GAAP net income of $3.7 million improved from last
quarter's loss of $42.1 million. This net income was due to the sizable gain
on the sale of investments noted previously. GAAP gross profit of $115.5
million, or 36.7% of revenue, improved from 33.3% of revenue last quarter.
GAAP operating expenses of $154.7 million, or 49.1% of revenue, were down
slightly from last quarter.

Moving to the quarterly results for the business segments, Optical
Communications revenue of $127.5 million was up 16% from $109.6 million last
quarter, and up 25% from $101.7 million a year ago. These results include the
first full quarter of revenue from our Agility acquisition.

For the fifth consecutive quarter, the segment book-to-bill was greater than
one. Higher revenue, in addition to our cost reduction program, resulted in
improved operating results for the segment, with the operating contribution
improving by more than $12 million, from a loss of $9.9 million last quarter
to an operating income of $2.2 million in the third quarter.

Our Optical Communications segment remains a work in progress, with product
transitions from our former Ottawa site ongoing through the end of this
calendar year. As with previous transitions, there are incremental costs
associated with the move to a lower-cost location. As a result, we will not
realize the full benefit of this action until calendar 2007.

As we expected, Communications Test and Measurement revenue declined in line
with seasonal trends from $146 million to $126.8 million. The resulting
decline in gross profit, along with higher SG&A expenses, reduced the
segment's operating contribution from $26.5 million last quarter to $15.3
million this quarter.

Lastly, our Commercial and Consumer revenue increased $1.8 million, from last
quarter's $59.4 million to $61.2 million. Growth in our laser and flex groups
more than offset the anticipated decline in our custom optics business. As
planned, we completed our phase out from the front surface mirror business
during the quarter end, and as a result, expect fourth quarter revenues to be
negatively impacted by several million dollars. Operating contribution from
the segment was $8.2 million, or 13% of revenue, up slightly from last
quarter.

Taking the Company as a whole, our Optical Communications segment contributed
40% of total revenue. Communications Test and Measurement also contributed 40%
of total revenue, while the Commercial and Consumer segment contributed 20%.

On a geographic basis, The Americas reported revenue of $190.6 million, or 60%
of non-GAAP revenue. Europe contributed $76 million, or 24% of revenue, and
Asia-Pacific contributed $48.9 million, or 16% of revenue.

Moving to the balance sheet, total cash increased by approximately $6.9
million to $847.3 million as of the end of the quarter. Net accounts
receivable declined to $216 million, reflecting improved collections. Our DSO
improved to 62 days.

Net inventory increased to $189.1 million, primarily due to the Agility
acquisition, as well as strategic purchasing activity. Inventory turns were
4.2.

As of March 31, 2006, head count was 7,005, down just over 200 headcount from
last quarter. We continue to add headcount at our Shenzhen, China facility to
support our manufacturing transitions, but this was more than offset by head
count reductions by virtue of the sale of our Ottawa manufacturing facility.

Moving to an update on our ongoing cost reduction initiatives, for the third
consecutive quarter, we met or exceeded our cost reduction targets. Compared
to the third quarter of fiscal 2005, we have reduced costs by more than $18
million per quarter, and we remain on track to reach our goal of $22 million
in cost savings in the fourth quarter of fiscal 2006. We expect to realize
approximately $4 million of additional cost savings, primarily in cost of
goods sold, in the fourth quarter.

On the last call, we told you that we would quantify the cost savings
anticipated from an additional set of actions announced in November. These
actions related to our Rochester, Ottawa and Santa Rosa sites. The Rochester
closure is expected to be complete by the end of June 2006. The Santa Rosa
activity is targeted for completion by the end of the calendar year. And
although we have transitioned our Ottawa site, we will not see the financial
benefits until the products have been transferred to lower-cost locations,
which we expect to be complete by the end of the calendar year. The expected
quarterly cost savings from these actions are $2 million in Q1 '07, growing to
$3 million in Q2 '07 and $5 million in Q3 '07.

Now to our guidance. For the fiscal 2006 fourth quarter, we expect revenue to
range between $302 million and $322 million. While the Optical Communications
environment continues to be favorable, we have widened our guidance range to
accommodate several potential impacts.

First, our program of North American assembly manufacturing transitions is
entering its final phase, and, as always, includes an element of execution
risk.

Second, you should recall that the June quarter has historically been the
seasonally weakest for our Communications Test and Measurement business.

Third, our Commercial and Consumer segment revenue will be negatively impacted
by low single-digit millions associated with our exit from the front surface
mirror business.

Fourth, you should be aware that we are approaching an important deadline for
our customers who serve European markets. We have been working with our
customers to meet the RoHS requirements. RoHS refers to the EU's restriction
of certain hazardous materials in products shipped after July 1, 2006. We
cannot preclude the possibility that this effort will exert a limited downward
pressure on the performance of our Optical Communications segment this
quarter.

Finally, our Optical Communications business continues to depend on a
relatively small number of very large customers. It remains to be seen what
impact, if any, the current consolidation activity will have on our business.
From a bottom-line perspective, if one or more of these items impacts our top
line, there could be an associated downward pressure on our gross margin and
other profitability metrics.

RoHS and factory transitions, for example, could result in lower revenue
and/or inventory write-offs that could impact our results. In addition,
product mix within the Communications Test and Measurement segment, which we
noted was favorable in Q3, could be less favorable in Q4.

Finally, the integration costs associated with each acquisition exerts an
upward pressure on our operating expenses. The scope of these factors taken
together may introduce variability on the order of zero to mid single-digit
millions.

That said, as we look forward to fiscal year 2007, we are very focused on
controlling costs and on improving our overall business model. We believe that
the investments we are making now in IT and finance support, for example, are
critical elements of our strategy to deliver an integrated business model that
is capable of sustainable profitability. With that, I'd like to invite the
operator to begin the Q&A.

","**Question-and-Answer Session**

**Operator**

(Operator Instructions) Your first question is from John Harmon, Needham &
Company.

**John Harmon - Needham & Company**

I was wondering what you were saying about your optical business, that most of
the growth came from new products. Is there any way to think about how big the
market for ROADMs and wavelength blockers might be, and how big it's growing?

**Kevin Kennedy**

There are other people that are estimating these things. I would say that
traditionally, we have felt that the optical market was growing at 5% to 10%
per year. I'd say based, upon what we've seen recently, it's at the high-end
of that range, if not better. So, it is a favorable market.

We think things like ROADMs and wavelength switches are probably growing at
the 40% or 50% per year growth rates, and those are numbers that people other
than myself, analysts, developed. I think we have a piece of our portfolio
that is in the lower end of the growth range, this 5% to 15%. We've got these
high-end products that are probably in the 40% per year growth rates. Then we
have products like tunables that are sub-$100 million markets -- and that of
course is true of ROADMs-- but over the next two years they will become $100
million markets, and they are probably growing at 40% to 50% per year as well.

So, I think there a lot of beacons for growth out there, and we know what
those are, the high-end products as well as the tunables. The traditional
stuff is growing a bit slower. I should say that both metro and long-haul for
us grew at double-digit growth rates quarter-over-quarter. So, there was good
activity in both of those as well. I hope that helps.

**John Harmon - Needham & Company**

It does, thank you.

**Operator**

Our next question comes from Dayle Hogg, JMP Securities.

**Dayle Hogg - JMP Securities**

With the RoHS, do you see some excess inventory in the channel already, or do
you see that as building in the next quarter?

**Kevin Kennedy**

I don't know that I see excess inventory in the channel. As you know, much of
what we make for the top-tier customers are built to order. So, they're not
the kinds of things that people would buy with the purpose of having inventory
in general.

But our big concern is that people could decide to flip a switch at some point
and require everything from some point forward to be RoHS-compliant. And that
would mean us accelerating the future and possibly having things left over
from the past. So, I don't know how to call that until we get further into it.
We are fairly intimate with each of our customers and trying to manage that
process one customer at a time.

**Dayle Hogg - JMP Securities**

Can you sort of quantify what percentage of your current shipments are RoHS-
compliant versus ones that you still have to do some work on?

**Kevin Kennedy**

I think the vast majority of what we have is either shipping or will be
shipping by July 1. It's very high percentages. But I don't have a specific
number that is quotable at this point.

**Dayle Hogg - JMP Securities**

Thanks.

**Operator**

Our next question comes from Paras Bhargava, BMO Nesbitt Burns.

**Paras Bhargava - BMO Nesbitt Burns**

Good afternoon. Just a basic question on your revenue growth, Kevin. There's a
lot of moving parts in terms of stuff you're adding with new acquisitions,
stuff you're taking off, especially in the optical components and the com
business. The commercial business looks like it's down year over year, but my
sense is that's mostly due to divestitures. The com business looks like it's
up massively, but I think some of that is due to acquisitions. I wonder if you
could tell us what it is on an organic basis from both of those two.

Secondly, for you Dave, the corporate overhead seems to keep on going up. Is
that all due to Agility, or is that due to other items? And will it come down
any from here?

**Kevin Kennedy**

Let me take your first question. On the optical coms, I don't know the numbers
and can't do them in my head, but I can give you the primitives to work with.
If you go back a year ago, we divested a cable TV asset and we exited a number
of businesses in coms, less than $10 million a quarter, more than four or
five.

So, the way to think about it is we took maybe a $5 million to $10 million run
rate business away from our optical coms. And the only thing that we basically
added through acquisition in optical coms was Agility, and that's very low
single-digit millions of dollars. So, we probably divested more than, or
exited more than we've added back organically. The organic growth rate is
actually higher than what was stated, if you will, because of what we've kept.
Does that make sense to you?

**Paras Bhargava - BMO Nesbitt Burns**

Absolutely. I forgot about the divestitures.

**Dave Vellequette**

As far as the corporate overhead, Agility did contribute to the increase in
the corporate overhead. At the same time our com test group was at the end of
their traditional fiscal year, and we had not adjusted their sales plans,
because when we completed the acquisition we wanted to leave them on their
sales plan. So, they had their typical end-of-year spike in earnings, having
to do with over-tier accomplishments.

Also, as we noted, we've hired a number of people in the finance organization
which has added to expense, and the integration cost with all our acquisitions
has also added to our expense structure.

**Paras Bhargava - BMO Nesbitt Burns**

What should the corporate overhead be going forward? Will it be closer to 25,
or closer to where it is now?

**Dave Vellequette**

The corporate overhead longer-term will be going down in that direction. But
right now, that's what we stated about. That will be more of a fiscal '07
action as we bring it down during that period. It's more in a percentage of
revenue range as opposed to an absolute dollar.

**Paras Bhargava - BMO Nesbitt Burns**

So, we should budget at 33%, 34% for now? Or will it go higher than this?
Because Oracle might chew up some more, right?

**Dave Vellequette**

We're at pretty much full speed on our Oracle integration activities. So, I'm
not expecting any big swings in that expense at this point.

**Kevin Kennedy**

Paras, let me take your question and generalize it and give you a way that at
least I'm thinking about it. I'll simply take the category of OpEx as a
percent of revenue. I actually think today we are nominally running at the
high end of our stated range although we ended up with reported 39%, remember
there's a high degree of seasonality. So, if you walk away from either the
nadir or the peak of com test, and you add $12 million back of revenue, at
that rate we are at around 37.5% of OpEx as a percent of revenue.

That being said, realize T&M has the highest ratio and does not scale their
seasonality. But of course, it will naturally improve as the seasonal cycle is
good in the second half of the calendar year.

The second piece is that the integration brings higher near-term transition
costs, but longer-term reduction in geographically-dispersed finance and other
resources. As I've said publicly with folks, you do need the Oracle
integration to be complete, which Dave has said he will get done by the end of
this calendar year, in order to be able to release those resources.

The next piece is acquisitions like Agility will add near-term departures from
any particular model. We were overt about the fact that Agility was not
accretive; it will be dilutive in the near-term, and that's what you're seeing
here.

I would say the last piece is we do have a program of ongoing reductions of
buildings and factory consolidations that will continue to drive improvement
at a lower level. So, that cacophony of items will accumulate into moving us
what I think nominally we're at the 37% to 38% range -- again, not accounting
for the peaks of seasonality. And as we exploit all of those four items, we
will get down to the 35% or better. Does that help?

**Paras Bhargava - BMO Nesbitt Burns**

Absolutely. Have you got a planned date for the reverse split, or have you
actually committed to it? Or is it just something that you are free to do
until the end of December?

**Kevin Kennedy**

The Board is free to exercise it until December 1 of this year. The discussion
that you would hope that a board has is what criteria are required to exercise
the authorization that shareholders have given the board. The first criteria
was that the Board wanted to make sure that we were non-GAAP EBITDA positive.
At the time the shareholders authorized it, we had not hit that threshold. We
passed that threshold in February.

I would say the next thing that you might think a board would discuss is, is
it sustainable? So this is the second quarter in a row that we've been able to
do it. I'm sure the next time the Board meets it will take a look and say,
how's the EPS number? Is it positive or negative, and what's the trajectory?
So those are the kinds of thoughtful discussions that occur at a board level.
Hope that helps.

**Paras Bhargava - BMO Nesbitt Burns**

That helps a lot. Thank you, gentlemen.

**Operator**

Our next question comes from Brantley Thompson, Goldman Sachs.

**Brantley Thompson - Goldman Sachs**

I was wondering if you could give us some more color on two things. First on
the gross margin front, you obviously had a pretty big swing in terms of your
operating income in your communications components business. Could you talk a
little bit about how that gross margin fared through that transition? It seems
like it would have been a big contributor; the incremental operating margin of
that business was phenomenal in the quarter. Could you just give us an update
on what you're seeing there?

Second, on your operating expense trends into the June quarter, how should we
think about them on an absolute level?

**Dave Vellequette**

The gross margin for op com, you're correct that the majority of the savings
that we realized in the quarter was in the Optical Communications segment. You
can see from the segment report that that's reflected in the numbers from the
$12 million improvement. That $12 million improvement reflects not only the
savings, but also the higher revenue levels that we achieved during the
period. So, the AON products helped, obviously, in the execution against our
cost reduction programs.

As far as the operating expenses go, as Kevin stated, we have a number of
expenses that we are incurring right now. We're at a level that's at the upper
end of the range that we want to be in. The ebb and flow of the revenues will
impact it as a percentage of revenue, but we're not really forecasting expense
levels. We're not seeing significant decline from the expense levels in the
next quarter, and over time we'll be looking at reducing them as we are able
to execute against the programs that Kevin just highlighted.

**Brantley Thompson - Goldman Sachs**

Thank you.

**Operator**

Our next question comes from Arnab Chanda, Lehman Brothers.

**Arnab Chanda - Lehman Brothers**

A financial question, I was taking a look at where you discuss different
businesses in terms of the operating contribution, and there was another item
that's all other. Is that exited businesses, or is that something that you
can't allocate? And then I have a follow-up, please.

**Dave Vellequette**

Those of the expenses that historically we have not allocated, and we were
just talking about those briefly with Paras, that relates to the basically
finance, IT, legal, HR, those departments. When we look at the segments, we
don't load those segments up traditionally, other than the com test, since
that's basically a stand-alone segment at this point. So, those expenses we
have kept separate, because as we measure the GMs, we don't include those in
their results.

**Arnab Chanda - Lehman Brothers**

Thanks, Dave. Maybe a question for Kevin. It sounds like we have kind of a
little bit come full circle from 2000, where your Optical Communications again
is your fastest growth business, and some of the other businesses inside of
the divestitures probably not.

If you just look at the Commercial and Consumer versus Optical Communications,
what do you think is the strategy there? Do you think it makes sense to keep
both businesses, is there enough synergy? If you could shed some light on
that. Thank you.

**Kevin Kennedy**

Clearly, you're right in asserting that we believe that coms has the greatest
growth potential in revenue and is where we focus on profit improvement. Our
test business, because of the leadership position we have, it is demonstrating
that it, too, can grow in double-digit year-over-year growth, as we've seen
here for a number of quarters.

On the CCP side, I think we have tried to represent that as a business that
has products that, we believe, serves markets that will allow it to grow
someplace between 5% and 10% per year. It's the slower growth, but on the
other hand, I believe that the three elements in it are capable of very good
profit.

So, let me now answer your question of how do those elements relate to
anything else we have in the Company? It turns out that the technology that
serves this very profitable pigments business, the anti-counterfeiting
business, is really a set of coating machines and the ability to, with high
precision and low defect, lay down two micron level particles. If you think
about that capability, that is also the capability that we use in our coated
optics business to serve night vision goggles and things that are very high-
precision boutique optics.

Now, the next piece is the laser business. And we've specifically chosen the
laser business, the solid-state laser business because it requires two or
three things that come from the rest of the Company. If you think of a
commercial laser, it's basically a set of electrons and there's a bar, a laser
diode that creates the stimulation, there's two mirrors and there's packaging.

The packaging in a solid-state laser is the same kind of packaging we use for
telco optics. The mirrors that are set on either side of the laser diode are
actually the reliability is improved by coatings, just like we get out of the
boutique coating optics business, and the laser diode actually comes out of
our telecom laser business.

So, think about the commercial lasers as simply a commercial use of the
technologies that we have developed in telco. Think of the coatings as serving
three things. One is this pigments business, one is a boutique set of coated
optics, and the third is the laser business. In fact, we use coatings for our
telco business as well.

So, that's the relatedness from a technology perspective. As you'll note, we
actually have a very low R&D in the pigments and the coated optics that serves
a resource to the rest of the Company. I hope that helps.

**Operator**

Our next question comes from Jeff Evenson, Sanford Bernstein.

**Jeff Evenson - Sanford Bernstein**

What's been the trend in gross margins in the test and measurement business
since the acquisition of Acterna?

**Kevin Kennedy**

I don't know that there's a trend to be stated. I think they have stayed
between the 55% and 59%, which is representative of the high-end of what has
been recent history for the com testing. There is a significant change in the
aggregate gross margin depending upon what's selling in that particular
quarter, so the mix. Some portion, some business units have a significantly
better mix than others. But I wouldn't suggest that there is a macro trend at
this point.

**Jeff Evenson - Sanford Bernstein**

You talked about share gains in optical components. Do you think that's
applying outside the Agile optical area, or it's pretty much due to that?

**Kevin Kennedy**

No, I think we are successful in general in the new areas that we chose to
invest when others couldn't. So, I think the tunable transponders, the ROADMs
are all areas where we were able to invest and others didn't, and that's where
the share gain will come from. So, I think it's more in the future products,
yes.

**Operator**

Our next question comes from Subu Subrahmanyan, Sanders Morris.

**Subu Subrahmanyan - Sanders Morris**

My first question is on the Agile optical components and modules. Can you talk
about what percentage of revenue they contribute? Given the gross margin
uptick and the operating margin uptick, were circuit packs a smaller
percentage of optical component revenues?

My second question is just a bigger picture question on orders versus
guidance. Kevin, we've seen strong orders in all groups. I understand there
are a bunch of variables for this quarter, including exiting FSM. But looking
out, are you going to start seeing this translate into revenue growth in the
second half of the year? We've had a couple of flat quarters in terms of
revenue.

**Kevin Kennedy**

Let me try to take them one at a time. We haven't provided any insight into a
specific mix between AON sales and the rest of our portfolio. What I can tell
you is that the aggregate of our AON products in any of the last two quarters
would account for more than $10 million of revenue and less than $50 million.
So, they are less than 50% of our total in any quarter right now, and we'll
try to update that in the future.

But that's about the most insight that we have provided to date. In terms of
circuit pack revenues, I don't know the answer to that specifically. Sometimes
when we sell ROADMs, we sell them at a circuit pack level, and sometimes we
just sell them at a device level. And I just am honest with you on the call
here; I don't have any delineation of what that mix is.

In terms of the environment, while our top line revenue for the Company was
flat, and certainly the significant growth in Optical Communications was
anything but flat, the $17 million growth of one quarter, that manufacturing
scaling was bigger than many of our competitors in their entirety. So, I think
that speaks to that the market is favorable.

I'd say the market right now is somewhat constrained by lead times and the
ability to ramp capacity. Half of the industry is transferring products from
one side of the ocean to the other. We've been blessed in being able to do
what we did this quarter.

So, I think the good book-to-bill means that the optical communications part
of the business is strong. The fact that we had year-over-year growth in test
and measurement that was double-digit means that that's a strong business;
it's just seasonal, which is something that we've been trying to communicate
to people.

I think what you're seeing on the other part of our business is that we either
hit this quarter or we will next quarter hit the nadir of the CCP business.
So, my suspicion is that optical coms will lead us through this from a revenue
perspective for the next quarter, and then in the second half of the calendar
year I think we're going to have all three segments having growth.

**Subu Subrahmanyan - Sanders Morris**

Just a quick follow-up. Was there any capacity limitation this quarter for you
guys in any of the areas that restrict your ability to ship and record
revenues?

**Kevin Kennedy**

I'd say every quarter for the last two or three we have had either supply
constraint problems, or if we had executed better we could have shipped more.
So, we were constrained by our ability to get things out the door. That would
be a true statement.

**Operator**

Our next question comes from Ajit Pai, Thomas Weisel Partners.

**Ajit Pai - Thomas Weisel Partners**

Good afternoon. Two quick questions. The first one is on the Test and
Measurement group. Even though you have excluded from the expense allocations
that would be one-time, it seemed like quite a sharp decline sequentially in
the operating margins for that business. Could you give us some color as to
how much of that was volume related, and then some color on the pricing
environment and competition you're facing within that business?

The second one would be looking at the Communications Products business, not
surprising that you are facing in terms of components or any kind of
constraints over there. But from a competitive perspective, have you seen any
pricing pressure, or is that being alleviated over the past couple of quarters
and is it actually looking, you're able to pass on higher prices to customers
right now?

**Kevin Kennedy**

Let me break it up into two pieces. I'm going to try to respond to the market
conditions and pricing strategies of the two segments that you asked about,
and then I will defer to Dave in terms of the specificity on the com test
operate margin.

I'd say in com test, this is a market that first and foremost is
consolidating. We saw Expo make a purchase, [Vira] make a purchase. And while
some people might think that that might improve the stability of pricing, I
would say that we don't think anything has changed significantly in the
pricing structure. So, I wouldn't call it a particularly painful environment,
but I don't think it's necessarily improved either. It's just much the same as
it's been for several quarters.

On the optical communications side, this is a market that has many suppliers
that are boutique and niche, so while there may be four or five prominent
names, there are many, many more start-ups. And so I would say that pricing
continues to be something that you watch very carefully.

In the past I've given a sense that we try to bucketize pricing into three
classes of products. There's the switching products, the transmission
products, and then what I would call the transport products.

The switching, which are the high-end, the ROADMs and such, is where the least
competition exists and the least pricing pressure exists. The transmission
products tends to be where the largest amount of pricing pressure exists. The
transport tends to be in the middle. So, if you were to take the high-end of
that might be 10% to 13% year-over-year change, the low-end is zero to 5%, and
the middle is 4% to 6% or 4% to 8%; that's sort of how I would parse that. So,
hopefully that helps on the market side.

Dave, maybe you could take a stab at the com test question.

**Dave Vellequette**

As far as the segment report goes and the operating income, as you noted, the
revenue alone was down $19 million quarter-to-quarter. As Kevin mentioned, the
margins from their revenue ranges between 55% to 59%. So, just the revenue
decline is the majority of the decline in the operating income.

**Operator**

Our next question comes from Ehud Gelblum, JP Morgan.

**Ehud Gelblum - JP Morgan**

Thank you. A couple questions, if I may. First of all, Kevin, you mentioned
that if you did not have the supply constraints that you ended up having you
would have been able to ship more. Can you quantify how much revenue you gave
up this quarter due to supply constraints, and how it compared that last
quarter?

**Kevin Kennedy**

You may be testing my age as to whether I can remember. But I would say it's
roughly the same. I don't remember any quarter where it was double-digit
millions; probably low singles.

**Ehud Gelblum - JP Morgan**

That's helpful. Do you think that situation of supply constraints will
probably remain going forward?

**Kevin Kennedy**

You know, I think there's enough growth that we will end up -- and I say this
as an industry, not as JDSU -- that people will fix some things, and then
there will be a new problem of the quarter. Optics is a place where in order
to have competitive advantage most companies have sole sources, and aligning
your needs with the ability of your source is often the thing that takes a
while to get right.

So, I think the industry, given where I see the favorable climate right now,
is that almost any company could end up having a supply-constrained
environment for a period of time.

**Ehud Gelblum - JP Morgan**

Thank you. If I move to Acterna for a minute and talk a little bit about the
seasonality there, just to understand. Clearly, it was down $19 million this
quarter. In the past you have said that the June quarter is the seasonally
weakest, following the March being the second weakest, and then it comes back
again in the back half of the calendar year.

Can you give us a little insight as to how to quantify the sequential movement
from March to June, vis-a-vis December to March? Now going forward to the back
half of the year, are we going to be off of the old Acterna seasonality? If
so, how should we view the step up as we get through back into December again?

**Kevin Kennedy**

I'll take a stab at it. Your second question is easier to answer than the
first, I think. I think it's reasonable to assume that overall the business is
going to continue to grow at this 8% to 12% year-over-year. I think it's
reasonable to assume that as you look forward from the June quarter to the
December quarter, that basic kind of dynamic that we have articulated in the
past will likely occur again. We haven't changed anything to make that
different.

So the guidance that we have given people, or the modeling that we have
suggested to people that we have observed from the past was that the ratio of
the peak to the nadir -- therefore, December to June -- could be anywhere from
1.1 to as high as 1.25 or 1.3. But there's quite a bit of variability.

I think we're learning as we go again, but I wouldn't change that. That
observation from the past is going to continue. Now, the only other guidance
that we give is what we've given to you in terms of the range for this
particular quarter. We have not given any guidance on a per-segment basis.

**Ehud Gelblum - JP Morgan**

Do you have something implicit in there?

**Kevin Kennedy**

Yes. It's all calculated implicitly in the guidance that we've given you, and
Dave has sort of walked you through -- if we are challenged in the way that we
thought about our guidance, the factors that are our risks relative to our
consistent thinking, he sort of enumerated for you. So, like RoHS and those
kind things are the ones that we have less of a model for, I guess, is what
I'm trying to tell you.

**Ehud Gelblum - JP Morgan**

Okay. Thank you. If I could squeeze one last in. Dave, you mentioned that the
move from 35% gross margins to 40% gross margins was not going to be a
straight shot. Is that due to the variability of this high-gross margin
Acterna business as it goes up and down, or are there other factors that will
play into the gross margin not necessarily being up or down?

**Kevin Kennedy**

There will be other factors as we do the manufacturing reductions. But
generally, it is the seasonality of the T&M business has the most significant
effect.

**Ehud Gelblum - JP Morgan**

Thanks so much.

**Operator**

Your final question comes from the line of John Anthony, Cowen & Co.

**John Anthony - SG Cowen**

Good afternoon, guys. A couple of questions. First, can you at least tell us
whether the test and measurement business was within your internal plans? Did
it hit your internal targets, or was that below or above expectations?

**Kevin Kennedy**

Obviously, since we met guidance, and the numbers for the quarter ended up
within the range of the model of peak to nadir that we just articulated and
have in the past, it was in the range of everything that we thought could
happen.

**John Anthony - SG Cowen**

So the sequential decline there did not surprise you?

**Kevin Kennedy**

That's correct.

**John Anthony - SG Cowen**

If you could also categorize or rank the drivers of the optical coms business,
ROADMs versus tunables versus other things; that would be tremendously
helpful.

**Kevin Kennedy**

I think the number one thing that has happened in the industry has been the
expansion of WDM into the metro core and access, and the minimization of
future SONET build outs. So, about 18 months ago metro eclipsed long-haul,
largely for that reason. We continue, as I stated here even in this last
quarter, saw double-digit quarter-on-quarter growth in metro.

Now, every now and then we see stronger growth in long-haul, so we are
continuing to see that. This quarter we saw strong growth in long-haul. The
second thing is tunables. And so, I think that's on a much smaller
denominator, but it's in every RFP, and that is the wave of the future. I
think the third is pluggable. So, if I were to talk about three dynamics at a
device level, those are the three. And of course, at larger than a components
level, all of the broadband build outs, anything that drives bandwidth,
whether it's the backhauls for 3G, whether it's fiber-to-the-home, all of
those things ultimately require more metro optic content. So that's been good
for us. I hope that helps.

**Operator**

This now concludes our Q&A session. Thank you for your participation in
today's conference. This concludes the presentation. You may now disconnect.

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30,100103-lecroy-corporation-f1q09-qtr-end-09-27-08-earnings-call-transcript.html,LeCroy Corporation,LCRY,industrial-goods,2008.0,,regular,"October 15, 2008",10:00 am,2008-10-15T14:00:00.000Z,52142,16538,35604,3,5,"['Thomas H. Reslewic - CEO, President', ""Sean B. O'Connor - Chief Financial Officer"", 'David Calusdian - Sharon Merrill Associates']","['John Harmon - Needham & Co.', 'Adeep Phi - Thomas Weisel Partners', 'Mike Crawford - Riley Investment Management', 'Sal Wayne - Lotus Investment Management', 'Rod Seth - Cowan and Company']","**Operator**

Welcome to LeCroy Corporation first quarter fiscal 2009 financial results
conference call. (Operator Instructions) At this time opening remarks and
introduces, I would like to turn the call over to Mr. David Calusdian of
Sharon Merrill Associates.

**David Calusdian - Sharon Merrill Associates**

Good morning, everyone and welcome. In connection with this conference call
LeCroy wishes to take advantage of the Safe Harbor Provisions of the Private
Securities Litigation Reform Act of 1995 with respect to statements that may
be deemed to be forward-looking under the Act. All such forward-looking
statements are only estimates of future results and it can be no assurance
that actual results will not differ materially from these expectations.

Information on all of the potential factors that could affect LeCroy
Corporation's business are described in the company's reports on file with the
Security and Exchanges Commission as well as in this morning's press release.
Any forward-looking statements only represent the company's view as of today,
October 15, 2008.

While LeCroy may chose to update these forward-looking statements at a later
date, the company specifically disclaims any duty to do so. On the call with
me this morning are LeCroy's President and Chief Executive Officer, Tom
Reslewic and Vice President and Chief Financial Officer, Sean O'Connor. I'll
now turn the call over to Tom.

**Thomas H. Reslewic**

As you saw in our news release, we kicked the fiscal year off with a
successful first quarter reporting strong sales and earnings. Our oscilloscope
business which continues to roll out exciting new products is largely
responsible for this growth. In fact, this is an all-time first quarter record
for oscilloscope sales which were up 12% compared to a year ago and 6%
compared to the sequential fourth quarter.

Protocol continues to be a bit sluggish as the next generation standard we
have traditionally focused on without being adopted as fast as the market had
anticipated. Our order linearly, which is measured by the orders we received
in the first nine weeks of a quarter, was 67.4% in the first quarter compared
to our target of 61%.

We had a very strong July and orders remain steady throughout the quarter.
I'll provide some financial highlights for Q1 before Sean reviews the numbers
in more detail.

The total sales for the quarter were $40.7 million an increase of 5.2%
compared to last year and up slightly from the sequential fourth quarter. Now
it's important to note that although our first quarter is typically our
seasonally slowest, this first quarter of 2009 represented the highest sales
in 11 quarters.

We owe much of this success to the timely watch of our new oscilloscope
products as well as our improved channel effectiveness in North America and
another quarter of extraordinary growth in our European scope business.

Our overall non-GAAP gross margin was slightly lower than we had originally
expected at 56.7%. We contribute this off primary to a lower percentage of
Protocol products in the overall sales mix.

Our non-GAAP net income for the quarter was 2.2 million compared with 2
million for the first quarter in '08. This translates into a non-GAAP EPS at
$0.18 for the quarter compared to $0.17 for the same quarter a year ago.

Now we continue to focus on strengthening our balance sheet. During the
quarter we repurchased another $2.7 million of our outstanding convertible
debt and so far we've repurchased 10% of the convertible debt at a discount of
more than 11%. We also repurchased 28,000 shares of common stock for $224,000
during the quarter. With that, I'll turn it over to Sean to review the
financials in more detail.

**Sean B. O'Connor**

Thank you, Tommy. Good morning, everyone. In my discussion, I will
occasionally be referring to adjusted non-GAAP operating results. We use non-
GAAP results as a supplement to our results based on GAAP because we believe
this provides additional insight into our underlying results and can enhance
the understanding of the company’s ongoing business.

The press release we issued this morning contains a reconciliation of the non-
GAAP results to their most closely related GAAP results. The non-GAAP
adjustment in the first quarter reflects non-cash as 123R share base
compensation expense of approximately $877,000. With that, we'll come to the
first quarter results.

As Tom mentioned, revenues for the first quarter increased 5.2% to $40.7
million from $38.7 million to the year earlier quarter and we're up slightly
from the sequential fourth quarter.

Our cost of sales in the first quarter was $17.7 million. This includes
$47,000 per share based compensation charges excluding the stock based
compensation costs. Non-GAAP gross margin for the first quarter of 2009 was
56.7%.

This compares with 58.5% non-GAAP gross margin for the same period last year
and 58.9% for the sequential fourth quarter of fiscal 2008. Gross margins are
down 180 basis points from prior year primarily due to the mix of the
oscilloscope products relative to protocol products as well as the continued
sales of Legacy Oscilloscope demo inventory.

Total operating expense for the first quarter was approximately $20.4 million.
This included $830,000 of non-cash share based compensation charges of which
approximately $585,000 was charged to SG&A and $245,000 was charged to R&B.
Excluding these items non-GAAP R&B expense was $7.6 million or 18.6% of
revenues. This is slightly higher from an R&B expense of $7.2 million or 18.7%
of revenue for Q1 of last year.

Excluding the share based cost I just mentioned, non-GAAP SG&A expense for the
first quarter was $12 million or 29.5% of revenue compared with $11.1 million
or 28.8% of revenues in the same period last year. The increase in our SG&A
expenses was primarily due to the increased variable costs on higher revenue
base as well as incremental marketing cost associated with the new product
launches.

Turning to operating income on a GAAP basis including the share base charges I
noted previously, we generated a first quarter profit of $2.6 million compared
to a $2.3 million profit for Q1 last year. Excluding our share base
compensation costs, our Q1 fiscal 2009 non-GAAP operating income was $3.5
million or 8.7% non-GAAP operating margin. This compares with $4.3 million or
11.1% non-GAAP operating margin in the first quarter of last year.

Other expense was $340,000 in the first quarter. This consisted primarily of
net interest expenses of $848,000 offset by $256,000 foreign currency gain as
well as a $252,000 gain on extinguishment of the company's convertible debt.

The company repurchased an additional $2,650,000 of convertible bonds at a
discount of more than 12%. However, that gain was reduced by $73,000 of pro
rata write-offs of unadvertised bond issuance costs.

In the corresponding quarter of fiscal 2008, we reported other expense of $1.3
million primarily net interest expense and the foreign currency loss. Our
affected tax rate on a GAAP basis for the first quarter was approximately
33.5% compared to 33.7% in the same period last year. Excluding the impact of
share based compensation expense, the full year normalized tax rate was
approximately 32% compared to 31.5% in the year ago period.

For the first quarter of 2009, we're recording GAAP net income of $1.5 million
or $0.13 per share. This includes the after tax effect of non-cash 123R
charges previously noted. Excluding those charges, our non-GAAP net income was
$2.2 million or $0.18 per diluted share. This compares with non-GAAP net
income of $2 million or $0.17 per share in the same period last year.

The number of shares outstanding [inaudible] the first quarter APS was 12.1
million shares. This compare with 11.9 million diluted shares outstanding in
the same period last year.

Now turning to our balance sheet, our cash position was approximately $7.7
million at quarter end. During the quarter, we repurchased and retired almost
$2.7 million of convertible bonds. During the past two quarters, the company
has repurchased approximately 10% of our previously outstanding convertible
bonds. We also repurchased approximately 28,000 shares of company stock paying
approximately $224,000.

Our Q1 net accounts receivable balance decreased to $32.6 million compared to
our prior end year of $32.3 million.

Inventory increased approximately $2.5 million during the quarter to $35.4
million. This is primarily due to the demo inventory built for the new Wave
Pro 7 product launch as well as material purchases for upcoming new products
offset by the sale of Legacy demo units.

In Q1, we used cashable operations of approximately $500,000 which is a bit
better than our plan and was significantly improved compared to the $1 million
used in the same period last year.

CapEx for the quarter was approximately $1.2 million. The company currently
has fortunately 62 employees about 65% in the United States, 20% in Europe,
and 15% in the Asia Pacific region. Our annualized revenue per employee was
$353,000 in the first quarter of 2009 down slightly from $359,000 a year ago.

So to sum, as Tom mentioned, we are pleased with our first quarter results
which gives us confidence in our prospects to execute our 2009 plan. With the
launch of our first major product with the Apollo chip set and plans for
aggressive rollout of additional exciting products, the company is in a much
stronger competitive position.

At the same time though we are carefully monitoring any customer weakness in
major segments we participate. We also continue to be prudent and keep a sharp
focus on controlling expenses.

I'll now turn the call back to Tom.

**Thomas H. Reslewic**

Okay, thanks, Sean. So I'll start to talk about the oscilloscope products a
little bit. As I mentioned the scope product line delivered a record summer
quarter for LeCroy. In Q1, in July actually we successfully launched our first
product to feature the next generation Apollo chip set, the Wave Probe 7
series.

We deployed the demos in the early part of the quarter, our trained sales
force in the beginning of July, and we began shipping the product in September
and it has been an absolute success so far. The feedback has been excellent.
Our customers are particularly impressed by the scope's speed, responsiveness,
and quite a number of less features. It's been a long time since I've seen our
sales force so excited about a new product.

Now in the standard LeCroy playbook, we have always tried to discontinue old
products as new ones replace them. Then we try to migrate the customers
quickly to the new products. Based on a lot of marketing, the field visits,
and significant customer inputs, we scrapped this practice when we launched
the Wave Pro 7 in July.

Some customers had build the Legacy Wave Pro and Wave Master Products, the
predecessors, into their R&D processes and may not be quite ready to move to
the Wave Pro 7, so we've continued to offer these products and will continue
to do so as long as customer demand remains reasonable. This really turned out
to be the right strategy in the summer as the older products continue to sell
well in Q1 right along side the even stronger Wave Pro 7 series.

The Wave Pro 7 is just the beginning of our new product rollout campaign. Our
pipeline is filled with exceptional new products that we expect to launch
throughout fiscal '09 and into fiscal '10. For example, in addition to the
Wave Pro 7, we entered a completely new oscilloscope market segment late in
this quarter with the launch of our Wave A series. The introduction of the
Wave A provides LeCroy with its first opportunity to participate in a sizable
market for very low cost scopes with some 100 megahertz based with price
points as low as a $1000.

During the past two years, we developed a second, third party distribution
channel to sell our lower price and [bend] with product line the Wave Surfer
and the Wave Jet. Now the way they physically load the Wave Jet enables us to
significantly expand our product line for our distribution network

In terms of the market segment breakdown, we saw only minor shifts this
quarter. Computer semi-conductor and consumer electronics segment remains the
largest component of our business at 32% of total. The automotive electronics
segment and the data storage segment traded places as automotive increased to
20% and data storage declined to about 18% of our total.

In terms of geography, our European operation continues to set the pace for
LeCroy quarter after quarter. Europe was up again more than 20% in year-over-
year and we believe we're taking real oscilloscope market share in that
geography. North America also performed very well reporting 10% growth year-
over-year. As we've been reporting market softness in Japan continues to
affect our sales in Asia. Overall Asia sales including Japan were down 7% and
to give you a sense of how the rest of Asia is performing if you exclude
Japan, Asia was up 5%.

Taking a look at the protocol business, on our last call I discussed our
efforts to drive growth in the protocol business by expanding beyond standards
such as USB, wireless USB, STATs, and STA and PCI Express. The pace of the
rollout of new silicon adoption rates for these next generation standards have
been slower than anyone had anticipated.

Now despite this slower growth our Protocol business remains very profitable
and the market share leader in each of our target segments. We've already
begun executing a plan to reignite the Protocol group as a growth business for
LeCroy and beginning in the second half of fiscal '09, we hope to see some of
the results of our early efforts to broaden the areas of focus for this
Protocol business.

At the same time we still see opportunities for our core standards as the
adoption of these standards begin to accelerate. And we're certainly prepping
our advantages in each of our core segments with a significant lineup of new
products. In August, we launched the world's first complete USB 3.0 Protocol
analyzer solution, the Voyager, which is our sixth generation verification
platform.

We believe that the emergence of USB 3.0 also known as super speed USB will be
a sizable opportunity for us. USB was LeCroy's first Protocol standard with
more than 10 years in the market and we have a commanding presence.

At the end of September, we also launched new Protocol tools for next
generation six gig STAT and STA data storage standards leveraging our
expertise in high speed serial data analysis, the new Sierra verification
system provides unparalleled performance in this industry.

Now a little bit on our outlook, so with one solid quarter in the books for
fiscal 2009, we need to turn our vision forward and take a look at what the
rest of year has to bring us. Unfortunately like many other companies right
now, our crystal ball is a bit murky. While our execution has been very solid
we're somewhat uncertain about the demand for oscilloscopes and Protocol
alliances towards the end of calendar '08 and the beginning of 2009.

We're hopeful that our high concentration sales into R&D and our limited
exposure to manufacturing applications combined with our impressive new
product pipeline will provide some insulation for many global slow down and
demand for test and measurement equipment.

After the first two full weeks of October in our second quarter, we continue
to see a healthy demand environment. orders are significantly higher than the
first two weeks of October a year ago which coupled with the strong linearity
we had in Q1 would normally give us cause for optimism in Q2 but despite these
positive indicators, given the external environment, we're keeping a sharp eye
on indicators like elongating sale cycles and delayed orders that would point
to a slowdown in our business. We feel well prepared to handle such a slowdown
if necessary. We're starting with solid operating margins, good control over
our expenses, and we are capable of reacting very quickly to any negative
change in demand.

Having said all that, we feel it's premature to make any changes to our
outlook for the full year which we just presented in August. Our full year
guidance for fiscal 2009 is for revenues in the range of 167 to 173 million
and non-GAAP operating income in the range of 17.5 to 18.5 million. Of course,
this excluded non-cash share based compensation expense and the other items as
we have defined in the past.

So with that, I think we've given you a sense for how well we're doing as we
started the year and some of our uncertainty regarding a demand environment in
the sense that we have and we feel we're reasonably well prepared if things
start to materially decay. So I think that’s a good place for us to stop and
take your questions.

","**Question-and-Answer Session**

**Operator**

Our first question comes from John Harmon – Needham & Company

**John Harmon** **–** **Needham & Co.**

A couple of questions please. For starters you said your gaining market share
in Europe. What is this there that you think you're doing differently?

**Thomas H. Reslewic**

I don’t think we're doing anything differently other than than pouring new
products into a very well established channel. So it's really more about
momentum than anything else. I think Europe has been a place where we have
continued to increase our penetration over the last several years particularly
in fiscal 2007 and in '08 when we did not have a lot of new products. We
really maintained our focus, built our channels well.

So it’s the place that where we start with the strongest share. I think we've
just done very well there and the new products just come down the onramp so
much more smoothly in areas where you have good share and strong presence
though its really a combination of the work that’s been done over the past few
years combined with a pretty exciting array of new products.

**John Harmon – Needham & Co**.

And secondly, I think in prior quarters you talked about a new product on the
Protocol side that would merge storage and data com protocols, how is that
coming along?

**Thomas H. Reslewic**

We're really focused on making sure that we bring PCI Express focused products
to the CSP Express guide and protocol solutions for storage technology, the
storage guides. When we start to talk about platforms that could potentially
merge things, you know a lot of that is internally focused platforms that give
us the ability to deploy our – customize and fine tune solutions that can then
be broadly deployed into various technology segments.

We haven't yet moved toward marketing products that serve multiple protocols
and leaving that as it is, we certainly have some ideas on things that we
might be doing in the future that kind of move a little bit beyond just the
Protocol and may offer various options and configurability to support multiple
protocols on a single platform; but that’s a little premature at this point in
time where our customer operators are still very focused around one technology
segment at a time.

**John Harmon** – **Needham & Co**.

Thank you, and just finally in previous times where businesses and [inaudible]
and you talked about warning lines or a red flag, it doesn’t sound like you
said that you’ve seen any thus far.

**Thomas H. Reslewic**

Well, yes, like I've been saying lately that if you flew in from Juniper and
landed at LeCroy first and didn’t read the newspapers or look at anything
other than our orders or our funnels, you would have a hard time being
convinced that there is anything amiss. But we know there is something quite
amiss and what we just don't know is what the impact is going to be.

I go back to the 2001 period and into 2002 and went back and really looked at
our own revenue drop was at that period of time and we felt like we're seeing
back then decays in the 15% range and of course, that was a largely technology
focused problem. Today I think what a couple of things that are different are
we have launched products that take us below and above where we have been
selling products.

I should say to be more precise the way they pick this gives us products below
the way of jest so that’s certainly into areas of the market that we haven't
been before. The Wave Pro 7 doesn’t do that. It really replaces products
between one and six gigahertz. We have had very limited offerings above six
gigahertz in the past and we are in the process now of dramatically changing
that.

I think that the products that we launch in the next 90 to 150 days as well as
the new Wave Age really give us an opportunity to reach into some market
segments that we haven't played in lately and we see those as great
insulators.

I have no way to predicate whether the overall test and measurement market
will see 20% drop or 25 or 50. I can't predicate the new – no lights on own
internal dashboard that say anything other than all systems go. I tend to be
rather concerned and to believe that sooner or later the check engine light
will be flashing.

So our focus is to drive hard on the products that we believe take us into
areas that we're not playing in right now because we think that anything we
gain in those areas will be incremental. We've got a real sharp eye on our
expenses and costs. We've proven in the past that we can react very quickly
and that we're not afraid to take strong actions if needed.

So armed with kind of planner on new products and an ability to react fast if
necessary, we feel reasonably confident. In fact I would even say that this
downturn just too some degree could be our friend.

I mean I think that we will come out of this much, much stronger than we go
in. We're probably in the best position we've been in a long time in terms of
the right team, really good execution, a little bit of track record behind us
here, and a lot of products in the pipeline. So, our lights aren't lit up but
we are concerned.

**Operator**

Our next question comes from [Adeep Phi] – Thomas Weisel Partners.

**[Adeep Phi] - Thomas Weisel Partners**

Just a couple of quick questions. I think the first one regarding your growth
margin. It's the lowest growth margin you've had now in five years. And I
think you just talked about mix like the lower protocol mix [inaudible] but on
the quality you also mentioned something about inventory, demo inventory that
you bought up. Could you give us some color as to what contributed how much to
that drop in growth margin on a sequential basis? And then after that, also
sort of address the pricing environment.

**Thomas H. Reslewic**

Yes, just, did you say pricing at the end –

**[Adeep Phi] - Thomas Weisel Partners**

Yes, yes.

**Thomas H. Reslewic**

Okay. Yes, okay, so the single biggest factor in the core without a doubt on
both a sequential basis and year to year basis is the relative mix between the
Protocol business and the scope business. So the scope business tends to run
more in the generally mid-50s and the Protocol business tends to run in the
mid to high 70s.

We had the lowest ratio of Protocol over scope revenue that we had in probably
12 or more quarters, so really a very soft quarter for Protocol. As luck would
have it, also an extremely strong quarter for scopes. Actually not only was it
was a record quarter, a record first quarter for scopes, it was actually the
second highest oscilloscope revenue quarter we've ever had in history. And for
that to occur in a Q1 is rather unusual.

So we had to just a great business in the scopes so the ratio of the two tends
to drive it the most. Then inside the scope business our gross margins inside
the scope business were actually off as well compared to what we had expected
and most of that had to do with selling of the demos and also the mix.

As I said we did something very different. Normally we like to discontinue the
old products and get rid of that all stuff and then switch everybody over to
the new products. The last couple of introductions that we've had in the last
couple of years, I'd been well somewhat disappointed in the process. I felt
that we disappointed some customers by not keeping the products that they had
built software around in the lineup for a while. So we did it very differently
this time.

We launched the new products and we sent the message out to the field and the
customers that the previous generation products would stay in the lineup.
We'll keep making them. If you –as long as the customers keep ordering, we'll
keep making them and they really took us up on it. So in our mix, we sold
quite a few of the older products. We moved a lot of demo instruments during
the quarter and that tended to drive down the average selling price through
the quarter as well.

Also, our early Wave Pro 7s – now the Wave Pro 7 runs from a gigahertz up to
six gigahertz and usually the higher end product, the four and six gigahertz
products, are sold heavily into serial data applications. We just launched, in
actually early October, a next generation serial data package called SDA 2,
which is really quite an innovative package and we felt that our mix in Q1
reflected this act that we sold a lot of the early Wave Pros at the one, two,
and one and a half, two and a half, and three and a half gigahertz range and
fewer at the four and six. That seems to be changing here as we move into the
October quarter with the launch of the SDA 2.

So, inside the scope business, demo sell off mix and pricing is getting –
pricing is a little bit harder to triangulate only because we're – we don't
have apples-to-apples comparisons. We're changing the product line so much.
And I would further say that we have not felt that we've been in a mode that
we've been over the past year where we've been conscientiously giving up a lot
of pricing. We felt that we've been able to maintain our prices pretty well.

Late in the quarter we started to have some decay in the ASPs as a function of
the strength of the dollar against the Euro and with such a strong quarter in
Europe, that had some impact on us late in the quarter. But fundamentally its
– the real restorative answer is mixed. First mixed between Scopes and
Protocol and then inside the Scope business mixed as well. And we still feel
confident that the gross margins are going to get to where we need them to in
the mid to longer term.

**[Adeep Phi] - Thomas Weisel Partners**

And with – so does that imply that you expect the Protocol business to start
seeing healthier trends than it has over the past couple of quarters?

**Thomas H. Reslewic**

Yes. I think that we've certainly seen a couple of quarters that have been
slower in Protocol mostly related to market adoption. And then I think that
the first quarter was just an exceptionally low data point. The number of
things happen kind of simultaneously. We had a new product launch at the end
of the quarter in data storage, so I think there was some anticipation of the
new product in data storage. In fact, our funnel as we go into the second
quarter for data storage is excellent.

We launched again at a plug fest toward the end of the quarter, our USB 3.0
Voyager solution which is a really outstanding and exciting product. We think
that had some impact on people waiting for that product line especially as
people want to buy USB 2.0 capability with migration path to 3.0. I think
people really wanted to get into that new platform and then also some general
softness in PCI Express.

You could say these things all together kind of conspired to make the first
quarter just really, really –

**[Adeep Phi] - Thomas Weisel Partners**

But see some of those others that are [inaudible] we saw like PCI Express and
some of the other weakness that you saw in the Protocol business, do you see
any signs of that actually improving going into the December quarter?

**Thomas H. Reslewic**

Yes, you know our funnels indicate that a much stronger December quarter and
of course, I answer all of these questions pretending that I haven't been
reading the newspaper at all in the last –

**[Adeep Phi] - Thomas Weisel Partners**

Right, just based on your visibility of what you're seeing, you saw some
weakness out of PCI Express. You had a product, a new product announcement on
the storage side. But when you put all that together and you see where you are
right now, you feel that the December quarter is going to be rebound on the
Protocol side because of the sales funnel as you see it.

You're not seeing customer weakness on PCI Express front or spending on next
generation technologies outside of storage. You're not seeing any third or
deteriorating trends over that? Is that fair?

**Thomas H. Reslewic**

Yes, that’s correct.

**[Adeep Phi] - Thomas Weisel Partners**

And then when you're looking at your tax rate, the past two years after your
first quarter, your September quarter usually marked the high point in your
annual tax rates and after that it usually dropped quite a bit for the
December quarter and the June quarter might see a little bit of an uptake but
usually it was pretty low in the December and March quarter.

Can you some color as to what drove that and how we should be modeling the
rest of this year as far as stats goes?

**Sean B. O'Connor**

Yes, if you– and actually with the President signing a new tax law ten days
ago or so, there is going to be another Q2 item in the December quarter, so a
lot of it has to do with either this R&D credit has been on again, off again
in terms of getting an R&D credit that’s a dramatic help in our tax rate, as
well as updates to our geographic earnings mix.

So the 32% that we have projected going into this fiscal year is probably on
the high side given the new tax legislation that was passed. And that could
help us by up to two points.

**[Adeep Phi] - Thomas Weisel Partners**

Then two more questions. One is regarding your liquidity, just the fact that
you’ve been buying back your shares and also buying back your debt, and you do
have a pledge [inaudible] that’s out there so can you walk us through what the
highest uses of your cash are right now. Whether there has been changes from
your bankers in terms of the credit actually and how you're prioritizing
buying back your shares and if you're buying back to convert on go forward
basis.

**Thomas H. Reslewic**

I'll just start with kind of strategic view and then give you to Sean for the
details. At the highest level we had been throughout the first half of
calendar '08 and into early part of the summer, we felt there was a real
opportunity to use our strong cash generation to go after our convertible debt
particularly because we're able to buy it back at about 11% discount. So we
did a fair amount of that.

And pretty much early in the summer, we stopped that practice just as we're
looking ahead to some of the overall issues in the overall credit market and
thinking that it'd probably be a little bit wiser to go into more cash
conserve mode. And that’s really where we are at the highest level right now
is just taking a little bit more of a not so aggressive approach even though
the discounts are still attractive, we think right now is just not the best
time to be sending our cash that way.

I'll give you to Sean for some of the thoughts between both –

**[Adeep Phi] - Thomas Weisel Partners**

And that would also apply share buy back. So you stopped your share buy backs
as well and conserving cash. You're in cash conserve mode right now. Is that
fair?

**Thomas H. Reslewic**

Yes. The cash mode, that’s correct.

**Sean B. O'Connor**

That’s fair.

**[Adeep Phi] - Thomas Weisel Partners**

We'd love some more color on your credit arrangements.

**Sean B. O'Connor**

We actually have an excellent relationship with our bank group. We have M&T
Bank as our lead bank, with Capital One and Bank of America as the three
members of our facility. And we have in terms of our cushion, if you will, in
terms of our convening calculations, we have enormous amount of flexibility,
if we wanted to borrow onto our facility, if strategically we changed our
minds with buying back the convertible bond, that's one of the enormous
flexibilities we have with the current facility.

So, there's no issues there and we're very pleased with where we stand in
terms of our, the $50 million revolver and we have no plan to change that.

**[Adeep Phi] - Thomas Weisel Partners**

But now why, when you're looking at your convertor and you're looking at you
now your draw down for this credit accessibility, I think one of them is much
cheaper than the other, right? I mean one of them is linked to the higher of
libel or primarily, not the lower, okay. So I mean when you're prioritizing
the two, you still think that the credit accessibility, the cost of the
[inaudible] as to the cost to convert, which one do you think in the long run
is going to prove more expensive for you folks?

**Sean B. O'Connor**

Well, the convertible bond being at a 4% rate compared to approximately a 6%
rate we borrowed under the revolver, there's clearly an advantage to keeping
the convertible bond as is. It's not you now on a put date for another three
years, it's longer term than that and we just don't see the strong need to
borrow under a revolver that's really primarily there for working capital
need, not necessarily to redeem the convertible fund, even though as Tom is
mentioning that it is trading at a significant discount, so getting that
discount is really money in the pocket, by taking advantage of where the bond
is at today.

**[Adeep Phi] - Thomas Weisel Partners**

Got it, OK and then just looking at it from a strategic high-level level
perspective, you looked at, you've talked about share gains, expanding a
portfolio and done a pretty incredible job instead of introducing new product.
But, could you give us some color right now, just in terms of you know you
read the scale to the larger players you know where you think your market
share and [inaudible] profit is right now?

And whether still as you introduce more and more product, but you have lower
volume in each product than a larger comparative, whether that actually is
playing to a scale disadvantage and whether there're any other methods they're
looking at from a strategic perspective of building scale further?

**Sean B. O'Connor**

You know, I think that one of the - I would say one of the areas that probably
didn't help us very much say, two, three years ago, was focusing more on scale
than raw competitive performance in the products. I think that the most
important thing that we can do for our customers and for the value of LeCroy,
relative to our competitors is to feel really meaningfully competitive well
differentiated products.

And I think that we are quite capable of doing that. I do believe actually,
out growth margin structure is very competitive. If I look at you know what
we've accomplished with the people we have, if you look at our revenue per
employee, compared to our competitors, which similar outsourcing mixes, those
numbers are all pretty impressive.

So, we get a lot done with a little. But I don't think it's a game of scale -
I definitely believe it's a game of really delivering more competitive
products with differentiating features that have meaningful impact on the
customer base. We see it, we're seeing some tremendous gains that we feel
we're still going to make in the market with the WavePro 7, but not just the
WavePro 7.

There's underlying technology, the architecture in the WavePro7 as we move
that up bandwidth, it's going to have some really significant impact on
customers. So, for us right now, it's about really making a meaningful dent in
the segment that we play in with competitive products that means that we'll
spend a bit more in R&D as a percentage basis.

It's impossible for me to calculate the share at this point in time, I don't
really know, but I definitely have the sensation that we have moved into a
domain where we're going to, when we get the chance to go head-to-head, we're
going to win more than we lose and so it's really all about the products right
not.

**[Adeep Phi] - Thomas Weisel Partners**

So, what percentage share you think now you have now in the overall scope
market and also any changes in comparative behavior out of your two largest
competitors there?

**Sean B. O'Connor**

I'm going to continue to decline the first one, because I just don't know. I
don't really know how to calculate it at this point and in terms of
competitive behavior, I think that you know the Wave 8 hasn't been out long
enough for us to see, but I will tell you that we have for years had a very,
very difficult time attracting top tier distributor companies.

People that have meaningful catalogs that get distributed in the hundreds of
thousands, it's never been anything we've been able to do, even then we've
been able to move our WaveJets and our WaveSurfers into a distribution
network, we've had a hard time attracting top share distributors. The
[inaudible] it's seriously changing that, we are engaged in a number of
productive conversations and we've signed a number of distributors that we
think are going to really help us move forward.

And I think that's going to be significant and I think that's going to change
the competitive landscape at the low end. And I think certainly in high end,
you know if high end business takes a lot of investment, takes a lot of time
in advance to make the investment chip developments, the tests to start and
run, two years in advance of products being deployed.

We're not at the beginning of that cycle today, we're at the end of that
cycle, so we're really on the door step of deployment and I think that you
know, especially if we move into more challenging economic times and we look
at our competitors, which I think will be more impacted, more exposure to the
manufacturing segment than we are, I think that we have an opportunity to
really maintain our focus on our new products and do well competitively.

Our next questions comes from [Mike Crawford] – Riley Investment Management.

**[Mike Crawford] – Riley Investment Management**

When does the WavePro 7 start shipping?

**Thomas H. Reslewic**

It started shipping in the early part of September, Mike.

**[Mike Crawford] – Riley Investment Management**

So you were taking orders since July 1 and it started shipping just about as
you expected, no hits there?

**Thomas H. Reslewic**

Exactly right, not quite to the hour, but almost

**[Mike Crawford] – Riley Investment Management**

Now, it's my understanding that this new kind of platform and chip set have
potentially a lower build of materials compared with the old platform, but
that maybe to get your manufacturing margins right and some ramp up time. Can
you kind of walk through the type of margin improvement in general that you
might expect going forward?

**Thomas H. Reslewic**

Yes. I think that the margin improvement as a function of the new product, it
becomes more significant as you get higher and higher in bandwidth. So, you
know really got in the WavePro space, it's not quite as significant, as we
start to look at you know products that may come in the future, it just gets
more and more significant as we move up in bandwidth.

And also, there's a time, there's a time period and also some, a few other
factors. So, if I go back to the very beginning when we had started you know
to plan the product, we are looking at bills of materials and manufacturing's
costs today that are in fact a bit higher than we had originally planned for.
And that's because we spent an awful lot of time in front of customers in beta
tests and with our sales force, trying to make sure that our feature set was
absolutely compelling enough.

And that sometimes meant a faster processor and a little bit more memory and
maybe more sophisticated relays and more rugged knobs and encoders. So, we bit
the bullet and added those things and so our building materials isn't quite
what we had expected when we started and I think it's you now probably about a
six month ramp before we get the early production cost to settle down to the
target.

But by and large, overall, we are going to see not only more favorable margins
because of the cost structure, but because of the fact that these products has
such a compelling capabilities that we won't be pricing them like we had with
the last generation products which was deep, deep discounts and much lower
pricing just to stay in the game.

So we feel have an opportunity to really command a great price for these
products and that plus some improvement in the building materials will drive
better margin structure. And particularly more so at higher bands.

**[Mike Crawford] - Riley Investment Management**

Okay and then on the lower bandwidth, so they stopped being produced and [Sen
Chang] is that –

**Thomas H. Reslewic**

Yes, that is correct.

**[Mike Crawford] - Riley Investment Management**

And when do those start to ship?

**Thomas H. Reslewic**

These things – at imminent. We're kind of as we speak we're in the process of
the first units coming out of the – off the manufacturing lines.

**[Mike Crawford] - Riley Investment Management**

Okay and then I think I heard you that Asia excluding Japan would have been up
5% but Asia and Japan was down 7% so Japan remains in some throes given the
change in the distribution channel there. What's –

**Thomas H. Reslewic**

Yes, although its been a long – its been a very long time since we've made the
changes to the channel. We definitely believe that we have a lot of external
factors there and so some key customers have definitely slowed down so we're
experiencing what we feel are some localized market and customer issues in
Japan.

Certainly even without the change in the distribution we've never really Japan
back to where I thought it should be. So it still remains as a project for us
but I don't believe that even as it is today it represents a threat to our
business plan.

Like I say I answer these questions as if I hadn’t read a newspaper in the
last two weeks, so keep that in mind.

**[Mike Crawford] - Riley Investment Management**

Okay, thank you.

**Operator**

Once again, ladies and gentlemen, to ask a question, please press star one on
your telephone keypad. Our next question comes from [Rod Seth] with Cowan and
Company. Please proceed with your question.

**[Rod Seth] - Cowan and Company**

Hi, Tom. Most of mine have been answered but I'm curious if your dashboard
lights are blinking orange and you start seeing things to begin to unravel a
bit like 2001, what are the first sort of things that you do in a business
like this to mitigate the damage that might result from a down cycle where you
begin to really see effect?

**Thomas H. Reslewic**

Well, there is a variety of stages, steps and some of which we're already
starting to think about in a preemptive sense. So as you starts to move into a
business where you expect your quarterly revenues to really boost particularly
when you're driving aggressive R&D programs, as you can imagine our fiscal '09
budget has got a lot of hiring in it, adding a lot of capabilities, filling
out our technical staff, our marketing organizations, and getting pieces of
manufacturing as we start to move more and more units.

So one of the things we do right away is start to really rein that in and make
sure that we're not going to get ahead of ourselves with head counts. We take
a long hard look at all of the NREs and programs and the variable expenses
that relates to all kind of programs, the CapEx, and so forth and start to
rein that stuff in.

I think that there is a series of steps that we been through in the past where
we just start to look at the layers of the types of expense and the layers and
start to work them one by one. I think that we're at this point in time where
we're acting as if the lights on the dashboard are orange even though they're
not.

And so, we don't have any – I don't plan to get caught by surprise with the
downturn and find out that we're really late. But I will say this, if from a
priority perspective there's –the Wave base that we just launched which still
requires a lot of engineering and a lot of support and there is some follow on
products to that that are vital.

Another product launch that’s coming up out in front of us. There are two or
three things that are absolutely vital to continue because products that will
take us into segments of the market where we haven't been for the past couple
of years, are the absolute best hedge against seeing some serious erosion on
the top line.

So the same things that we think can drive growth can really provide a bit of
an insulator for us. So we are making sure that we're pulling out all the
stops and throwing everything we have at making sure that the [inaudible] and
the next couple of key products make their way to the market on track, in a
timely fashion with all the enthusiasm and promotion that we had initially
planned because those are the things that can really have a meaningful impact
on our top line if the overall demand of our [inaudible] starts to decay.

So we've identified a couple of key projects like that and then everything
else we're willing to let some things slide and shift and move around a little
bit to deal with any kind of strong wind, headwind that we face.

**[Rod Seth] - Cowan and Company**

And then this business – I did know 2001, 2002 isn't necessarily comparable
but what would you expect assuming that this begins to happen. It sounds like
you're taking some early actions to guard against. Where do you start feeling
it in the business like how does it metastasizes itself in the business like
yours. Is it something you feel more on the high end or low end or is it just
general booking level in general coming down everywhere?

**Thomas H. Reslewic**

Well here's what I believe is the most prudent thing that we can do. Its best
to start looking deal by deal …So you know rather than just kind of wait for
overall trends our forecasting methodology and process is very well suited to
getting early indications so we don’t just, we don’t review our bookings
monthly.

We have a pretty rigorous weekly hygiene around the bookings in the business.
Now we have done a very, very careful forecast on a monthly basis and even
expectations and guidance on a weekly basis by region, by product line, and so
we know pretty quickly whether we’re starting to not hit the week as we expect
them to occur and so that’s a very, very good quick sensation for what’s
happened.

We don’t have to wait until the second week of a fiscal month to see what
happened in the previous month. Like a lot of processes so we’ve got good real
time information and secondly as I started to say it’s about looking at deals.

And so I like to identify five to ten specific relatively, a medium to large
size deals that we’re working on and watch the dynamics of the deals and I
would expect if things are going to really start to turn down, those deals
will have difficulty getting signed off but the sales guys will be optimistic
and they’ll expect the deals to come in this week.

And it's in fact won’t or it’ll slide out to the next month or it’ll get
kicked out to the first quarter, those are the things, the specific things
that I am looking for. And, when I start to see enough of those then it will
be time to start reacting a bit more strongly.

  
Even it at that point our dashboard lights haven’t gone all red yet so that’s
kind of the approach we take.

**Operator**

Our final question comes from [Sal Wayne] -- Lotus Investment Management

**[Sal Wayne] – Lotus Investment Management**

A couple of questions please. First I think you talked about this a little bit
but given the, I think you mentioned a booking number for the first nine
weeks, something like 67% and 51 is more or less what you target.

Can you talk specifically about the order flow coming in at the end of the
month or whether you saw any, how you describe the orders coming, going
through September specifically towards the end of September? Totally separate,
on your head count number, do you have a census what you think that count
might be for the fiscal ’09? Thank you.

**Thomas H. Reslewic**

So, yes, I’ll start with the linearity, if you, so we like 61% of our orders
to come in the first nine weeks of a quarter and this quarter was actually
64.7 I believe. So, yes, certainly higher than that and that really was
attributed to a very strong July.

And, a lot of that had to do with, we announced the WavePro 7 on July 1 and
we, basically, sent a message to our international distributors in some
countries, Israel, most of Scandinavia and number of places in Asia, Canada,
we don’t have a direct sales force and so we use distributors to sell our full
product line and the message to our distributors was the guy that gives us the
earliest orders will get the earliest products out of production.

So we got a nice surge at the beginning of July in orders for the WavePro and
that really was one of the things that made July particularly strong and then
thereafter the quarter, particularly on the scope side was very linear.

Orders were strong in July, strong in August, strong in September and scopes
business has continued very strong right into October. So I have seen almost
no [inaudible] just a very steady linear really ideal order flow in the scope
business.

Our protocol business tends to be more back end loaded in general. Back end
loaded in each of the months and in particularly back end loaded in the
quarter the Protocol business on it’s own. doesn’t achieve those kinds of
linearity and that’s partly because the protocol business is made up of a
smaller number of larger deals, more discreet deals in the business where the
scope business is lots of orders every week from all over the place.

And, so, the protocol business was heavily back end loaded in the first
quarter, so September was extremely strong. In fact, even though I wasn’t
thrilled at the overall number in protocols, weeks 11,12, and 13 in the summer
quarter in the protocol businesses were actually very strong and then the
first couple of weeks in October, I would describe the protocol orders as
okay.

Not great, but not unusual for the protocol business. And in particularly when
we had such strong weeks 11, 12, and 13 you could expect the fall to be
completely dry but that wasn’t the case either. So, again, if you only tried
to look at our business from a order flow linearity and steadiness perspective
you would be hard press to detect a problem.

**Thomas H. Reslewic**

That’s not to say that there isn’t one out there. But it’s just not manifest
in our order trend. And the second question was in regard to employees. At
this instant we have 462 employees and how many did we have a year ago Sean,
from now?

**Sean B. O’Connor**

Twenty-five left.

**Thomas H. Reslewic**

So we’ve hired about 25 people in the past one year and we’re at 462 today.
And, if I just look at our budget I’m going to take a bit of a swag at this, I
would say that our fiscal ’09 budget which has still three quarters to go,
would probably adding something on the order of another 20 to 25 people. And,
I would guess that we would probably not get that done.

**[Sal Wayne] – Lotus Investment Management**

Okay, got it.

**Thomas H. Reslewic**

So, yes, I don’t want to say anymore about that at this point in time because
it’s still relatively uncertain but I can assure you I don’t know all the
things that we need to do but I can assure you we are not just hiring to our
budget in the face of the uncertain environment.

**[Sal Wayne] – Lotus Investment Management**

One last thing, I missed I think you gave some of the percent revenues by, or
percent orders by, end market. I missed what it was for computers and military
and government.

**Thomas H. Reslewic**

We focus on three segments. So the one that we felt computers, semi conductor
and consumer electronics is one big blob for us and it includes things like
Intel and Dell and Sony and so forth and that was 32% and that’s about the
same as it’s been for the last several quarters. Harvard’s in that one third
of our business range.

**[Sal Wayne] – Lotus Investment Management**

Okay.

**Thomas H. Reslewic**

And then the other two we report are data storage and automotive electronics
which also includes a lot of industrial control applications and each of those
roughly speaking are about 20% each.

**Operator**

I will now turn the conference back over to Mr. Tom Reslewic for any closing
or additional remarks.

**Thomas H. Reslewic – CEO, President**

Okay, well, thank you very much and thank you everyone for listening and for
all of your questions this morning. We look forward to speaking with you again
when we announce our second quarter results in the January time frame. Good
day to everyone.

**Copyright**

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33,100110-amr-corporation-q3-2008-earnings-call-transcript.html,AMR Corporation,AMR,services,2008.0,,regular,"October 15, 2008",2:00 pm,2008-10-15T18:00:00.000Z,48406,20579,27827,3,8,"['Eric Briggle - Managing Director of Investor Relations', 'Gerard J. Arpey - Chairman of the Board, President, Chief Executive Officer of', 'Thomas W. Horton - Chief Financial Officer, Executive Vice President - Finance']","['Jamie Baker - J.P. Morgan', 'Bob McAdoo - Avondale Partners, LLC', 'William Greene - Morgan Stanley', 'Michael Linenberg - Merrill Lynch', 'Gary Chase - Barclays Capital', 'Hunter Keay - Stifel Nicolaus & Company', 'Kevin Crissey - UBS', 'Bill Mastora - Broad Point Capital']","**Operator**

Welcome to the AMR third quarter 2008 earnings conference call. (Operator
Instructions)

We are very pleased to have on the call with us today AMR’s Chairman and Chief
Executive Officer, Gerard Arpey, and Executive Vice President of Finance and
Planning and Chief Financial Officer, Tom Horton. Here with our opening
remarks is AMR’s Managing Director of Investor Relations Eric Briggle.

**Eric Briggle**

During the call Gerard Arpey will provide an overview of our performance and
outlook and then Tom Horton will provide the details regarding our earnings
for the third quarter along with some perspective on the remainder of 2008.
After that we’ll be happy to take your questions. In the interest of time,
please limit your questions to one with a follow up.

Our earnings release earlier today contains highlights of our financial
results for the quarter. This release continues to provide additional
information regarding entity performance and cost guidance which should assist
you in having accurate information about our performance and outlook. In
addition, the earnings release contains reconciliations of any non-GAAP
financial measurements that we may discuss. This release along with the
webcast of today’s call is available on the Investor Relations section of
[_www.aa.com_](http://www.aa.com).

Finally, let me note that many of our comments today regarding our outlook for
revenue and costs as well as forecasts of capacity, traffic, load factor, fuel
costs, fleet plans and other matters will constitute forward-looking
statements. These matters are subject to a number of factors that could cause
actual results to differ from our expectations. These factors include changes
in economic, business and financial conditions, high fuel prices and other
factors referred to in our SEC filings including our 2007 annual report on
Form 10K.

With that I’ll turn the call over to Gerard.

**Gerard J. Arpey**

As you’ve all seen in today’s press release excluding special items in the
third quarter we posted a loss of $360 million, which obviously compares very
unfavorably to the $215 million profit that we earned in the third quarter a
year ago.

As in previous quarters this year, fuel prices were the big driver of our
performance and the volatility of fuel prices continues to be quite
extraordinary. The last time we were together on one of these conference
calls, the cost of a barrel of oil was about $135 a barrel. Yesterday oil
closed at about $79 a barrel, which is obviously a big drop but I do think we
need to all keep in mind that $70+ a barrel for oil is not really a bargain by
historical standards and volatility continues to be a significant concern.

As so often seems the case in the airline industry, there’s another challenge
on the horizon. As we have all witnessed over the last month, the financial
markets are in turmoil and this is certainly having an impact on the economies
both here in the United States and abroad. Events of this magnitude will
undoubtedly have an impact on our business although how much of an impact
remains to be seen.

I’d like to reiterate that we have accomplished a lot over the last several
years to prepare us for difficult times, and whether our challenges are
historically high fuel prices or troubled economies we are continuing to move
forward. As you will hear today we continue to take steps to ensure that we
not only can meet our near-term challenges but also build for the future.

One big factor in our ability to navigate this tough road has been our
capacity discipline. As fuel prices climbed throughout this year we have not
been shy about eliminating unprofitable flying and attempting to improve the
supply and demand equilibrium in order to gain more pricing traction. Earlier
in the year we announced our main line capacity reductions of 11% to 12%
domestically and 7% to 8% for the system versus the fourth quarter of last
year, and we’re certainly on track to do that.

Given the uncertainties of the economy and the volatile fuel environment, we
are setting our capacity conservatively for next year as well.

We continue to believe that a more balanced supply demand environment is
necessary to offset some of the disruption caused by the economy and fuel
prices, and we continue to do everything possible to raise revenues through
higher ticket prices and the unbundling of our products and services. As you
can tell from our third quarter revenues those efforts have begun to bear some
fruit.

We’re doing our best to manage costs. Capacity reductions make that difficult
so it will take some time to ring these costs from our system. But as always,
costs will be a priority for us as we work through the planning process for
next year.

We continue to focus on the balance sheet. I think it’s fair to say we’re in a
relatively good spot with approximately $5.1 billion in cash at the end of the
third quarter, and we’re looking to further strengthen that cushion to help us
better face the challenges ahead.

It has certainly been a busy quarter for Tom and his team. We closed the sale
of American Beacon Advisors in mid-September, we raised several hundred
million dollars in financing over the quarter, and we’ve secured financing for
20 of our 2009 737-800 orders in addition to the previous backstop financing
that we talked about in the third quarter. That means we have financing
commitments covering most of the 76 737s we expect for delivery in 2009 and
2010, and given the current credit environment getting those deals done I
think was a significant accomplishment and a credit to our treasury team.

We’re also of course looking to the future. We have announced our joint
business agreement with British Airways and Iberia. We have of course applied
for anti-trust immunity with these carriers along with Finnair and Royal
Jordanian, and we are optimistic on our chances of getting that approved.

We continue to move forward with our fleet replacement program, and in the
third quarter we increased our commitment to 76 737-800s over the next two
years. We mentioned on the previous couple of calls that we’ve been analyzing
our next steps on the wide body front and I’m pleased that today we did
announce that we have entered into an agreement with Boeing under which we
intend to take delivery beginning in 2012 of 42 Boeing 787-9 aircraft with
options for 58 more to replace our existing wide body aircraft and provide the
potential for long-term growth opportunities in conjunction with our joint
business agreement with BA and Iberia.

While we certainly face near-term challenges along with the rest of the
airline industry, we continue to be firmly focused on the future and building
a company that can be successful for the long run. I do think it’s fair to say
we have faced and met tough challenges in the past, and we plan to continue to
do so. And in the process we hope to create the best outcome for our
shareholders and all our other constituencies.

With that said, I’ll turn things over to Tom.

**Thomas W. Horton**

As you can see laid out in the press release, we recognized a few special
items during the quarter. The most significant of these was the $432 million
gain associated with our sale of American Beacon Advisors. For the remainder
of the call I’ll exclude the impact of special items to more accurately
reflect our performance on an ongoing basis.

Excluding these special items, we lost $360 million versus a profit of $215
million in the third quarter of last year, a change of over $575 million. The
driver of this change was clearly fuel prices. Remarkably in this quarter
alone we spent almost $1.1 billion more for fuel than we would have paid at
last year’s third quarter prices. The good news is that spot prices for fuel
have come down from the record highs of early July but fuel prices remain high
and volatile by historical standards and remain an enormous challenge.

While fuel may have abated somewhat for the time being, these are
extraordinary times. The turmoil in the financial markets reflects yet another
challenge we intend to face head on. Through our efforts over the past several
years we have put ourselves in a better position to face difficult times, and
we continue to take action in light of these challenges. A part of the
solution is to affect a more stable supply demand balance, and for several
years we have taken a very disciplined approach to our capacity plans.

Earlier in the year we announced capacity reductions that have begun to take
effect, and we’ll see the full effect of these cuts towards the end of the
fourth quarter. These reductions will help to offset weakness in the revenue
environment associated with a recessionary economy, and given that we think it
makes sense to revise our capacity downward further for next year while at the
same time accelerating our fleet replacement with more fuel-efficient
aircraft.

In terms of liquidity we have arranged financing for a number of our upcoming
aircraft deliveries and we have completed a number of significant financing
transactions and taken additional steps to reduce our capital expenditures
this year.

On the revenue front, throughout the year we have taken the initiative on
several fare and fee increases as we work to ultimately pass along the
increased costs of our flying to the customer. Along with the capacity
reductions we have begun to see the impact to both passenger and ancillary
revenues.

There remains a lot more to do, and with that I’ll first discuss our revenue
performance.

Our third quarter main line unit revenue increased by 10.9% year-over-year on
yield improvements of over 13% while unit revenue for our consolidated system
was up 10.4%. While we currently face a challenging revenue environment moving
forward, yield and unit revenue improvements of these levels are encouraging
and demonstrate the pricing traction possible under rational capacity levels.

In our domestic markets third quarter main line unit revenue increased by 7.7%
compared to last year on about 5% less capacity as yield improvements more
than offset lower load factors. On the international front we saw
unprecedented unit revenue growth in the third quarter versus 2007 across all
entities led by Pacific and Latin driven by very strong yield performance. In
total international unit revenue was up almost 16% year-over-year.

A quick product update. We have now completed the standardization of the 777
first class product around the flagship suite and we’ve installed our next
generation business seat on all of our 767-300 and 777 aircraft.

Latin America continued its positive performance this quarter posting a
remarkable unit revenue improvement of almost 20% despite a very competitive
environment in some markets. For our Pacific operations we also saw very
strong yield improvement of almost 17.5% offset by lower load factors that
drove unit revenues higher by nearly 14%. Finally even as competition
continues to evolve under open skies, our Atlantic third quarter unit revenues
were up 11.5% versus last year on a bit lower capacity driven by yields which
were stronger by over 14% versus last year.

Turning to other revenue items, third quarter passenger revenue for our
regional affiliate operations increased over 3% even with capacity lower by
about 4%. Total card revenues increased by over 17% year-over-year on strong
yield performance. In other revenue we’ve seen substantial increases from the
fees we put in place in June including the first bag fee. So for other revenue
we saw an increase of over $70 million or 14% versus last year.

On the alliance front we were pleased to announce during the third quarter a
joint business agreement with our one-world partners BA and Iberia. In
conjunction with this agreement we’ve also applied for anti-trust immunity
with BA, Iberia, Finnair and Royal Jordanian. With the granting of the anti-
trust immunity and implementation of the joint business agreement our
customers will have access to more destinations, more convenient and
coordinated flight schedules, increased access to lounges and enhanced
frequent flier benefits.

There’s no denying that the Star and SkyTeam alliances have strengthened
substantially over the last few years, particularly as they have extended
anti-trust immunity to cover more of their member carriers. A stronger one-
world will counterbalance this evolving duopoly and will help ensure customers
have ample alternatives over the long term.

Our application for anti-trust immunity now rests with the regulators, and
while we can’t make promises about the outcome of the process we believe we’ve
made a very strong case.

Turning to costs. While the spot price for fuel has decreased substantially
since its peak in July, in the third quarter we recorded the highest fuel
prices we have ever experienced in our company’s history. This drove a sharp
increase in our third quarter unit costs which were up more than 22% year-
over-year. Our fuel price came in at $3.57 a gallon consolidated. This
represents an increase of 64% and as mentioned earlier this raised our
consolidated fuel costs in the quarter by $1.1 billion more than we would have
paid at last year’s third quarter prices.

Excluding fuel, our unit costs rose by 4.3% main line and 4.4% consolidated
driven by reduced capacity and headwinds from higher materials and repairs
costs, facilities expenses and foreign exchange.

Now turning to the balance sheet. We ended the quarter with $5.1 billion in
cash including $456 million in restricted cash. $5.1 billion is a sizable
amount of cash but given the uncertainties with fuel prices and softening
economies both here and abroad, it makes sense to maintain significant
liquidity and we continue to seize on opportunities to build our financial
flexibility.

During the third quarter we completed the sale of American Beacon Advisors,
raised $300 million from the sale of new equity, drew our revolver and we
raised aircraft financing of over $500 million. Furthermore we have arranged
financing for 20 of our 737-800 deliveries for next year, which combined with
the recently-announced backstop facility will cover most of our 2009 and 2010
deliveries. Furthermore, through our efforts to repair our balance sheet over
the last few years we’ve created additional financial flexibility, and even
after these financings we still have unencumbered assets and other sources of
liquidity that we valued at over $3.5 billion.

In the third quarter our scheduled principal payments on long-term debt and
capital leases totaled approximately $500 million and our capital expenditures
totaled about $200 million. On the pension front we have contributed $78
million to our defined benefit pension plan this year and we have reached our
minimum required funding obligation for the year.

Our total debt defined in the earnings release is now $15.4 billion. Our net
debt defined as total debt less unrestricted cash and short-term investments
is now $10.7 billion. This represents a $450 million reduction in net debt
versus the same time last year.

Shifting to guidance, it would be an understatement to say the industry is
facing big hurdles over the coming quarters. There is great uncertainty about
the direction of the economy and the volatility and price of fuel remains a
concern, both of which can significantly impact our business. With the
weakening global economy we have seen softening demand with fourth quarter
booked load factor about two points lower versus last year with domestic down
about a point and international down about 4.5 points.

Throughout the year we’ve discussed that the supply/demand imbalance in the
industry was hindering our ability to pass along our costs to the customer. In
May we took action by announcing our fourth quarter capacity reductions for
the main line system of 7% to 8% and domestic capacity to be reduced by
approximately 11% to 12% versus the prior year along with proportional
regional flying reductions. The industry followed, and as you can tell from
our booked load factor statistics these reductions are taking affect not a
moment too soon.

In the fourth quarter we expect main line capacity to decrease 8.3% year-over-
year with domestic down 12.5% and international down 0.6%. On a consolidated
basis for the fourth quarter capacity will be down 8.4% versus last year.

With the exception of 9/11, reductions of this magnitude are unprecedented in
our industries history, but given the economic environment we have revised our
2009 capacity plan modestly downward. Using full year 2007 as a baseline we
expect full year 2009 main line system capacity to be down over 9% with
domestic down about 14% and international about flat.

Let me add that we’ve been quick to act in the past when we felt that
additional reductions were needed, and to that end we’ll be keeping a close
eye on the revenue environment and fuel prices.

Turning to fuel, on a consolidated basis we forecast fuel prices to remain
high with fourth quarter fuel price of $2.76 and a full-year price of $3.07
based on the October 6 forward curve. In regard to hedging, we have 38% of
fourth quarter consumption capped at an average price of $116 per barrel or
$3.33 per gallon and a full-year hedge of about 37% of consumption capped at
an average price of $91 per barrel or $2.78 a gallon.

We are beginning the budgeting process for next year and will have estimates
of next year’s unit costs to share on the next call, but over the next few
quarters we expect to face unit cost pressure from reduced capacity. That said
we anticipate 2008 full year main line ex-fuel unit costs to increase by about
4.9% and consolidated to increase by 5.2%. In the fourth quarter we expect our
ex-fuel main line unit costs to increase 7.7% year-over-year and consolidated
unit costs to increase 7.8%.

Moving to the cash forecast, our scheduled principal payments from debt and
capital leases are expected to equal about $1 billion for the full year. Year-
to-date we’ve paid about $900 million of that.

We’ve been diligent in monitoring our non-aircraft capital spending, and in
the third quarter we entered into a pre-delivery payment financing
arrangement. That will reduce our expected full-year PDPs for 737 aircraft to
approximately $400 million or $200 million below our prior guidance. In total
we expect full-year 2008 capital expenditures to be approximately $850
million. So we’re taking a measured approach to our capital with our aim being
to make sound investments in our business that will keep AMR competitive for
the long term.

While we’re on the subject of capital, I want to provide an update on our
fleet replacement program. On the narrow body front we announced in the third
quarter we are accelerating our fleet replacement program and we’ve now
committed to take 76 737-800 aircraft over 2009 and 2010 to replace our
MD-80s. Given the cost efficiency of the 737-800 versus the MD-80, this makes
a lot of sense particularly in this volatile fuel environment. We’re going to
continue to look for opportunities to move even faster.

In terms of our wide body fleet, I think many of you know that we’ve been
giving this a lot of thought. As Gerard mentioned and you’ve seen in our press
release this morning, through our long-term purchase agreement with Boeing we
intend to acquire an additional 42 787-9 aircraft scheduled for delivery
beginning in 2012 through 2018 with the right to purchase up to 58 additional
787s which may be scheduled for delivery between 2015 through 2020. This
agreement illustrates how we remain focused on the future even as we battle
through the present.

This state-of-the-art aircraft will offer many cost and environmental
benefits, particularly fuel efficiency and customer friendly attributes and
comforts. We expect that the 787 will be an important part of our wide body
replacement plan and also help to support the international growth that we
expect down the road from our closer relationship with BA and Iberia.

While the agreement contains a provision that allows us to forego purchases of
some or all of the 42 aircraft if we haven’t reached a satisfactory agreement
with our pilots union to operate, we remain confident that we’ll be able to
move forward with our 787 purchase plans that we firmly believe are in the
best interest of all of our stakeholders.

To conclude, while fuel prices have used off their incredible heights in early
July, the volatility remains and uncertainties around the global economy are
certainly top of mind. This said we are working diligently to right-size the
airline, opportunistically bolster liquidity, increase revenues through fares
and fees, and reduce costs wherever possible. These are the right things to do
for our company to better help us deal with the challenges ahead.

With that, Gerard and I would be happy to take your questions.

","**Question-and-Answer Session**

**Operator**

(Operator Instructions) Our first question comes from Jamie Baker - J.P.
Morgan.

**Jamie Baker - J.P. Morgan**

Gerard, having joined in 1982 you’ve been in the industry through two
recessions and obviously one terrorist attack. I think that’s a bit more
industry experience than some of your peers. Given the current size and shape
of AMR and the industry and given the spot jet [carol] price in the $230
range, have you ever witnessed a demand environment that you couldn’t handle
at today’s fundamentals? Because quite frankly I’m struggling and I think
others are as well to come up with a plausible scenario where you don’t make
money next year unless the economy does something meaningfully worse by
several orders of magnitude than anything that’s ever happened.

**Gerard J. Arpey**

You’ve been around a long time as well so you’ve seen many cycles. I do think
that we’re sitting here compared to where we were in July with oil at $147 a
barrel and the crack spread then I can’t remember what it was, but the
leverage in that oil number is obviously very significant and it has obviously
moved significantly in our direction since mid-summer. But oil is still, and
again it’s moving every day, but it’s still up a little bit from where it was
a year ago and it’s very volatile.

I think we can’t necessarily depend on oil one way or the other, and we’ve
been I think for many years focused on the fact that we were going to get in
difficult times again whether that was going to be the economy, whether it was
going to be the oil or God-forbid something else that would put the industry
in some difficulty. So we have been building our cash reserves, paying down
debt and preparing for difficult times.

We’ve certainly had them this year and I think the wild card which you
highlighted is the economy, and this industry is highly correlated, traffic is
highly correlated to GDP. That’s going to be the wild card along with oil for
next year. I don’t think anybody really knows what the fallout is going to be
from all of this financial turmoil but I do think the capacity reductions that
we decided on early this year are coming just in time and we’ve got lots of
degrees of freedom to work next year if GDP really significantly goes in the
wrong direction or if oil likewise goes in the wrong direction.

I think we have been and continue to do everything we can to prepare for very,
very difficult times in the near term while at the same time recognizing that
we’re running the business for the long term and we are trying to do the right
things for our shareholders for the very long term. That’s what the aircraft
replacement program and the 787 decision is all about. I’m not specifically
answering your question but I think I’m giving you fuel for how I look at it.

**Jamie Baker - J.P. Morgan**

You came pretty close. I didn’t think you were going to let me paint you into
a corner there, but that brings me to a follow up though. Tom, Mark and I were
wondering if there’s any more color you could give us on the financings, what
parties were involved in the sale leasebacks and whether it’s Boeing that’s
the backstop provider?

**Thomas W. Horton**

Unfortunately, given the confidentiality provisions of those contracts I can’t
disclose that. But those were significant moves forward in financing. We’ve
obviously accelerated our fleet replacement plan which we feel pretty good
about and in the last month we’ve also secured most of the financing with
respect to that. The backstop deal covers 2/3 of the 76 airplanes, now we’ve
got permanent financing for 20 of those, so the way to think about that is
almost all of those airplanes are now financed one way or the other. In this
market I think that’s good. We’ve got more work to do but I think we’re in a
pretty good spot right now.

**Gerard J. Arpey**

If I could just add something to that, I would again credit a lot of good work
by our treasury team and a lot of my colleagues in the finance organization.
But the point I’d like to add to is that I do think that I have been saying
and my team has been saying for a long time that it should matter to the
capital markets who pays you back and who doesn’t. As you know we have paid
folks who have lent us money over many, many years; we’ve paid them back and
I’d like to think that does matter and is mattering right now.

**Jamie Baker - J.P. Morgan**

Gerard, just one final question. Now that you’ve got 787s on order if I’m not
mistaken, that plane has to be painted which is a concept you are somewhat
unfamiliar with. Have you chosen a color?

**Gerard J. Arpey**

I’m sure our engineering staff is wrestling with that very [inaudible]. That’s
one I’m not terribly troubled with right now.

**Jamie Baker - J.P. Morgan**

Not a top priority, I realize that. We’ve just been waiting for the 787 order
for a while.

**Thomas W. Horton**

You know Gerard’s a Texas Longhorn so he’s been looking at burnt orange.

**Operator**

Our next question comes from Bob McAdoo - Avondale Partners, LLC.

**Bob McAdoo - Avondale Partners, LLC**

You talked about booked load factor but didn’t give us any sense about what
yields are looking like in the upcoming period, and are new bookings
continuing to flow in at normal rates or do we see any kind of degradation
here in the last few weeks?

**Thomas W. Horton**

We generally don’t comment forward on yields but I think the way to think
about that is we’ve got a little bit of a mixed bag here. We’ve got unit
revenues which have really been quite strong, up almost 11% in the most recent
quarter, but if you look at the third quarter traffic is off around 5%. So
going into the fourth quarter we have got capacity down much more. It’s down
8.3% for the system and a booked load factor that’s down a couple of points.

So all of that implies that traffic in the fourth quarter is going to be a
fair bit weaker than it was in the third quarter but fortunately we’ve got the
meaningful capacity reduction in place. That seems to have had the predicted
affect on unit revenues. I think we’re just going to have to wait and see.

**Bob McAdoo - Avondale Partners, LLC**

That leads us where I was hoping it would go. The way the prepared remarks
were, it wasn’t clear whether you were trying to paint a darker story than
maybe we’ve seen here in the most recent quarter where obviously squeezing
capacity does in fact drive the RASM up.

The other thing is, can you give us any clue as to what you’ve done so far in
hedging out into 2009? Do you have anything out there that would drive your
costs higher than what spot prices might imply in terms of fuel going forward?

**Thomas W. Horton**

As you know we’ve tried to take a very disciplined and systematic approach to
fuel hedging. So we haven’t reacted strongly one way or the other as oil
prices have moved, and I think that’s served us pretty well. For this year our
hedges have saved us over $500 million and that’s worked out reasonably well.
As you look out into ’09 we do have today about 20% of our consumption hedged.
The cap on that is about $109 a barrel. That’s what we’ve got going out into
next year. It does have a floor; some of it has a floor around in the $80 a
barrel range.

**Bob McAdoo - Avondale Partners, LLC**

If we were lucky enough to or at least got rid of the volatility and stayed at
$80 a barrel throughout, you wouldn’t necessarily be paying a penalty on that
20%. Is that what that says?

**Thomas W. Horton**

That’s right.

**Operator**

Our next question comes from William Greene - Morgan Stanley.

**William Greene - Morgan Stanley**

Gerard, I’m wondering if you can talk a little bit more about this order on
the 787s. It’s pretty big and I realize that it’s quite flexible, but am I
right in assuming you either have tremendous flexibility or an incredibly good
price because it’s not clear to me why at current return levels you’d even
want to look at investing? I realize this is way out in the future but even so
we’re talking about at least the next 12 months being rather uncertain. How
should I think about what you’re trying to do here?

**Gerard J. Arpey**

I think that’s a fair question on the basis of certainly our current earnings
and the past several years although we did manage to get ourselves profitable
in ’06 and ’07 but as you point out, not very profitable.

The way to think about this order is it positions us to begin to replace our
767s as they reach their maturity level and the economics of that airplane
against an old 767 are going to be very favorable. The 42 airplanes in the
context of the entire wide body fleet that we have, which of course includes
the 34 A300s that’ll be out of the fleet by the end of next year and then
150+/- 767s, we’ve got lots of room there for replacement economics and then
the options position us for growth that we anticipate if we/when we, however
best to say it, get into more calm waters.

I thought for many, many years that once this industry reaches some sort of
supply/demand equilibrium so it can price its product in a way that we can get
sensible returns for our shareholders, once we’re at that point there’s no
reason why our company shouldn’t be able to grow with GDP here in the US and
around the world.

If you couple that with the AA/BA/Iberia immunity application which just puts
us on a level playing field with Star and SkyTeam, we should have some growth
opportunities there. That’s a long way out and we’ve got a lot of flexibility
to decide whether these airplanes are replacement or growth. That’s the way
I’d describe it.

**William Greene - Morgan Stanley**

Maybe I can turn it now as well to CASM. If we look at your CASM guidance for
the fourth quarter here, it’s going to go up a fair amount which seems like
you’ve had maybe less success recently taking out some of the structural
costs, maybe just more on the variable side versus some of the competitors.
I’m just wondering if you can talk a little bit about are there any other
options you have here to remove costs permanently or is a lot of what we’re
going to see here based on the capacity cuts going to lead to pretty big CASM
growth ex-fuel?

**Thomas W. Horton**

I think what you’re seeing is as you pull out capacity it takes a little while
to get some of the fixed costs out. That is reflected in our fourth quarter
cost numbers.

Specifically we’ve got capacity down pretty significantly but at the same time
we have maintenance and repairs costs going up as our fleet has aged a bit and
as we continue to work on our dependability. Those are things that will begin
to abate as we start moving the fleet age in the other direction, but we’re
seeing that for now.

We’re also seeing as we pull down capacity and the rest of the industry pulls
down capacity, these facilities costs at airports don’t go away. They just get
spread over a smaller base so that tends to have an unfortunate affect on unit
costs.

The last thing, in the most recent quarter was pretty significant foreign
exchange impacts as foreign currencies were moving around on us.

I think the important point is it’s going to take us a while to get the fixed
costs more in line with the size of the company, and we’re going to be very
focused on that as we roll into the ’09 planning process. We’ll have some more
to say about that on the next conference call.

**William Greene - Morgan Stanley**

Debt payments and pension in ’09? Do you have those handy what they will be?

**Thomas W. Horton**

In ’09 our total debt maturities are $1.5 billion. That includes the $300
million roughly convert. We don’t have any required pension contribution for
’09.

**Operator**

Our next question comes from Michael Linenberg - Merrill Lynch.

**Michael Linenberg - Merrill Lynch**

Maybe this is a bit of a nit to Tom, but when you put out your 8K in the
middle of September I think you were forecasting a cash balance of $4.9
billion at the end of the quarter and you came in at $5.1 billion. I’m
curious. The $200 million swing, was that something your end of quarter maybe
financing or one of the deals tied to the aircraft?

**Thomas W. Horton**

A little bit bigger than expected seasonality associated with the air traffic
liability but nothing material other than that.

**Michael Linenberg - Merrill Lynch**

When the DOT, I think it was last week when they put out the August consumer
report we saw that on-time was the best in five years. I think the rivals were
up 6% points and I think they indicated it wasn’t really weather but it was
supply was coming out. August was down but September’s going to be down a lot.
Obviously there are a lot of cost headwinds. Tom, you just ran through them.
When we start thinking about the size of your operation and the block hour
times and the schedule, is there an opportunity as maybe delays in congestion
come down that you can reduce block and as you know there’s obviously
significant cost savings on that? What are your thoughts or where you are on
that?

**Gerard J. Arpey**

That’s a good question. We, American, have not been happy with or satisfied
with our dependability this year and there are a lot of reasons why we haven’t
performed up to the standards we hold ourselves to. Some of those within our
control and some outside of our control.

One of the biggest ones outside our control is the fact that with the high
degree of concentration of operations that we have at O’Hare and in the
Northeast, we’re subject to something like 30% to 35% more ATC ground hold
activity on average than any other airline in the US. That’s just because of
the percentage of flights we have in those locations. We kind of start every
month knowing we’re going to be in the hole because of that.

Certainly over the years we have worked really hard to push the utilization of
our airplanes to extract block time, to extract ground time and some of those
initiatives as our fleet has aged have not synced up as well as we would like.

So we’re having to reinvest some ground time and some block time into our
network in order to offset some of the ATC environment, some of the
reliability issues we’re dealing with as our fleet ages, and hopefully we will
pick up the benefit that you highlighted, which is with the reduction in
overall flying in the country it will take some pressure off the air traffic
control system which today certainly in the Northeast and in Chicago is
absolutely overscheduled. It cannot handle the scheduled operation. We can’t
operate reliably in New York on a good weather day given the amount of flights
that are today scheduled.

I don’t anticipate a lot of relief in New York but we may get some relief
across the country.

One more thing I would add is everybody focuses a lot on the A+14 rank in this
industry and certainly we pay attention to it, but one of the things the
industry does and certainly we’re a part of that is add block time in order to
improve your relative performance in your A+14 rank. You can be number one
pretty easily in A+14 if you accomplish it through block time but that is very
expensive.

We have been reluctant this year up until the fall when we felt like we had
some more degrees of freedom financially to add block for our flights and add
ground time. But we did those primarily to react to things we had done over
the past few years and give our line maintenance folks more touch time on the
airplanes for reliability reasons. We’re trying not to play the A+14 rank game
by spending a lot of money adding block time because as you know we pay the
greater of scheduled versus actual on block as do many of the other airlines.

But I think if you do some comparative block analyses, you’ll see that there’s
been a lot of block added in the industry which contributes to some of the
rankings you’re seeing.

I apologize for the long-winded answer but that’s the way I see the landscape.

**Michael Linenberg - Merrill Lynch**

Just one quick follow up because you did bring up O’Hare and capacity. When
the additional runway comes on, will that help you? I’m just trying to figure
out where that capacity comes from and maybe it’s new entrants, or do we have
some unintended consequences where you get more capacity in Chicago?

**Gerard J. Arpey**

Sure the new runway is going to help but I believe what we should be doing is
lowering the capacity levels at these congested airports until we get the
capacity levels to the point where we can run reliably. Then when we get them
there, then we can start talking about how we increase capacity at these
airports but do it in a way where we don’t take it out on our customers.

The notion that airlines over-schedule is a confusing and sort of fallacious
discussion or argument because we schedule the airplanes when people want to
go. That’s why there are lots of flights at 5:00 out of LaGuardia. It’s not
because we’re trying to jam the ATC system. That’s when people want to leave
New York or go to New York.

That’s why when we cut our schedule earlier this year, we cut significantly
LaGuardia; we said very publicly to the DOT and the FAA, “Here are some slots
at LaGuardia. You should vanquish these slots, draw capacity down, use these
as a first cut, draw it even further down and we suspect other airlines that
have capacity at LaGuardia may or may not participate. We can’t talk to them.”
But thus far the FAA and DOT have not taken us up on that so we ended up
adding back flights into LaGuardia. We’ve kept our capacity cut the same so we
took the flying out elsewhere but we put the flying back into LaGuardia to
protect a lot of our slots.

We’re not making much progress on my world view as to what we ought to do with
capacity but I think until you can get more volume in the system, you ought to
just reduce it until we can figure out how to build more runways, create more
ATC and let people travel reliably. We’ll keep sending that message and see
what happens.

**Michael Linenberg - Merrill Lynch**

As a road warrior I’m in full agreement of what you said.

**Operator**

Our next question comes from Gary Chase - Barclays Capital.

**Gary Chase - Barclays Capital**

I wondered Tom if you could give us a little context. You talk about the
booked load factor comparisons in the fourth quarter. I think we’ve heard that
booked loads have actually been running up or people have been booking in
advance from if not American, others during the year. How does that experience
that you described compare to where you’ve been in prior quarters this year,
and do you think there’s some read that we ought to get on what’s happening as
a result of that?

**Thomas W. Horton**

I don’t know that we have enough insight on that to be able to give you a good
answer as to whether the booking pattern is changing as we roll into the
fourth quarter.

We have seen a little bit lower corporate travel. That’s down a few percent in
the month of September, though it’s down less than it was in August. We saw a
pretty good down-draft in corporate travel in August. It’s really a little too
early for us to have a good look at that because it tends to be late bookings.
I guess the point is a little bit of a mixed bag over the last couple of
months on that front.

We have seen that with the turmoil in the financial markets the demand out of
New York is softening more than other parts of our domestic system. So as we
look at our advanced book load factors out of New York, it’s weaker than the
rest of the system.

I’m not sure if that answers your question directly. It’s too early to tell
but clearly some weakness in corporate travel and certainly what you would
expect to see given the headlines.

**Gary Chase - Barclays Capital**

I think when you said not a moment too soon, I was wondering if you were
trying to telegraph that it was not a mixed bag and something a bit more
negative.

**Thomas W. Horton**

No. I just think given the traffic reduction that we saw in the third quarter
and is implied for the fourth quarter, it’s awfully good that we got in front
of the capacity.

**Gary Chase - Barclays Capital**

Shifting gears entirely, as you look at the aircraft replacement decisions
that you’ve been making, I’m thinking particularly on the narrow body side,
obviously the calculus there is very sensitive to fuel prices and I understand
your point that it’s volatile and they could be back north of $100 shortly.
But at current levels, would that change the thought process on how compelling
those replacement decisions are?

**Gerard J. Arpey**

I don’t think it would because I think the other variable you’re trying to
manage is the overall age of your fleet; not that you’re concerned necessarily
about age but you are concerned about maintenance costs and reliability as the
fleet ages. When you have a fleet as large as ours, you’ve got to stay at that
every year or you can get behind the curve. Certainly we’ve had hatches
battened down here for many years as we have navigated our way through some
tough times. I think irrespective of fuel prices, we’re doing the sensible
thing on the narrow body fleet side given the size of our narrow body fleet. I
think the same goes for the wide body fleet.

**Operator**

Our next question comes from Hunter Keay - Stifel Nicolaus & Company.

**Hunter Keay - Stifel Nicolaus & Company**

On pension you said you had no minimum required contributions next year. How
has the funding status been impacted by the recent conditions in the market?

**Thomas W. Horton**

We formally update that analysis at the end of each year, so we don’t have the
formal answer. But you can surmise from what’s happened in the markets that
the funding status is down considerably from where it was at the end of last
year. We’ve been working real hard to improve our pension funding status
through funding and through returns that have exceeded our peer group. By the
end of last year we were up to about 96% funded status. It’s down from there
but moving day-by-day, moving today in fact.

**Hunter Keay - Stifel Nicolaus & Company**

So the declines wouldn’t necessarily impact the potential cash obligation that
you would have next year if you do readdress at year end?

**Thomas W. Horton**

Right. Not for 2009.

**Hunter Keay - Stifel Nicolaus & Company**

On the financing I know your hands are tied with regard to confidentiality,
but as you look at the sale leaseback and the backstop financing, can you at
least maybe give us an indication if this is from maybe a new provider of
financing or is this from an organization that you guys have used before in
previous transactions? Any color there at all?

**Thomas W. Horton**

I can’t really give you any color unfortunately because we’ve got to comply
with the confidentiality provisions. I will say it’s really important to have
that financing in place in an environment like this and I credit [Bev Goulet]
and our entire treasury team for doing a great job of getting out in front of
this and being really aggressive about getting the financing lined up for the
fleet replacement, which is something that’s going to be really good for our
company going forward.

**Operator**

Our next question comes from Kevin Crissey - UBS.

**Kevin Crissey - UBS**

Fx impact in terms of RASM this quarter and maybe on a go-forward business at
current exchange rate?

**Thomas W. Horton**

Let’s see if I have that handy here somewhere. There was an impact. It was
about two points of our third quarter transatlantic RASM improvement. About
two points of it was driven by fx.

**Kevin Crissey - UBS**

What about your ability to cut more international capacity? What is your
ability there?

**Thomas W. Horton**

We have an ability to do so if we choose to go down that track. I think we’re
going to have to watch the international environment very carefully. In recent
quarters it’s been quite strong but I think we all know that the international
part of our business and the airline business, transatlantic in particular,
tends to be more cyclical than the rest of our business.

As the global economies get softer, we’re going to have to keep a real close
eye on what happens with that part of the business. As you saw from our booked
load factor numbers, our advance bookings internationally are a little softer
than they are for the system. I think you’ve seen some of the other airlines
have added a lot of capacity across the Atlantic over the past few years and I
think it remains to be seen whether there’s perhaps a little more capacity
than we need right now.

**Kevin Crissey - UBS**

In your prepared remarks you were talking about the difference in capacity
international was flat to slightly down I thought was your overall number.
What are you going to do? Park those aircraft? Just go from five flights to
four flights? How would that work? It seems to me you have less flexibility on
the international front given the long stage length and the size of the
aircraft and so forth. How might that work?

**Thomas W. Horton**

It’s too early to say but if we chose to pull back on international capacity,
there are lots of different ways to do it. You could fly fewer frequencies;
you could pull some of the flying back into the domestic long-haul system.
It’s also important to remember that we’ve got the Airbus A300 aircraft
retiring in 2009 so that’s a meaningful chunk of wide body capacity that’s
going to be coming out and some of that will be backfilled with 767s.

**Kevin Crissey - UBS**

How did you get the 787 slots so early? Was it your relationship or was it
that someone canceled?

**Thomas W. Horton**

We’ve been saying for a long time that by virtue of our long-term agreement
with Boeing we have access to the 787s. This is just manifestation of what
we’ve been saying.

**Operator**

Our next question comes from [Bill Mastora - Broad Point Capital].

**[Bill Mastora - Broad Point Capital]**

Tom, my question is for you. The aircraft that you’re going to take out of
your system next year besides the A300s, are those all unencumbered or would
they have debt attached to it that might suggest a future additional charge?

**Thomas W. Horton**

It’s a mixed bag. I don’t know that there’s anything that would drive an
additional charge. Some airplanes are leased. Other than what we put in the
press release about the A300s as we retire those, but other than that I’m not
aware of anything that would drive an additional charge.

**[Bill Mastora - Broad Point Capital]**

Do you have the flexibility if general economic conditions get worse to
further ground other unencumbered aircraft? I’m assuming these would all be
MD-80s. Correct me if I’m wrong here.

**Thomas W. Horton**

We have considerable flexibility and yes, the MD-80 would be the most likely
candidate.

**[Bill Mastora - Broad Point Capital]**

Are there any other aircraft that would be candidates? I’m just curious.

**Thomas W. Horton**

No plans at this time.

**Gerard J. Arpey**

The only thing I might add there is the economics of the 737-800 potentially
the 900 traded against the 757. I think it’s something we’re going to want to
be looking at very carefully in the next couple of years because we’re looking
at some stiff increases in stuff that would be a rounding error to you guys in
terms of your modeling, but something that we’re paying attention to related
to the costs on the rolls powered 757. So we’re going to be looking at those
757s in comparison to a new 737-800, possibly 900 and trying to decide whether
there’s a better trade-off there for us going forward.

**[Bill Mastora - Broad Point Capital]**

So it is safe to say, and this is just for capacity through the end of next
year, that really all of these are unencumbered aircraft. Did I state that
correctly Tom?

**Gerard J. Arpey**

What are you defining as these?

**[Bill Mastora - Broad Point Capital]**

On capacity reduction. Aircraft that is being put on the ground. In other
words there’s no associated let’s say ETC or EETC that might be impacted is
really what I’m getting at.

**Thomas W. Horton**

No, I don’t believe so. I think you’re materially correct.

**Operator**

Ladies and Gentlemen, members of the analyst and financial community, that
does conclude your question and answer session for today.

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34,100111-datalink-corporation-q3-2008-earnings-call-transcript.html,Datalink Corporation,DTLK,technology,2008.0,,regular,"October 15, 2008",5:00 pm,2008-10-15T21:00:00.000Z,23443,11952,11491,3,3,"['Charles B. Westling - President, Chief Executive Officer and Director', 'Gregory T. Barnum - Vice President, Finance and Chief Financial Officer', 'Scott Robinson - Chief Technology Officer']","['Glenn Hanus - Needham', 'Clinton Morrison - Feltl', 'Aaron Rakers - Wachovia']","**Operator**

Welcome to the Datalink third quarter analyst conference call. (Operator
Instructions) Mr. Westling, I’d like to turn the call over to you.

**Charles Westling**

With me today are Greg Barnum, our Vice President of Finance and Chief
Financial Officer, and Scott Robinson, our Chief Technology Officer. Let me
first turn the call over to Greg to discuss the third quarter results and then
I will provide some additional perspectives on Q3 and our outlook for the
fourth quarter.

**Gregory Barnum**

Before we start, let me first cover the Safe Harbor on forward-looking
statements. The Private Securities Litigation Reform Act of 1995 provides a
Safe Harbor for certain forward-looking statements. In this conference call,
we will be discussing our views regarding future events and financial
performance. These forward-looking statements are subject to certain risks and
uncertainties. Actual future results and trends may differ materially from
historical result or those anticipated, depending upon a variety of factors.
Please refer to Datalink’s filings with the SEC for a full discussion of our
company’s risk factors.

Also let me remind everyone that the third quarter and nine months of 2008
include three months and nine months of the results of operations of MCSI,
which we acquired on January 31, 2007. The 2007 third quarter and nine month
results include three and eight months of MCSI.

For the quarter, on a GAAP basis, third quarter revenues were $50 million
dollars, which is up 9% from revenues of $45.8 million in the third quarter of
2007 and up slightly from $49.7 million in the second quarter of 2008.

Revenues for the nine months ended September 30, 2008 were $147.4 million
compared to $127.1 million for the prior year period, which represents a 16%
increase.

For the third quarter, our overall gross margin was 27.5% compared to 25.9% in
the third quarter of 2007.

Our product gross margins for the third quarter was 25.7% compared to 24.2% in
the third quarter of 2007. The increase in product gross margin in the third
quarter was due to the continuing effort by our sales force to sell higher
margin storage solutions.

Service gross margins in the third quarter of 2008 were 30% compared to 28.38%
in Q3 of 2007. On a year-over-year basis, service gross margins increased by
170 basis points, due primarily to the sale of more profitable services to
customers that came over with the MSCI acquisition and to an increase in
Datalink delivered professional services. On a sequential basis, service gross
margins increased 70 basis points, due again to a higher percentage of
Datalink delivered professional services.

Going forward, we expect service margins to be in the range of 28% to 30% and
we expect overall gross margins to be in the range of 26% to 27%.

For the quarter, we saw revenues consisting of 38% disc, 9% tape, 8% software,
3% storage networking, and 42% services, which is consistent what we saw in
the third quarter of 2007.

Third quarter GAAP were approximately $1.1 million or $0.08 per diluted share,
which compares to net earnings of $844,000 or $0.07 per share in the third
quarter of 2007.

GAAP net earnings for the first nine months of 2008 were $2.6 million or $0.20
per share, which compares to a net loss of $221,000 or $0.02 per share in the
first nine months of 2007.

On a non-GAAP basis, net earnings for the third quarter of 2008 were $1.3
million or $0.11 per share, compared to a non-GAAP net earnings of $1.1
million or $0.09 per share in the third quarter of 2007. The non-GAAP net
earnings for the first nine months of 2008 were $3.4 million or $0.27 per
share, which compares to non-GAAP net earnings of $898,000 or $0.07 per share
in the first nine months of 2007.

The non-GAAP results we refer to for the third quarter of 2008 are adjusted
for the following items. $35,000 relating to the adjustment to the MCSI
deferred revenue liability, which is required by purchase accounting, $251,000
relating to stock-based compensation charges, $178,000 relating to the
amortization of backlog and customer relationship intangibles, and $190,000
income tax expense adjustment relating to the above non-GAAP adjustments.

Turning to the balance sheet, our cash and investment balance at the end of
September was $25.7 million, which down from $28 million at the end of the
second quarter. The decrease in cash is primarily due to the timing of cash
receipts during the quarter. In fact, we received two large payments totaling
$2 million dollars in the first two days of October that were due in September
and we also have another $1.5 million dollar payment that’s on its way as we
speak.

For the quarter, we used $2.1 million of cash from operations, which is mainly
due to the timing of collections mentioned above. Our DSO at the end of the Q3
decreased to 31 days from 32 days at the beginning of the quarter.

So now with that as a background, let me now turn the call back over to
Charlie.

**Charles Westling**

Reflecting on Q3, overall we delivered a strong quarter and I am very pleased
that we continue profitably grow our business in this very challenging
environment. The team is executing well. We are taking market share in many
accounts and I believe we are well positioned to weather the current and
longer term challenges that many of our customers are facing, indeed we all
are facing, in this world of economic uncertainty, tremendous market
volatility, and credit and capital constraints.

As I look back on the third quarter and year-to-date results, I think it is
important to highlight the fact that are team has delivered a revenue increase
of more than $20 million dollars for the first nine months of the year, which
represents an increase of 16% from the prior year period. More importantly,
however, we’ve improved our non-GAAP operating income by over 500%, from
$875,000 in the first nine months of 2007 to over $5.3 million dollars in the
first nine months of this year.

Here is my list of the top five reasons why we continue to do well in this
environment. First, our customer support business continues to be a shining
star. Customer support revenues were at a record level in the third quarter
and had increased over 30% through the first three quarters of 2008.

We are increasingly winning with support as a point of entry into new accounts
and our customer satisfaction levels are consistently higher than industry
averages.

Our investment in customer support and the leadership changes that we have
made in this area over the past year continue to pay big dividends and further
differentiate us from others who resell storage products and technology.

In addition to providing us with more visibility and stickiness into our
customer storage environments, support allows us to deliver a more predictable
and profitable source of revenues as we manage the company for continued
growth.

Second, our sales and engineering teams in the field are doing a better job of
identifying, positioning, and delivering storage solutions that meet our
customer’s business needs. The increases that we continue to see in product
and services gross margins highlight the fact that our sales teams are doing a
better job of selling and delivering value. Another reflection of our
improving performance in this area is the more balanced mix of customers that
we are seeing in our results.

While we continue to grow our revenues, we do not have a single customer who
represents 5% of our total revenue so far this year. I expect that as we
finish out the year, 2008 will mark the first year in Datalink’s recent
history that we will not have a customer represent 5% or more of revenues.

Third, though our practice is focused in initiatives, we are successfully
transitioning more and more of our business into emerging areas in storage,
which add very compelling returns for our customers. These areas include data
de-duplication, systems and storage virtualization, and LAN optimization. It
is interesting to note that virtualization de-duplication, and LAN
optimization solutions as measured by revenues generated through our key
technology providers in these areas have increased almost three fold through
the first nine months of the year and represent an addition to customer
support, the bulk of our growth in year-over-year revenues.

Fourth, we continue to grow our business and invest more in customer facing
headcount while managing our corporate and back office resources and headcount
very effectively. Our teams in this part of the business are doing a very good
job of supporting the overall growth of the company and our customer base. Our
general and administrative expenses are up just 3.3% for the first nine months
of 2008, while our revenues have increased 16% during this period. The
combination of top line growth, improving gross profit margins, and solid G&A
expense management has led to the significant lift in our operating income so
far this year.

Fifth, as we are getting better at training and hiring our people, sharing
better practices, developing tools and capturing our knowledge and
intellectual property across our teams, we have been able to continue to
improve the overall productivity of our employees. We strive to be able to
generate at least $250,000 to $275,000 of annualized gross profit per employee
on average each quarter to allow us to cover our operating expenses and
deliver acceptable levels of profits to our shareholders.

We have been consistently in this range so far in each quarter of this year
and we saw this metric improve by 14% in Q308 versus Q307.

Let me now turn to our outlook for Q4. During the third quarter, we did start
to see the impact of tightening credit conditions for a few of our customers,
which resulted in delayed and in some instances scale down purchases.

In terms of backlog, we ended Q2 at $32 million versus $31 million at the end
of Q3. All things being equal, this would suggest flat to slightly lower
revenues for Q4 versus Q3. On the other hand, as we have gone back and
analyzed the seasonality impact of the fourth quarter over each of the past
five years, we have seen on average an increase in revenues from Q3 to Q4 of
approximately 10%. This would suggest revenues in the range of $55 million for
Q4.

As we continue to drill down into our customer base, sales pipeline, and key
opportunities for Q4, we see the majority of projects are expected to move
forward as planned this quarter.

We also see, in some cases, projects that have a significant risk of being
delayed or scaled back. A key swing factor, if the amount of yearend budget
plush activity that happens this quarter. At this point, it is too early to
tell how much activity and opportunity we will see in this regard.

As we assess all of these variables, we believe that we have an opportunity to
deliver another quarter of year-over-year growth and profitability in the
fourth quarter; however, not at the historical Q4 growth rates that we have
seen in the past. Specifically, we expect revenues for the fourth quarter to
be in the range of $49 to $53 million with fully diluted earnings per share of
$0.08 to $0.11 on a GAAP basis and $0.19 to $0.14 on a non-GAAP basis. As a
point of comparison, in the fourth quarter of 2007, we generated revenues of
$50.7 million and fully diluted earnings per share of $0.11 on a GAAP basis
and $0.13 on a non-GAAP basis.

In closing, I am confident that we are well positioned to continue to
profitably grow our business in these challenging times. We will continue to
manage our expenses smartly, making sure that we have the flexibility to run
the business effectively in the event that external market conditions
deteriorate further faster.

We will also take advantage of our relative strength in this difficult
environment by investing in more sales and engineering pallet in locations
where we can accelerate our market share.

I believe that our ability to execute on our key initiatives and continue to
deliver superior value for our customers, will enable us to be successful in
the near term and beyond.

Let’s now go to the Q&A portion of the call.

","**Question-and-Answer Session**

**Operator**

(Operator Instructions) Your first question comes from Glenn Hanus – Needham &
Company.

**Glenn Hanus – Needham & Company**

Charlie, can you take a stab and kind of roughly quantify how much of storage
spend is required versus optional? How would you break that up, what people
absolutely have to do and what are sort of more optional?

**Charles Westling**

That’s a tough question, Glen. I’ll take a shot at it and maybe Scott Robinson
can provide some perspective as well. I think that with the continued growth
of Data at 40-50-60% per year, which really is not swelling and the reality
that companies are not aggressively hiring IT staff, storage staff, at this
point, that the need for technology and the best technology to manage that gap
becomes clearer and clearer and more significant for our customers. I think
that to the extent that there are places or points within the storage
environment where the capacity simply has run out. We’re backed up, jobs are
starting to impede on production, data creation, and it starts to back up on
the business, there are situations where customers are having to invest in
more capacity. So some of that I would put in the category of really not
discretionary, it’s either invest and have the capacity or the business starts
to bottleneck itself and slow down. With the emerging technology de-
duplication, virtualization, those things that can allow for that capacity to
be more effectively utilized and better managed, I think that also is becoming
increasingly part of the required as opposed to discretionary part of the pie.
What is perhaps more discretionary right now are some of the technologies and
opportunities on the fringes outside the core of the data center, outside the
core of the environment. Those be even more compelling I think are getting
more and more scrutinized and in some cases tend to be areas where people will
push them off or decide not to invest going forward, especially in this
environment. So it’s a hard question to calibrate. I don’t know if it’s 90% of
what we’re seeing is really capacity utilization, just have got to manage the
data that continues to grow type of a spend and 10 to 15% is new or emerging
technology that might be more of a quantum leap into a newer environment or
newer world orders. Maybe I’ll have Scott provide some perspective on that as
well. Scott?

**Scott Robinson**

Hi Glen, this is Scott. What I would reiterate what Charlie said is that
capacity, even in an economic downturn, the capacity requirement continue to
march on unabated. So customers have to figure out how to do that, how to
handle that in some fashion. Now what you may see is incremental capacity
upgrades to existing infrastructure versus new infrastructure. So that just
remains to be seen. Although what Charlie talked about in our call is that we
are seeing growth in things like de-duplication. Things like storage for
virtual environments. At least up until now, the ROI for those kinds of
projects is compelling enough to drive customers to make significant changes
in their environments. So we think that those are pretty compelling and we’re
hopeful that we’ll be able to continue to drive that kind of new
infrastructure. If customers decide to try to extend their existing
infrastructure, what happens then is it drives a larger support opportunity,
because those support costs go up fairly dramatically once you get past the
warranty periods for storage infrastructure. So we’re looking to have
offerings to take that direction as well.

**Glenn Hanus – Needham & Company**

Can you give us a little more color around the credit impacts? Is that
primarily with a few of your smaller customers or where do you see that in
your customer base and how is that manifest itself as you go through a
purchase, a sales cycle?

**Charles Westling**

It’s hard to just paintbrush it, Glen. I guess we have seen it in a couple of
instances in some of the financial sector. In one instance, a fairly large
opportunity that had very compelling economics yet the CEO decided not to move
forward with the project. Having said that though, our finance and banking
exposure is not real significant to our business; it’s far less than 10%. So
that particular segment, we’re not overly dependent upon it. It goes back to
what I said before about balance. That would be a good term to use as it
relates to the industries that we service while it’s a pretty horizontal and
balanced industry mix that we have. So it’s hard to say it’s an industry or a
series of companies within an industry where we’re seeing credit crunch or
impact have a difference in their storage spending. It really is customer
specific and the other comment I’d make is that a large number of our
customers are very strong, strong balance sheets, very profitable, fortune
thousand type customers, that while people are certainly more scrutinizing and
cautious about how they’re spending CapEx, from just a financial strength of
the customer perspective, I think continue to be fairly well positioned to
weather the storm.

**Operator**

Your next question comes from Clinton Morrison – Feltl.

**Clinton Morrison – Feltl**

Can you comment a little bit on the channel. Obviously things are kind of
tight out there and thinking specifically about potential disc counts and as
part of looking at the end of the year, this budget flush, do we get the, you
know, your equipment suppliers giving you a little extra incentive so that
they can boost their bottom line too or what do we anticipate there?

**Charles Westling**

I think that we’ll likely see, Clint, an environment where people are going to
continue to be very aggressive, that they’re going to try to close as much of
business as they can in the end of the year. They’re going to try as much as
they can to take deals off the street. I don’t see that pattern of behavior
changing differently than other past fourth quarters. I think the variable is
what the customers will do on their side. I think it will be a very compelling
and attractive buying environment, but whether or not customers in this
environment will behave as they have over the last several years and spend to
budget and use excess or unspent budget to take advantage of some of those
economics. Like I said in my commentary, I think it’s a little bit early to
just broad brush or make any assumptions there.

**Clinton Morrison – Feltl**

I realize figuring out what your customer is going to do is tough. I was
looking for insight on your suppliers and it sounds like you believe they’re
going to be somewhat generous in trying to push equipment into the market.

**Charles Westling**

This is clearly an environment where people are pushing hard for market share.

**Clinton Morrison – Feltl**

So hopefully that translates into reasonably healthy margins. You feel
comfortable with your margins because of that environment.

**Charles Westling**

That will help us. We also on our side have to continue to sell the value and
wrap the services around the product so that we can achieve the kind of
margins that we’re achieving.

**Clinton Morrison – Feltl**

Mechanical, looks like you had a big jump in shares outstanding. Was there a
bunch of redemptions? You’ve been kind of flat for a number of quarter and all
the sudden a big jump. Any comment there?

**Charles Westling**

There were some restricted shares that we issued throughout the year that just
got issued on the books in the quarter, but no it wasn’t an issue, it was just
a catch-up entry more than an issuance during the quarter. Restricted shares
and stock options we granted earlier in the year.

**Operator**

Your next question comes from Aaron Rakers – Wachovia.

**Aaron Rakers – Wachovia**

A couple questions. The first question, to kind of seg-way off the prior one.
You’re kind of taking it a different way when you talk to customers in this
environment, would you say that they’re more open or less open to looking at
some of the new alternative technologies coming into the space. You know, be
it from new vendors, some of the newer smaller guys within the disc storage
market.

**Scott Robinson**

Aaron, this is Scott. I would say we have not seen any decline in the openness
of customers to look at some of this new technology. As Charlie said in our
comments, that’s driven a lot of our growth and up until this point, we’re not
seeing them pull back from looking at that technology. What I said earlier
too, I think it really rings true that some of these things are pretty
compelling where they’re talking about de-duplication, where they’re talking
about virtualization initiatives within customers. Customers are in the middle
of some of these initiatives. The ROI is fairly compelling and at this point
we have not seen customers pull back from those projects in a significant way
outside of selected financial services customers. So whether that starts to
happen, I can’t tell you, but so far we’ve seen pretty good activity.

**Aaron Rakers – Wachovia**

Right. I appreciate that, Scott. The other way I’m thinking about it is in
this environment if we go back in the prior downturn, was this an environment
where customers tend to retrench to kind of a main state, a bigger players
into the market, or would they be increasingly open to say a go equal logic or
a compellent or what have you in this space.

**Scott Robinson**

One of the key things that I think is different this time from the last time
is back in 2001, 2002, a lot of customers had upgraded their infrastructure
for Y2K. So they had just gone through a cycle of a lot of new infrastructure
and so they were better positioned to hunker down and do incremental upgrades
at that time. So we saw a bigger downturn then than I think we will see this
time, because customers have not made it. There’s not been a wave of major
upgrades over the last couple of years. It’s been more of a steady pace of
infrastructure upgrade. So I don’t think we’ll see that kind of a downturn,
but we’re being cautious about it.

**Aaron Rakers – Wachovia**

That’s helpful. When you look at the customer environments today, where do you
typically see your customers running out from the utilization perspective?

**Scott Robinson**

I don’t know if I’ve got a hard number for that, but I would say that we’re
seeing customers in that 50 to 70% utilization rate pretty typically.

**Aaron Rakers – Wachovia**

That’s a lot higher than what I would think. Final question, lots being said
about data de-duplication and you guys obviously benefiting from that. Just
your sense, what the competitive landscape is starting to look like there in
that market. Obviously Data Domain continues to be very well positioned, but
are you starting to see alternatives coming to the market and grab the
attention of some of your customers?

**Scott Robinson**

Yes, I think we’re starting to see some of the other players get more
established. I think Data Domain was out there early and they continue to be
one of the key players in that space, but absolutely, with our Quantum
relationship, Quantum, Sepaton, Net Technology. We’re seeing all of them get
some traction.

**Operator**

There are no more questions in the queue at this time.

**Charles Westling**

Thank you all for your interest in Datalink and for your participation on
today’s call. We look forward to updating you on our progress against our key
initiatives and our efforts to continually profit, profitably grow our
business our next conference call. Thanks everybody.

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36,100113-pacific-continental-corporation-q3-2008-earnings-call-transcript.html,Pacific Continental Corporation,PCBK,financial,2008.0,,regular,"October 15, 2008",2:00 pm,2008-10-15T18:00:00.000Z,32518,19795,12723,4,4,"['Hal M. Brown - Chief Executive Officer', 'Roger Busse - President, Chief Operating Officer', 'Michael Reynolds, Sr. - Chief Financial Officer', '[Casey Hogan] - Chief Credit Officer']","['Jeff Rulis - D.A. Davidson & Company', 'Kristin Hotti - Howe Barnes Hoefer & Arnett, Inc.', 'Tim Coffey - Fig Partners, LLC', 'Ross Haberman - Haberman Value Fund']","**Michael Reynolds, Sr.**

Welcome to Pacific Continental Corporation conference call webcast to discuss
our third quarter 2008 results. Presenting today will be Hal Brown Chief
Executive Officer, Roger Busse President and Chief Operating Officer and me.
We will update you on our recent activities and discuss the financial results
reported in our press release distributed after market close October 14, 2008.

At the conclusion of our prepared remarks we will provide analysts and
institutional investors with a question and answer opportunity. Where we’ll
address any questions and provide additional background information when
appropriate. During the Q&A session [Casey Hogan] Executive Vice President and
Chief Credit Officer will also be available to answer questions.

Today’s press release is available in the investors relation section of our
website at [_www.therightbank.com_](http://www.therightbank.com).

Before we commence the formal remarks we advise you that this webcast contains
forward looking statements. Statements made are factual as of the time of this
webcast. Such forward looking statements are subject to risk and uncertainties
that may cause actual results to different materially than those projected.

Pacific Continental Corporation undertakes no obligation to publically revise
or update the forward looking statements to reflect the events or
circumstances that arise after the date of the company’s third quarter 2008
earnings release referenced in this webcast and the date of this webcast.

Participants and listeners should also carefully review any risk factors
described in the company’s periodic reports on Forms 10-K, 10-Q, 8-K and any
other documents filed or furnished from time to time with the Securities and
Exchange Commission. This statement is included for the express purpose of
invoking the Safe Harbor Provisions.

Now let me turn and introduce, and turn the call over to Hal Brown, Chief
Executive Officer of Pacific Continental Corporation.

**Hal Brown**

Well you all know these are unprecedented times. And it is not necessary for
me to expound on all the issues facing the financial market. The events taking
place are way beyond the ability of our bank to influence. And instead we must
do what we can to maintain stability on a daily and weekly basis.

On a national and global perspective it is difficult not to be pessimistic.
Fortunately at least in the areas through which we can influence and have some
control, there is reason to be optimistic. Pacific Continental’s third quarter
results are again solid and without surprises.

Earnings remain steady with previous quarters. Our credit quality statistics
improved and we’re very much in line with our second quarter conference call
discussion. And we again experience good loan and deposit growth. Frankly,
these are pretty good results and I’m quite pleased with this performance and
the prospects for the future.

With respect to today’s conference call we will continue our practice of being
as transparent as possible. Obviously however, the current volatility makes
even near term forecasting nearly impossible. And so our comments today will
have far fewer forward looking comments.

Roger will discuss the condition of our loan portfolio and Mick will speak to
our liquidity status and give you his insights as to our interest rate margin.
I hope you also noted that we have expanded the financial details provided in
our press release which will eliminate some of the discussion we previously
provided in the conference call. We would welcome your comments regarding this
added material.

Before I ask Mick to continue let me address a few question and concerns that
have surfaced during the quarter. First, we had no equity exposure to either
Freddie Mac or Fannie Mae. We do have equity investments in the Federal Home
Loan Bank but only to the extent that they are required to fulfill our
borrowing obligations.

Our investment portfolio is free of all commercial paper or corporate notes
and after extensive evaluation we are comfortable with the credit quality of
our mortgage-backed and other investment securities.

Our unsecured overnight credit lines with our correspondent banks remain open
and available to us and we test them regularly. In the last few months we have
had collateral reviews by the Federal Reserve and the Federal Home Loan Bank
and received no material comments, again validating our underwriting
practices.

Finally there have been questions regarding the stability of our deposit base.
Our bank has been very proactive with our clients, answering questions and
discussing the strength of our balance sheet. There have been a few clients
who have reduced their deposit levels. But in total we have been the recipient
of deposit inflow as people look to make deposits in quality institutions.

So with that as a backdrop to the quarter I’ll ask Mick to continue our
discussion.

**Michael Reynolds, Sr.**

For my portion of the presentation I will be covering our net interest margin,
liquidity position, non-interest income and non-interest expense. I will be
making year-over-year comparisons and when appropriate I will discuss
comparisons on a linked quarter basis. Also when appropriate and as best
possible I will provide listeners and analysts with fourth quarter 2008
expectations.

In line with our projections in our second quarter 2008 conference call our
third quarter net interest margin of 5.08% was down 15 basis points from our
second quarter margin of 5.24%. The factors that contributed to the late
quarter decline in the bank's net interest margin in the third quarter were as
we discussed last quarter, and included the higher competitive market for core
deposits, the continued high cost of alternative funding sources, the
extension of the maturities structure of liabilities for the use of local time
deposit promotion and broker time deposits. And a core deposit promotion that
attracted money market deposit at an average rate of 3.3%.

While historically our guidance on the bank's future net interest margin has
been on target, as Hal mentioned in his opening remarks in light of the daily
volatility and diSr.uption in the financial markets. It is becoming
increasingly difficult to provide forward looking projections in some areas
and this includes the bank's margins.  

An illustration of the daily volatility we are seeing affecting the banks
margin would be in the area of our overnight and short-term borrowing. We
maintain secure borrowing relationships with both the FHLB at Seattle and the
Federal Reserve Bank of San Francisco, plus unsecured borrowing lines with six
correspondent banks.

During the last four weeks and on any given day, quoted daily overnight rates
from these sources have ranged between four tenths of one percent to as high
as 3.75%. This daily volatility along with many other factors have caused the
bank’s net interest margin to fluctuate in a wide range. As evidenced by the
monthly net interest margin recorded during the last three months, which
ranged from 4.94% to 5.27%.

Looking forward there are some factors suggesting some improvement in the
bank’s net interest margin in fourth quarter 2008 including the fact that with
the recent 50 basis point emergency reduction in market interest rates
approximately $233 million of the bank's variable rate loans again have active
floors.

In addition we are seeing loan pricing opportunities due to the lower level of
credit availability in our market as indicated by improved loan yields during
the month of September.

On the funding side, while we have experienced significant volatility in
overnight funding rates, to date our multiple sources of overnight funding
have allowed the bank to consistently use the lowest cost provider for short
term funding, which has in turn led to an average cost overnight borrowing at
approximately 1% in the past two to three weeks.

In addition the 100 basis point drop in the 91 day Treasury bill that has
lowered the rate on approximately $160 million of the bank's index money
market account. On the other hand, certain factors point to a flat and lower
fourth quarter margin when compared to third quarter.

First, all of the banks reached a core deposit promotion was concluded on
October 10th, 2009. The 3.09% promotional rate on approximately $60 million
money market deposits is effective through January 9, 2009.

Second, the extension of liability maturities during the late second quarter
and third quarter through our local time deposit promotion, while improving
the bank's liquidity position came at the expense of the banks margin.

Third, while we were able to lower rates on much of the bank’s core deposit
base with the recent 50 basis point decline in market interest rates, a
portion of the bank's core deposits were already as stated or virtual floors
thus not fully offsetting the effect of drop in yields on variable rate loans
not at floors.

Fourth, while to date the bank has been able to take advantage of volatility
in the short-term funding market to lower its cost of funds, there is no
guarantee such conditions will continue to exist during the entire fourth
quarter. I guess we do expect to continue to see a highly competitive market
for core deposits in terms of rates as many banks continue to face liquidity
issues.

And last, the 91 day Treasury bill rates which had a precipitous drop during
September 2009 during the flight to quality and should this key rate return to
normal level in the 1.3 to 1.5 range rates would increase on the bank's
indexed money market accounts.

It is virtually impossible to model all of the combinations, possible
combinations of variables to get an entirely clear picture of the direction of
the bank’s net interest margin. However if the bank continues to have
opportunities for better loan pricing, continues to have access to very low
cost overnight funding, similar to the past two to four weeks and the bank
experiences its typical seasonal increase in core deposits, then my outlook
would be for a somewhat improved net interest margin in the fourth quarter.

However in this rapidly and changing economic environment and with the
possibility of a number of factors that occur, that might negatively affect
the margin, including a further reduction in market interest rates, less
reliability should be placed on this outlook than in our past presentations.

Now I would like to discuss the bank's current liquidity position. During the
third quarter 2008 due to the strong growth in core deposits and an increase
in collateral pledge on the bank's secured borrowing lines, the bank's
liquidity position improved over the prior period.

As Hal mentioned we are seeing a net inflow of core deposits from businesses
and individuals seeking safety and soundness and we typically expect to see an
increase in our core deposit base during the fourth quarter.

The bank continues to have full access to a number of alternative funding
sources. Presently the bank has secured borrowing lines with the Federal Home
Loan Bank of Seattle, the Federal Reserve Bank of San Francisco, totaling
$299.3 million. The bank also had unsecured borrowing lines with six
correspondent banks totaling $118 million. The unsecured lines remain
unchanged and fully intact when compared to a year ago and are regularly
tested.

In addition Pacific Continental has full access to the brokerage CD market and
has had no issues in using this funding source. And as of September 30th 2008
the bank was using approximately $40.4 million in brokerage CDs for funding.

Continental Bank has approximately $34.5 million of short-term funding
available through the State of Oregon and Washington CD programs for community
banks. With these multiple alternative funding sources the bank has ample
access to liquidity and more important is able to manage the use of these
sources in a manner that maximizes the bank's net interest margin.

Turning to non-interest income, on a linked quarter basis non-interest income
was $1 million in the third quarter 2008, down approximately $116,000 from the
second quarter. On a year-over-year basis the bank continued to experience
solid increases in the account service charges on analyzed business accounts,
due the lower earnings credit on deposits and increased merchant bank card
fees due to both higher sales volumes and better margins.

Looking forward in the fourth quarter 2008, the bank expects non-interest
income will be similar to or up on third quarter as service charges on
analyzed accounts are expected to increase and due to an historical seasonal
increase in merchant bank card fees in the fourth quarter.

Last I will report on our non-interest expense. On a linked quarter basis non-
interest expense of $7.5 million in third quarter 2008 was virtually unchanged
from second quarter 2008. For the first nine months of the year non-interest
expense was $22.1 million and increased up $2.9 million or 15% over the same
period last year.

Personnel expense accounted for the majority of the increase, up $1.9 million
on a year-over-year basis. Increased salary expense and increased benefits and
taxes accounted for $1.3 million and $705,000 respectively. Approximately
$400,000 of the increase in salaries was due to lower loan origination costs
which are a direct offset to salary expense and the remaining $900,000 was
related to staff additions and performance increases.

The increase in benefits and taxes was primarily attributed to higher group
insurance costs up $266,000 over last year and increase accrual for incentive
compensation and 401K contributions up 327 last year. Looking forward to the
fourth quarter 2008 we expect non-interest expense will be comparable with
third quarter expense levels.

  
That concludes my prepared remarks and now Roger will continue the
presentation.

**Roger Busse**

With the addition of market-specific data to our press release my portion of
the presentation will now focus on credit quality and provisioning.

After our formal comments are completed, [Casey Hogan], Chief Credit Officer
will join us to answer any additional questions you may have.

In line with our expectations in previous conference call comments. The bank's
credit quality improved as of September 30th, 2008, evidence by all key
ratios. Non-performing assets net of government guarantees improved,
decreasing to 0.60% of total assets from 0.74% last quarter.

Net charge offs for the first nine months of 2008 remained low at $552.2
thousand or 0.08%. And the allowances of percentage of net non-performing
loans increased to 347%. Loans past due less than 90 days also improved over
the previous quarter end and were 0.64%. Despite these solid results
management prudently elected to increase the bank's allowances of percentage
of period end loans to 1.15% at quarter end from the 1.0% held at June 30th,
2008.

This is primarily due to concerns over the increasingly unsettled economic
trends. Market conditions continue to call for conservative provisioning and
the maintenance of unallocated reserves at the higher levels of the acceptable
range, which at quarter end was 7.8% of the total allowance. This amount is
deemed satisfactory at this time.

I would like to provide more insight into why we believe the level of
unallocated reserve is satisfactory, and more, how it continues to reflect
conservative and forward looking credit practices, in an accurate and timely
risk rating process.

A significant part of the $2.55 million year to day contribution to the
allowance for loan loss was in response to our loan growth of almost $100
million. This of course accounts for approximately $1.1 million of that
provision. Additional contributions offset year-to-date low level net charge
offs of $552, 000 thereby leaving approximately $848,000 in residual reserve
contributions.

As noted, management's concern over current market uncertainties prudently led
to an increase in allowance to 1.15% of total loans from the 1.10% in last
quarter end. This five basis point change required an additional $461,000 of
the total allocation.

Finally based on the proven forward looking credit disciplines embedded in our
credit culture and practices, our commercial banking offices conservatively
lowered a handful of commercial and industrial credit, down one risk grade to
our past watch rating. None of these credits are anticipated to deteriorate
further to lower grades. And in fact are expected to upgrade into higher pass
ratings in the near term.

Consequently these changes along with other internal adjustments led to the
additional allocations. Clearly accurate and conservative risk rating of our
portfolio provides assurance as to sufficiency of the unallocated reserve at
7.8%. It is important to recall that all third parties continue to confirm the
accuracy and timeliness of our risk rating process, which includes the results
of our last safety and soundness examination in May.

It is expected that future allocations or additions to loan loss reserves will
be related primarily to loan growth. While loan growth is anticipated to
moderate during the fourth quarter, as outstanding balances for commercial and
residential properties continue to decline.

Our dental niche and our activity there will likely expand in line with third
quarter results. Currently the dental segment of our portfolio now represents
12.22% of total loans. Also we continue to see solid opportunities for
selective growth in commercial and industrial lending.

Many banks are inwardly focused on credit issues. Clients become
disenfranchised and concerned about access to credit. And many have approached
Pacific Continental Bank. As noted we will be very selective and also price
conscious.

That concludes my presentation, I’ll now turn it back over to Hal who will
conclude our prepared remarks.

**Hal Brown**

As you’ve just heard we remain optimistic and comfortable that we will
continue to perform as a top tier institution. You will also have noted the
degree of caution as evidenced by the number of factors that could affect our
margin and Roger’s comments about the declining economy and the potential risk
to the wider loan portfolio.

I want you to understand that the purpose and tone of these comments is not to
imply an impending deterioration, but instead a commitment to the continuation
of our practice of full transparency. In difficult environments it is
especially important for us to continue this practice.

For Pacific Continental the immediate outlook is indeed positive. We have the
capital to meet the needs of our existing clients and to selectively serve
additional businesses as the clients and credit availability become more
apparent.

Similarly we have been attracting new deposit relationships as people seek out
the stronger institutions. The business model we have employed and the
practices we adhere to are being increasingly and positively recognized in our
free market. I refer to this as the blocking and tackling strategy, sticking
to the basics and doing more of what we already do well. We will be successful
with this strategy.

At the same time we realize that the current conditions may present other
opportunities. We are now witnessing the separation between institutions that
practice solid and consistent underwriting disciplines from those institutions
that look for a short-term gain at the expense of sound banking practices.

This differentiation will continue in subsequent quarters and may result in
some unique opportunities. Should these opportunities materialize we will
employ a disciplined best practice approach when evaluating the impact on the
company, its earnings and resultant shareholder value.

In concluding our prepared remarks I’d like to recognize the exceptional work
of our employees and Board of Directors. Everyone has worked long hours and
contributed in multiple ways. It is comforting to know that our company
culture is just as effective in times of stress as will be in the better times
to come.

And with that we’d like to entertain your questions.

","**Question-and-Answer Session**

**Operator**

(Operator instructions) Your first question comes from Jeff Rulis – D.A.
Davidson  & Company.

**Jeff Rulis – D.A. Davidson & Company**

Wanted to know if you guys would consider using the TARP tackle purchase
program, and if so do you have any reason to believe that you wouldn’t be
eligible for that?

**Hal Brown**

Well Jeff, we’re still investigating this program and our real quick initial
review of that asks the question why would we do it? Why would we give
warrants to the government? And frankly, I think we still have access to other
sources of capital. Mick, you have some thoughts on that as well?

**Michael Reynolds, Sr.**

Yes, Jeff. I mean, I think first and foremost I believe that we don’t need the
additional capital given our current solid capital levels, or low levels of
non-performing assets and our outlook.

In addition, our forecast for the fourth quarter indicates that an even
stronger capital position than we have in the third quarter. And as Hal just
mentioned, just due to the strength of our balance sheet and financial
performance, we believe that capital would be available to us in the open
market.

**Jeff Rulis – D.A. Davidson & Company**

Do you have any expected time frame on unloading your other real estate owned
or other factors that you’d want to be hanging to that in terms of maybe the
projects are in construction or you’re just holding out for better prices or
if you could provide any color on that?

**Casey Hogan**

We are very active as we’ve mentioned in our press release. What we have in
our [inaudible] properties right now is about 20 individual residential homes,
or lots, undeveloped unimproved lots. We’re very aggressive at moving those
out as quickly as possible at reasonable values, and we’ll continue to be very
aggressive in getting those lifted and moved.

We’re not in a hurry to take low market prices necessarily, but we certainly
are aggressively marketing those and pushing them out.

**Jeff Rulis – D.A. Davidson & Company**

And, Casey, the point loss, are those centered in any one area in your market?

**Casey Hogan**

No, we’ve talked before about the kind of a concentration we would see in
southern Oregon, southern Washington, you know, a couple in Bend, a couple in
Boise area, just, but no concentrated effort, or concentrated geographic area
per se.

**Roger Busse**

It’s just as a reminder, these are private consumer construction portfolio
that had a 20% cash guarantee involved in it, all of these are, so there’s
minimal loss expected. That’s also why we can be more patient, and we’re
taking minimal losses on those as we move them through. And those numbers are
reducing each time we report to you.

**Jeff Rulis – D.A. Davidson & Company**

Thank you for the added information in the release. It was helpful.

**Operator**

Your next question is from Kristi Hotti – Howe Barnes Hoefer & Arnett.

**Kristin Hotti – Howe Barnes Hoefer & Arnett, Inc.**

I have a question regarding the, I believe you said it was C&I loans that were
low in terms of your risk rating, is there any particular concentration in
terms of a buyer business sector, or regions, for those down-graded credit,
and I was wondering whether you can comment on transcending on your 30 to 90
days past due for the quarter?

**Roger Busse**

First of all, with regards to the C&I loans that I referenced, I can tell you
that there is no concentration, and these are just a handful of credits with
the lenders that have raised their hand and said, you know, we’re real
concerned about this deal and here’s why.

I’ll give you one example how strong these deals really are. We have one deal
where the individual took a leave and to supplement their cash flow, they were
using part of their proceeds at a business to finish their higher degree and
so diverted some of the cash flow.

The cash flows were strong and he’s assigning the rents over to us, so the
cash flows are back and they’re paying on time, and he’s going to finish up
his degree and come back and that credit will be upgraded.

So that’s the kind of thing we’re talking about. Very conservative indications
of possible cash flow issues, nothing systemic, nothing significantly material
or concentration related, and as a result we just want to be conservative.

And then with regard to the 90-day trend, I’ll let Casey speak to that.

**Casey Hogan**

Sure, our 90-day trend primarily relates to those loans in non-performing
status, but our 60 and under continues to be performing very well. I think
Roger mentioned that we were at 0.64% as far as total loans that were 60 or
under days past due, which is a pretty good number in today’s economy we
believe.

We continue to work those very aggressively, and to Roger’s point earlier, if
and when a borrower gets 30 days past due, we’re immediately putting those on
the watch list or making certain that we understand that there’s no systemic
or significant issues on moving forward.

So very aggressive and working all this, our lenders are doing a great job of
staying on top of potential issues that are out there.

**Roger Busse**

Yes, so to that point our 90 day trend is continuing to contract nicely.

**Operator**

Your next call is from Tim Coffey – Fig Partners.

**Tim Coffey – Fig Partners, LLC**

I just had a question regarding Washington Mutual. Have you seen any kind of
decrease in an overall deposit cost or an outflow of deposits?

**Michael Reynolds, Sr.**

In our bank, an outflow of deposits?

**Tim Coffey – Fig Partners, LLC**

No, within the markets the bank markets.

**Michael Reynolds, Sr.**

No, we’ve actually had a net inflow of deposits, I would say, as a result of
Washington Mutual, and I’m not sure what your question is.

**Unidentified Corporate Participant**

Because we’ve seen rates start fall.

**Michael Reynolds, Sr.**

In some cases some banks may be a little less aggressive, but there’s still an
awful lot of promotions going on in our market right now, Tim. A number of
institutions, clearly with some of the rates that are being advertised, seem
to be suggesting that there are still some liquidity issues at certain banks
that operate in our market, so I say the competitive pressures are still
present for in terms of rates.

**Tim Coffey – Fig Partners, LLC**

And then on the C&I loans, the issues with those loans, is that just the cash
flow able to service the interest on the debt service?

**Roger Busse**

Oh, yes, that’s not an issue. These are watch credits. Those are all pass
rated credits. There’s just an indication that there might be an
individualized change with the borrower, or there might be some kind of trend
that we’re seeing, but nothing where there’s insufficient cash flows. If that
was the case, we would have a lower risk rating to a seven or an eight, a sub-
standard, because that’s our profit.

**Tim Coffey – Fig Partners, LLC**

Well, give do an example of an individualized issue.

**Roger Busse**

Well it’s like the one I just mentioned. You might have a borrower that has
become distracted, which was the case in one of our loans, and so he was using
some of the proceeds and cash flow to business to support his higher degree
and completion of that.

We saw the stress there and we told him that was inappropriate and was still
servicing his debt, but he assigned the proceeds of some rent to us to make
sure the cash flow continued to be sufficient on the debt service side and it
is. And then once he finishes he won’t be distracted, so it’s a kind of an
individualized issue.

Another business might just be experiencing some stress to a loss of a client,
but they’re just forming their company around that cash flow, for example.
Those are individualized things that you’ll see and any kind of a slow down
that would take place, but nothing significant. No insufficient 1.25 to one
debt service position or anything like that.

**Tim Coffey – Fig Partners, LLC**

Not to beat on the C&I, but were these issues you were seeing all quarter
long, or is it something that came up in the second half of the quarter?

**Roger Busse**

No, they’re developing during the quarter. I would say in the last month or so
we asked people to be very conservative and tell us if they saw anything at
all that concerned them, and we just went ahead and accepted those into our
into the process of our watch category.

So we want to be really conservative right now and make sure that we have our
best early warning practices in place and that’s what we see here. So in every
case, as I mentioned a few minutes ago, every case, every one of these
credits, we expect to see upgraded in the short term

**Operator**

Your next question come from Ross Haberman – Haberman Value Fund.

**Ross Haberman – Haberman Value Fund**

Two quick questions. You’re mix, what you deem residential construction of 86
million, and other construction of 155. How much of that combined number would
you deem spec?

**Michael Reynolds, Sr.**

I think Roger and Casey have that information, so just hang on just a second,
Ross.

**Ross Haberman – Haberman Value Fund**

Well while they’re looking for that, a quick question for Hal. Hal, have you
looked at the government TARP Plan, and is that 5% preferred offering
interesting to you, and do you think you might take a piece of it?

**Hal Brown**

Ross, we talked about that just a little bit earlier. We’re still
investigating all of the pieces of that, but our very quick overview, we
question why we would do that. As Mick said, we have lots of capital, our
projections for fourth quarter capital levels actually increased, and I’m not
certain that’s beneficial to our existing shareholders to provide the warrants
that come with that as well.

So we’re still investigating and we’ll make that decision before any
escalation of availability takes place.

**Roger Busse**

Ross, on the residential construction, spec construction, fall into about
4.61% of the portfolio, about $42 million; it’s coming down nicely. Last time
we talked it was about 5%, and it was about $45 million, $44.5, $45 million,
right in there, so it’s come down nicely, it continues to roll down. We don’t
really have any purely construction spec projects that I’m aware of. I don’t
if Casey has any.

**Casey Hogan**

We probably have one that you’d consider spec that’s under active negotiations
right now up in the Seattle area, but other than that.

**Ross Haberman – Haberman Value Fund**

And that 42 which you referred to, is part of both the 86 as well as the 155
number?

**Roger Busse**

That would represent the residential construction pieces in total.

**Ross Haberman – Haberman Value Fund**

And just one other question. Of that 42, is any of that what they call the
two-step construction loans like West Coast has?

**Roger Busse**

No, there’s none of that. These are pure in-fill builders that are developed
in established locations. These aren’t tract deals. They’re all selling out.
They’re proceeding normally. I don’t know how to say it.

You know, we’ve talked about Charlotte Boxer and to the excellent work she’s
done in identifying these projects, and as in-fill builders in small
developments in well-established communities, she avoided a lot of the county
issues that other banks experienced, and so we continue to see the sell-out of
our specs moving along pretty nicely.

If there’s a prolonged recession, of course, we’ll have to keep an eye on
that, but right now I think things are moving along pretty well.

**Ross Haberman – Haberman Value Fund**

And did you have any exposure to a number of large bankruptcies, I think in
the last couple of quarters, in and around your area, did you have any
exposure to those?

**Roger Busse**

No, Ross, we don’t. We weren’t involved in any of those projects.

**Ross Haberman – Haberman Value Fund**

Maybe you guys ought to give some lending seminars to some of your
competitors.

**Operator**

At this time I have no other callers.

**Hal Brown**

Well let me just add a little more color to some of the questions that we’ve
been hearing with respect to C&I migration. I just want to reiterate that this
is part of our practices of being accurate and timely with our risk ratings.

And as Casey and Roger noted, the economy is showing signs of weakness, and so
we have heightened our review of our credit and where they are. So what we’re
really seeing is this, the practice of early warning.

You should not read into this a systemic deterioration of our credit
portfolio. This is just a realization that the economy is not as strong as it
was in the past and that we should be very forward as we review the credit, so
please don’t interpret this as something very large or negative migration
earnings stamp.

So with that, I’d like to thank everybody for attending today’s conference
call, and we look forward to the fourth quarter.

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37,100114-novellus-systems-inc-q3-2008-earnings-call-transcript.html,"Novellus Systems, Inc.",NVLS,technology,2008.0,,regular,"October 15, 2008",4:30 pm,2008-10-15T20:30:00.000Z,44080,8890,35190,3,20,"['Robin Yim - Investor Relations', 'Jeff Benzing - Chief Administrative Officer', 'Rick Hill - Chief Executive Officer']","['Weston Twigg - Pacific Crest Securities', 'Brett Hodess - Merrill Lynch', ""Steve O'Rourke - Deutsche Bank Securities"", 'Patrick Ho - Stifel Nicolaus & Company, Inc.', 'Steve Deneau - Barclays Capital', 'Steven Pelayo - HSBC', 'Gary Hsueh - Oppenheimer & Co.', 'James Covello - Goldman Sachs', 'Timothy Arcuri - Citigroup', 'Edwin Mok - Needham & Company', 'Stephen Chin - UBS', 'Mahesh Sanganeria - RBC Capital Markets', 'Jay Deahna - J.P. Morgan', 'Krish Sankar - Banc of America Securities', 'Atif Malik - Morgan Stanley', 'Satya Kumar - Credit Suisse', 'Suresh Balaraman - ThinkEquity', 'Bill Ong - American Technology Research', 'Ganesh Royal - CREF', 'Benedict Pang - Caris & Company']","**Operator**

Welcome to Novellus third quarter 2008 earnings conference call. (Operator
Instructions) I would now like to turn the conference over to Robin Yim of
Novellus Systems.

**Robin Yim**

With me today on the call here in San Jose is Rick Hill, Chairman and Chief
Executive Officer, and joining us from off site is Jeff Benzing, Chief
Administrative Officer.

Financial results for our third quarter were released on PR Newswire shortly
after 1:00 p.m. Pacific Daylight Time. You can obtain a copy of the news
release in the Investor Relations section of our website at www.Novellus.com.

Today's earnings call contains forward-looking statements about Novellus'
business outlook, the future performance of Novellus, and our products and
forecast of key metrics for the fourth quarter of 2008. Specific forward-
looking statements include but are not limited to our plan to continue
lowering our cash breakeven level until business conditions improve, the
forecasted bookings and shipment volume, revenues, gross margin, operating
expense, tax rate and earnings per share, both on a U.S. GAAP and pro forma
basis, our expectation that we will continue to maintain our market position
to maximize our position within the semiconductor industry, the effect of the
current economic climate on our performance over the next several quarters,
and other anticipated future events.

We caution you that forward-looking statements are projections and
expectations regarding future events. They involve risks and uncertainties
that could cause actual results to differ materially from the results
contemplated, including an inaccurate basis for our financial forecast.
Information concerning risks that could cause actual results to differ
materially is contained in today's press release and our filings with the
Securities and Exchange Commission, including our Form 10-K for fiscal 2007,
our Form 10-Q for the first and second quarter of fiscal 2008 and our current
report on Form 8-K. Forward-looking statements are based on information as of
today and we assume no obligation to update any such statements.

Jeff Benzing will being today's call with a review of the financial results
for the third quarter. Rick Hill will then discuss the state of the business,
followed by guidance for the fourth quarter of 2008, and then we'll open up
the conference call for the Q&A session.

Now I'll turn the call over to Jeff.

**Jeff Benzing**

I'll start by reviewing our third quarter 2008 operating results. Bookings for
the third quarter were $202.8 million, down 13.6% from the second quarter of
2008 and at the low end of our guidance range of up 5% to down 15% as the
weakening macroeconomic environment continued to adversely impact our
customers' business.

Shipments for the third quarter were $230.2 million, down $10.2 million or
4.2% from the second quarter and within the guidance range of $225 million to
$250 million.

Revenues for the third quarter were $250.1 million, down $7.6 million or 3.0%
from the second quarter and at the high end of the guidance range of $240 to
$252 million.

Third quarter revenues by geographic region are as follows: United States,
29%; Greater China, 26%; Korea, 19%; Japan, 13%, and Europe, 13%.

Gross margin for the third quarter 2008 came in at 44.6% and was slightly
below the low end of guidance range of 45% to 46%. This represented a 1%
decline from the second quarter of 45.6%, which excludes $6.5 million in
charges related to our decision to curtail certain business activities. The
decline from our second quarter gross margin without charges was due to
product mix in our Industrial business and lower absorption of fixed overhead
costs on reduced shipment levels.

Total operating expenses for the third quarter were $105.5 million, well below
our stated target of $110 million and down $9.7 million or 8.5% from the prior
quarter, excluding $7.1 million in charges taken in the second quarter related
to cutbacks in certain business activities. This further reduction in
operating expenses yielded an operating profit of $6 million in the third
quarter 2008 compared to $2.2 million in the second quarter, excluding the
previously discussed charges. While we have made significant progress in
reducing our ongoing operating costs, we will continue our progress on
lowering our cash breakeven level until business conditions improve.

Other income was $3.1 million for the third quarter, down from $4.9 million in
Q2. This decline was primarily due to marked-to-market adjustments on certain
hedging contracts.

Our expected 2008 effective annual tax rate increased to 50.8% from 36.7% last
quarter before discrete items due to a decrease in forecasted year end profit
in our [four] entities. The increase in the 2008 effective annual tax rate,
combined with a true-up effect of that increase for prior quarters, resulted
in a third quarter tax rate of 84.6%. Pre-tax profit for the third quarter of
$9.1 million was eroded by the 84.6% tax rate discussed above, resulting in a
third quarter net income of $1.4 million or $0.01 per share, which was at the
low end of our guidance range of $0.01 to $0.05.

Turning to the balance sheet, we ended the third quarter with $702.6 million
in cash, short-term and restricted cash and long-term, which is down $6.1
million from $708.7 million in the second quarter. Cash remained relatively
flat quarter to quarter despite generating $46.7 million in cash flow from
operations. We used $44.3 million of cash to repurchase $28.8 million of stock
and repay approximately $15.6 million of debt.

In the third quarter we purchased approximately 1.4 million shares at an
average price of $21.01. Year-to-date, we have purchased 7.6 million shares at
an average price of $22.74, for a total spend of $173.8 million. We have $846
million left under our buyback authorization, which expires in October 2011.

Net accounts receivable decreased in the quarter by $7.9 million or 3.6% to
$210.4 million, which was approximately the same rate as the decrease in
revenues. As a result, third quarter DSOs remained flat with Quarter Two at 76
days.

Inventory decreased $17.3 million sequentially due to tighter controls of
materials in light of declining bookings quarter-over-quarter.

That concludes my comments on the third quarter 2008 results. Now I would like
to turn the conversation over to Rick, who will comment on the state of our
business and provide guidance for the fourth quarter.

**Rick Hill**

Since our mid-quarter update on August 28th, the market for semiconductors and
semiconductor capital equipment has steadily accelerated its decline. Tight
credit markets, declining consumer demand, political uncertainty and
increasing unemployment are all affecting technology spending. While the
semiconductor equipment business is notoriously cyclical, this is quite
different.

On a bookings front, all our regions are down. On a customer basis, there
remain only three with the economic power to buy and less than three with the
will to buy. The outlook right now is totally unpredictable to us. The rapid
decline in demand for high tech gadgets, whether that decline is real or
perceived, is causing our customers to continue a cautious stance.

On a bright note, investment in advanced technology, the transition of
aluminum to copper in memory, is continuing, but capacity expansions are
virtually nonexistent.

Operationally, we continue to drive down our breakeven as our OPEX hit 105.5,
down from a $125 million per quarter run rate in 2007. Given the uncertainty
in the market, we're driving our cash breakeven level to approximately the
$187 million level for quarterly revenues.

As Jeff reported, during the quarter we remained strong on the balance sheet
relative to our cash position. We continued to manage our assets, accounts
receivable very carefully, with the lowest level of delinquencies that we've
actually ever had, and we're focused on this given the climate that we're in
today.

We do have a slight increase in the inventory number, due largely to some late
pushouts of shipments that caused finished goods to rise. We did buyback 1.4
million shares, $28 million worth in the quarter, and yet our cash balance
remains relatively unchanged.

Now with that, I'd like to give you what we - the best we can give you at this
time for the fourth quarter is bookings will be up 5% to down 15%. There's a
lot of uncertainty in those numbers based on changing customer plans almost on
a daily basis. Shipments are expected to be between $220 million and $245
million; revenues, tracking with the shipments, about $230 million to $243
million. Our gross margins are expected to be in the 43% to 44% range. The
decline is due primarily to customer and product mix. And our earnings per
share is expected to be at a breakeven basis, between minus $0.03 a share to
plus $0.03 a share.

So with that, I'll open it up for what I would assume will be many, many
questions, of which -- will probably be difficult to answer these days. Thank
you.

","**Question-and-Answer Session**

**Operator**

(Operator Instructions) Your first question comes from Weston Twigg - Pacific
Crest Securities.

**Weston Twigg - Pacific Crest Securities**

On the cost control side, I'm wondering, I know you have a really nice
facility up here in Tualatin. I was wondering if there's any chance you're
going to do some consolidation in this down environment?

**Rick Hill**

Yes, we don't discuss the operational details of what we're doing over these
calls because they are, in fact, public calls. But we're looking at everything
we can do in order to make sure that we can operate as efficiently as possible
in these very uncertain markets.

**Weston Twigg - Pacific Crest Securities**

Would you have enough capacity in Tualatin to meet all your manufacturing
needs?

**Rick Hill**

We have enough capacity in Tualatin and we have enough capacity in San Jose.

**Weston Twigg - Pacific Crest Securities**

Also, just curious on the logic side, your logic customers, are you seeing any
pushouts from the logic customers right now?

**Rick Hill**

We see pushouts from both logic and memory customers.

**Operator**

Your next question comes from Brett Hodess - Merrill Lynch.

**Brett Hodess - Merrill Lynch**

Rick, I'm wondering, when you commented on the fact that the technology
changes were still going on in your customer base but no capacity additions,
can you give us a feel for what customers are doing with these technology
buys? Is it onesie, twosies to try out the copper instead of aluminum at the
memory guys and similarly some of the guys there trying to shrink into the 5X
node on DRAM or the 4X node on NAND? Is it just a small amount of equipment to
try it out or, you know, how does that really play out in this kind of
environment?

**Rick Hill**

I would more classify it as building of small lines with moderate volumes.

**Brett Hodess - Merrill Lynch**

So it's not necessarily upgrading their existing line, it's actually adding
another small line?

**Rick Hill**

In the case of the backend for copper in memory, that's more an accurate
description.

**Brett Hodess - Merrill Lynch**

And the second question is: This year you introduced a number of new products
within CVD, like ashable hard mask, and some of the other segments. So what's
happening with new product acceptance, then, at this stage of the game? Are
customers at a standstill or are they still moving forward and giving you the
kind of acceptances that you'll need when business comes back?

**Rick Hill**

I think that the new produce acceptances are actually pretty good, as can be
seen by the relative revenues and shipments that we have been continuing to
make. I think that the real big question is when do we get capacity purchases
again, and unlike historically, we haven't had the great economic uncertainty
in front of us that we have today. So that's what makes it very, very
difficult to predict.

With the shrinking in the financial markets, as all of you guys are well
aware, there are not certainly documented reports but certainly conjecture of
dramatic shrinkages in IT spending, which I'm sure ripples into the planning
of our customers and also their confidence level to commit capital to expand
facilities if they believe there could be a potential for a shrinking market.

I don't think we know that for sure yet, but as you all know, the environment
that we're in is being driven more by emotions than by necessarily facts.

**Operator**

Your next question comes from Steve O'Rourke - Deutsche Bank Securities.

**Steve O'Rourke - Deutsche Bank Securities**

Rick, can you kind of give us an idea based upon everything you're seeing now,
how are you looking at 2009, and do you have some maybe more specific ideas on
what you think industry spending could be in 2009?

**Rick Hill**

Based on the limited concrete data that we have and more on the notional data
that we have, we are tending to be pessimistic on 2009. What would change that
pessimism would be a substantial change in the front end of this engine which
would include consumer spending in the financial markets. Short of that, it
doesn't bode well for 2009 at our current level. Bringing our cash breakeven
expenses down even further than they currently are, we tend to think that, at
best case 2009 is flat.

**Steve O'Rourke - Deutsche Bank Securities**

If we get a lot of this consolidation that's either been kind of proposed or
thought about in the memory sector in 2009, what does that mean for spending
when you look out over the next 12, 18 months?

**Rick Hill**

Well, one of the factors in the consolidation within the markets, of course,
is that there are two types of capacity out there - obsolete capacity and less
efficient capacity. So to the extent there's consolidation in 300 millimeter,
which is a very, very viable technology, and depending upon who does the
consolidation, you actually create more capacity, you create the ability to
operate that facility more efficiently, depending upon who picks up those
facilities, and you also have the potential for increased capacity by taking
somebody's more advanced technology and using that equipment.

Having said that, there will be opportunities for upgrades for some of that
equipment because those that are being swallowed up have typically
underinvested and are not operating at the same levels as those that are doing
the consolidating. But there's no question that it will basically make the
capital deployment more efficient.

**Operator**

Your next question comes from Patrick Ho - Stifel Nicolaus & Company, Inc.

**Patrick Ho - Stifel Nicolaus & Company, Inc.**

Rick, in terms of the bookings range for the December quarter towards the high
end, what would swing it towards the high end - is it memory or is it, I
guess, a broader base of customers?

**Rick Hill**

It basically is a combination of both memory and IDM players, depending upon
what they do with their plans.

**Patrick Ho - Stifel Nicolaus & Company, Inc.**

Secondly, in terms of your Services and Spare Parts business, what type of
effect are you seeing in the near term on that and has the decline in that
area been larger than you've anticipated?

**Rick Hill**

No, Services and Spares is a relatively predictable and steady revenue stream,
although as utilizations come off there is some falloff of it. But it isn't as
dramatic as it is from the standpoint of capacity expansion purchases.

**Operator**

Your next question comes from [Steve Deneau] - Barclays Capital.

**Steve Deneau - Barclays Capital**

Rick, I guess the first question, you talked about $187 million cash
breakeven. I guess can you help me understand what kind of gross margin OPEX
and what mix you're assuming there from Industrial and what's the timeline of
achieving that target.

**Rick Hill**

That assumption is our ongoing normal mix, no change in mix, no fundamental
change in mix. And our timeframe for that will be by the end of the fourth
quarter.

**Steve Deneau - Barclays Capital**

And I guess just to go back to the previous question on the $41 million delta
in the low and the high end of the order range, you alluded to memory and IDM.
Is that one or two type customers or more than that driving that larger range?

**Rick Hill**

I think it's more than that.

**Steve Deneau - Barclays Capital**

And then I guess last question for me, in terms of a tax rate for 2009, I know
there's a lot of uncertainty in what the revenue run rate and geographically
what it will look like, but what's the best guess today?

**Rick Hill**

Jeff, why don't you take that question?

**Jeff Benzing**

The best guess for 2009 will be provided when we go through our 2009 planning
session this quarter and when we have our earnings release in January we'll
have that '09 rate for you.

**Rick Hill**

I guess at this juncture, given the uncertainty in the markets, we're not
going to forecast it.

**Jeff Benzing**

It'd be too difficult.

**Operator**

Your next question comes from Steven Pelayo - HSBC.

**Steven Pelayo - HSBC**

Hey, Rick, I was just curious if you can comment on the ability to get credit,
either from - are your customers struggling or potentially within your own
supply chain, any suppliers to you struggling at all?

**Rick Hill**

Well, I think obviously credit has been hard to come by for anyone, period.
And you only have to look at what GE's just paid for credit. And if you can
imagine what they paid for credit what it would cost entities in the
semiconductor industry or our supplier base, you can understand why people
might be reluctant to go to that particular bank.

**Steven Pelayo - HSBC**

Okay, but as far as you - there hasn't been any significant struggle where
your supply chain can't buy working capital?

**Rick Hill**

There have been no significant defaults that I have seen.

**Operator**

Your next question comes from Gary Hsueh - Oppenheimer & Co.

**Gary Hsueh - Oppenheimer & Co.**

Hey, Rick, I'm just trying to make sense of some of these comments here and
your actions in reducing cash breakeven further. You know, you talked about a
steady accelerated decline in fundamentals, yet you're really only guiding
revenue and bookings kind of down single digits. And shipments are kind of
flattish, so it really doesn't sound that bad. Is it actually something that
we will see in sort of the timing post the fourth quarter? Is that sort of
the, you know, sudden need here to reduce cash breakeven?

**Rick Hill**

When I look at how far we've already fallen, I mean, obviously we've been
ahead of the curve in January when we announced how far we were going to take
it down, and now we're taking it down an additional amount. I'm giving you my
best estimate of where I think it's going to come out.

And our attempt, this is an abnormally low level for what historically has
been a high growth industry, which we have always seen slowing to about 7%, to
going to where we see some contraction. Now the question is how long it will
last. And if it lasts for a longer duration, then we may have to cut deeper.

**Gary Hsueh - Oppenheimer & Co.**

Okay, so just let me clarify, Rick. I mean, you're cutting cash breakeven down
to $187 million per quarter to basically maintain breakeven results or maybe
slightly better in Q4 and not necessarily an indication that there's a
steeper, deeper trough beyond Q4?

**Rick Hill**

That's correct.

**Gary Hsueh - Oppenheimer & Co.**

My second question is, you know, I think we understand pretty well what's
going on in semiconductor land. I was wondering if you could help parse your
guidance for Q4 and just your overall general market commentary, specifically
in terms of industrial applications? What are we seeing there and what's the
downside risk in that business if conditions in the credit markets and the
macroeconomic environment persist?

**Rick Hill**

Our Industrial Applications group largely is revenue based in Europe and
outside of the United States, and up until three weeks ago had not seen the
type of pressure that the semiconductor business had seen. But as of recent,
we are seeing a weakening, not as dramatic as the semiconductor industry, but
clearly there's a global weakening going on right now.

**Operator**

Your next question comes from James Covello - Goldman Sachs.

**James Covello - Goldman Sachs**

Just two questions. First, how many customers did you have this quarter? You
referenced it a little, but you said there were three customers that can
afford to spend and less than that that are willing to spend. But how many big
customers did you have this quarter as defined maybe by kind of $20 million
orders - one, two, none?

**Rick Hill**

Okay, we don't break it down to that level. We actually have had, you know,
when you count Spares and Services, a large number across the spectrum of
customers. But when we're talking about committing large amounts of capital,
there's been only about a handful committing large amounts of capital.

**James Covello - Goldman Sachs**

You know, maybe, if I - and you referenced a little bit of this too, earlier,
but maybe a little more granularity how in your mind is this different from
other equipment downturns? The numbers, you know, if you look at the year-
over-year decline in Capex this year and the likely year-over-year decline in
Capex next year, it looks pretty similar to what we've seen in the other five
industry downturns. Does this feel any different to you other than just it
being a bad downturn?

**Rick Hill**

Well, it feels differently because I don't see what drives it out of the
downturn. I've always seen the opportunity for strong IT and strong computer
spending, and as I've said in almost every conference call, that's the number
one leading indicator that's going to sustain the industry as a whole.
Everything else is just icing on the cake.

With what's happened in the financial markets, which are one of the largest
consumers of IT investment, we need to see where that falls out and how that's
going to drive really the server industry, the computer industry, and that
would be my major worry and the thing that's significantly different than
previous cycles that I've seen in my 15 years. We've not had this.

**Operator**

Your next question comes from Timothy Arcuri - Citigroup.

**Timothy Arcuri - Citigroup**

First of all, I'm just trying to figure out how much of your current revenue
is actually Service. I guess if I go back to 2006 and 2007, I seem to recall
that may 15% to 20% of revenue when you were doing something in the mid to,
low to mid 4 - you know, $100 million - was Service. So that'll put your
Service business at maybe $80 to $100 million. So is that the right kind of
general ballpark to think of your base of service revenue right now?

**Rick Hill**

I don't think that the base of service has changed much historically, and we
don't break it out because it's not a separate business. It's all part of the
semiconductor business as a whole. And when you're talking Service, are you
talking just labor, because if you're talking just labor as service, that
certainly would be too high a number.

**Timothy Arcuri - Citigroup**

I guess maybe my second question is kind of a bigger picture question, then.
If you look at the total enterprise value right now of the company, it's about
$700 million, and it's tangible book is about $1 billion. So relative to the
commitment that you have to being in all these different product lines, it
would seem that at some point, given the current stock price, that if even one
business is attractive to some company, that the company at this level would
be a very good acquisition candidate. So I guess I'm wondering, does this
downturn and does this level make you think that maybe - and beyond even CMP -
does it make you rethink why you're in all these different businesses?

**Rick Hill**

Well, we're only going to be in businesses we can make money at. And if we
don't think we can make money at a business, then we'll kill the business,
okay? But what it does do is it gives us a lot of knobs from where we are and,
with the balance sheet that we have, the ability to be able to, if we feel
products are going to be successful, stick with those products.

And we try to run the company not only from a standpoint of positive cash
flow, but we try to continually earn money, even if it might not be at the
level that our model is due to the economic times. The reality is we have
plenty of flexibility. We're constantly looking at businesses. And we haven't
gotten ourselves in the shape of the banks, thank goodness.

**Operator**

Your next question comes from Edwin Mok - Needham & Company.

**Edwin Mok - Needham & Company**

I'm curious about your comment about your driver. You have - before, you were
quite positive on the SSD markets. Has your view changed on that space?

**Rick Hill**

I'm still very hot on the SSD marketplace. I still think it'll be a hot
product when the right product hits the marketplace. But right now, given the
climate across the globe, it's very, very difficult to focus on a hot product
and expect it to take off like a rocket ship.

**Edwin Mok - Needham & Company**

I see. So your view is macro impacting that. And then just a question on the
operating expense there and the tie to new products, given that you guys have
cut back on the OPEX, any thought about cutting back on any of your new
product programs, like CMP?

**Rick Hill**

You know, we are constantly reviewing all programs. We obviously cutback
dramatically on where we were, focusing a lot of our dollars in trying to win
business into various customers. And we've cut that back dramatically. We're
constantly looking at products and refocusing our R&D. It's part of our
everyday job.

**Operator**

Your next question comes from Stephen Chin - UBS.

**Stephen Chin - UBS**

Just a couple of clarifications, Rick. In terms of trying to track it on the
balance sheet, will you consider temporarily suspending the company's stock
buyback here?

**Rick Hill**

Well, we look at the cash on the balance sheet as our vehicle to be able to
invest. We're constantly looking at what investment opportunities we have,
from products internally to companies externally, plus our own. As someone
pointed out, our economic value of $700 million we clearly don't think
represents the fair value of the technology and the potential cash flows from
these businesses. And so to the extent that cash continues to be positive, we
continue with our buyback.

**Stephen Chin - UBS**

Two clarifications - given what you know about the industry right now, Rick,
do you get the sense that during this down cycle the company will actually
drop down to this breakeven level, the $187 million? Is that the message
you're conveying?

**Rick Hill**

Well, I'm not conveying that message. I just told you where I'm brining the
breakeven down to.

**Stephen Chin - UBS**

And the last question I had is I wanted to make sure I understood your
comments about there being three customers that don't have the will to buy the
equipment. Is that because they don't have the cash or is that simply that
they don't have the [customers] to buy?

**Rick Hill**

No, I said three customers have the economic power right now to continue to
invest. But I said even of those three customers, there's some question of
their will to invest at this juncture given the uncertainty in the market.

**Operator**

Your next question comes from Mahesh Sanganeria - RBC Capital Markets.

**Mahesh Sanganeria - RBC Capital Markets**

Rick, the question on the cash flow, I mean, cash breakeven, what tax rate
assumption is there in that? And [inaudible], I want to make it clear that,
when you say cash, you're taking out the stock option, which is close to $8
million, and depreciation and amortization - that is $17 million - so $25
million is the item you're excluding from being EPS breakeven. Is that
correct?

**Rick Hill**

That's correct.

**Mahesh Sanganeria - RBC Capital Markets**

And what is the tax rate assumption in that?

**Rick Hill**

Our normal corporate on a normalized basis, with normal business levels in the
regions is running around 35%.

**Mahesh Sanganeria - RBC Capital Markets**

Okay, so that assumes 35% tax rate?

**Rick Hill**

That's right.

**Operator**

Your next question comes from Jay Deahna - J.P. Morgan.

**Jay Deahna - J.P. Morgan**

Rick, do you believe that there is such a thing as a maintenance level of
orders that would be a sustainable level pretty much no matter what's going on
out there? And if so, where do you think you are relative to that?

**Rick Hill**

I would say we're near the maintenance level, slightly above it due to the
transition of copper in memory.

**Jay Deahna - J.P. Morgan**

And then the other question that I had is at the SEMICON West analysts meeting
that you guys did this year you threw out some fairly specific market share
targets by product line. I'm just wondering if you could give us an update on
where you think you stand towards those.

**Rick Hill**

I think in the case of PECVD, we've made progress. In the case of HDP, we've
made progress. In the case of Electrofill, we've made progress or exceed. In
the case of Tungsten, again, we meet or exceed our goals. In the case of CMP,
we've not made progress at this juncture. In the case of PVD, we're making
progress but not as quickly as I'd like to make progress. And in the case of
strip, of course, we've made progress.

**Jay Deahna - J.P. Morgan**

And then lastly, in the last call or two you sort of threw out the idea of
potentially being a little bit more willing to do acquisitions, and I'm just
wondering, given how nasty it is out there, do you see opportunities getting
more attractive and is your will to do that increasing as a result?

**Rick Hill**

I think the determination on the ability to do that is going to be dependent
upon the financial markets. I think the ability to be able to jump in front of
a - you know, grab a falling knife or jump in front of a freight train isn't
highly likely. Depending upon what it takes to see the credit markets become
more normalized, we'll determine how big a chunk - if a chunk - is we would
want to take.

**Operator**

Your next question comes from Krish Sankar - Banc of America Securities.

**Krish Sankar - Banc of America Securities**

If in the best case scenario '09 is flattish, who do you think will lead us
out of the downturn? Is it going to be the logic guys or the foundry guys or
maybe the memory guys who will turn around in terms of bookings?

**Rick Hill**

It'll be memory first.

**Krish Sankar - Banc of America Securities**

And [inaudible] logical foundry customers, do you think they're being more
cautious due to the macro or is it more direct sales related? I mean, do you
think they're actually hedging on the side of caution?

**Rick Hill**

I think everyone at this juncture is paying more attention to the macro than
what's actually happening in front of them. That's what I commented earlier.
There's more of a perceived falloff in demand than I think is actually being
experienced right this minute, and I think that's causing everybody to become
cautious. And it's, you know, it isn't unpredictable given the market
condition, and you guys probably know it better than anyone and are
experiencing it firsthand. So that's the current situation.

**Krish Sankar - Banc of America Securities**

And just a last housekeeping question for Jeff. Did you say anything on '09
tax rate?

**Jeff Benzing**

We didn't give a rate for '09. What we gave was our forecast rate for '08 and
we will be providing that estimate and a forecast for our '09 tax rate in our
call in January.

**Operator**

Your next question comes from Atif Malik - Morgan Stanley.

**Atif Malik - Morgan Stanley**

Rick, given the depressed level of Capex next year, let's take your best case
flat, is it fair to assume that your top line growth is going to be better
than the industry if you layer the copper migration, the market shares and the
industrial exposure?

**Rick Hill**

That's our intent.

**Atif Malik - Morgan Stanley**

And then a question on tool reuse. I know one big logic MPU maker is moving to
30 nanometer next year, and you guys have been some victims of movings. When
that guy moved from 65 to 45, there was a lot of tool reuse. How would you
look at your tool reuse rate when that logic maker moves to 30 nanometer?

**Rick Hill**

Well, reuse is definitely not as ideal as totally new tools, but in making
these transitions in these advanced technologies, there's still business
associated with these reuses in the form of upgrades and things that are able
to improve power, performance and other things. But clearly reuse isn't what
we love to see. We like to see new innovative technology.

We've basically positioned our products such that a lot of the new products
have such productivity advantages it really behooves the customer to look at
going new in a lot of instances because of the ability to get greater
throughput. Obviously reuse has a zero capital cost, but when we look at some
of the progress we've made relative to energy consumption, gas consumption,
through put, the payback can be a pretty short period of time for some of the
large customers and it's one of the things we're working on.

**Atif Malik - Morgan Stanley**

And one last thing, the three guys you said who have the power to spend, I
assume you mean Samsung, TSMC and Intel. How would you compare your market
share or average market share at these three spenders relative to the
universe?

**Rick Hill**

These are our three favorite customers.

**Operator**

Your next question comes from Satya Kumar - Credit Suisse.

**Satya Kumar - Credit Suisse**

You know, the [inaudible] time you gave guidance, the mid-quarter update, and
it appeared that maybe bookings were up 30% to 40% in the fourth quarter. Much
of the three segments, right - microprocessor, foundry, logic was closest to
plan, as you know, look at bookings down 10%. Which was farthest away from
plan?

**Rick Hill**

Well, I don't have that number right in front of me, but I would tell you that
none of them made plan.

**Satya Kumar - Credit Suisse**

You're guiding Q4 bookings to roughly $180 million. Shipments are a good $50
million above that. If I go back and look at your cumulative bookings and
shipments, it seems like shipments are running sustainably over bookings. Is
there a catch-up quarter or a couple of quarters there that needs to happen in
the first half of next year?

**Rick Hill**

It has to catch up and therefore you make sure your breakeven, we're down at
those levels.

**Satya Kumar - Credit Suisse**

How does it meet that? I'm just kind of [inaudible] understanding how the
breakeven can go so low, I mean, $50 million lower breakeven level in just a
quarter from Q4 to Q1.

**Rick Hill**

It's the cash breakeven, which is very, very different. Obviously, you know,
there's not much you can do with depreciation and buildings, especially in
this climate. So we've been very explicit to focus on cash breakeven.

**Operator**

Your next question comes from Suresh Balaraman - ThinkEquity.

**Suresh Balaraman - ThinkEquity**

In terms of the unraveling of the financial markets, it just happened in the
last four weeks and most of your purchase orders must have happened well
before then. And I'm wondering, is the net change in your outlook, is it
primarily due to actual cancellations and - for [inaudible] is there a level
of caution that you're adding onto your guidance?

**Rick Hill**

Well, while the crash in the financial markets occurred over the last four
weeks or three weeks, I think the anticipation of that crash has been building
for some period of time. Our bookings and everything is published on a
quarterly basis. You always hope you won't go into disaster, you'd avoid
disaster, but unfortunately in this case we haven't avoided disaster. Disaster
has occurred, and that disaster that's occurred on Wall Street is now
affecting consumer demand, corporate Capex expenditure, all of which
ultimately ripple down to semiconductor companies and capital equipment
companies.

And all we can do it try to give you a picture of what we're dealing with and
how we're trying to respond to it to make sure that A) we're solvent, okay,
without having to take in money to loot our shareholders and other activities,
really try to run a financially solid business, and, you know, navigate our
way through these very difficult times. I don't want to have to go to the
government for a bailout.

**Suresh Balaraman - ThinkEquity**

Also, do you see some customer segments more pessimistic than others in your
recent conversations with them?

**Rick Hill**

No, I don't see any segment more than the other. I think everybody's prudent.
We're running businesses with products. We have real customers, real demands.
I think everyone's concern is the consumer, what's going to happen with the
consumer, what's going to happen with corporate spending. Because certainly,
in our business, that's the very front end of the train. And there is a high
level of caution on all of us, and our intent is to preserve the most precious
thing we have, which is cash, and continue to try to stay on our technology
programs to improve our efficiencies, make our products more competitive, and
hope that we come out of this.

But we can't come out of it without stronger consumer demand and stronger
Capex from corporations. I mean, I couldn't sit on this call and tell you that
without those two things we'll just blow right through this. It just won't
happen for anybody.

**Operator**

Your next question comes from Bill Ong - American Technology Research.

**Bill Ong - American Technology Research**

Can you qualitatively classify how you measure orders that will likely occur,
like you're up 5% bookings guidance versus a little bit more speculative, your
two end points? Is it a function of delivery dates or quality customer or
market share win-loss? Maybe you can sort of rank those variables?

**Rick Hill**

Well, one, we have an intricate sales network that deals with customers on a
daily basis. And we get their input on a weekly basis, and then we do a risk
assessment based on looking at what their availability of cash is and we
compare that to what we analyze is the overall macroeconomic trends going on
from the standpoint of computer growth, which dipped below the 10% in the last
month, annualized growth rate of greater than 10%, which is not a bullish sign
for the semiconductor industry.

And we measure those things and then we come to a conclusion on which bookings
and capacity purchases are most likely to occur. Some of them are R&D, and we
know those customers are going to follow through with their R&D because, like
us, we're trying to extend our technology in a downturn so we're better
prepared in the upturn. That's the reason why we just don't cut all the R&D in
a downturn immediately.

And so we weigh all of those factors and we say look, if things keep going,
knowing the customers we have, we believe these are going to come in and here
are the ones that we think are doubtful and that gets us down to our low end.

**Bill Ong - American Technology Research**

And then my last question is: What's your current cost of capital and how does
that compare to what you were paying earlier in the year?

**Rick Hill**

You know, right now I don't have that right at hand, our current cost of
capital. But, I mean, if we had to go out to the market today, I'm not quite
sure what you could get it for. But historically it's been around 12% to 13%.

**Operator**

Your next question comes from [Ganesh Royal] - CREF.

**Ganesh Royal - CREF**

Your view for 2009, even your best guess scenario is calling for flat. I'm
sure your realistic scenario is probably less than that. I wonder why keep the
breakeven at $210 or higher? Why not take breakeven down lower further when
you are only booking for $180 million?

**Rick Hill**

Well, I think the reason is based on what you want to do to keep your products
in a more competitive position coming out, whether it's three products, four
products or five products. And it's not a stagnant number.

**Ganesh Royal - CREF**

Well, based on my understanding with - and again, this is based on our prior
conversations; I understand you are trying to invest in some of the products
which are not part of our revenues today and which one could classify a little
bit as speculative - why not take actions today and, you know, have a cost
structure which can produce enough leverage if things do recover in 2009?

**Rick Hill**

Well, there's always that opportunity for us to utilize that lever. When we do
it, you'll know about it when we announce it.

**Ganesh Royal - CREF**

Can you just at least help me understand what are the variables that you need
to see? Do you just need to see further deterioration in bookings to be
convinced that we should cut more or what, besides booking, what else is there
that you would like to see?

**Rick Hill**

Well, actually it's the customers we're dealing with with those products,
okay? And to the extent that those customers we're dealing with, who also know
this situation, commit to us to make those products successful, then we'll
stay in those businesses. To the extent they don't commit to us, then we won't
stay in the businesses. It's quite simple.

**Operator**

Your next question comes from Benedict Pang - Caris & Company.

**Benedict Pang - Caris & Company**

In regards to the copper transition for the DRAM industry, where do you think
that is right now and are you seeing that the customers are having a problem
to finance that transition? And do you expect that they'll ask for money from
the equipment companies in order to complete the migration there?

**Rick Hill**

Well, I think that the strongest positioned companies are continuing with the
transition. There are some that are falling behind. You will know there's all
sorts of trading of who's partnering with who going on in the industry, so you
have to sort of see where that falls out first.

I think that those that don't have the cash to finance it themselves are
looking at any mechanism possible in order to be able to finance purchases.
The reality is we're not of the size to be a bank, and it's very difficult for
an equipment company to go out and preferentially loan money to a competitor.
We have an array of customers that we've tried to treat evenhandedly, so we
try not to treat a competitor of our customer's who's also our customer, we
try not to give one preferential treatment. And if you were to go out and loan
money to one company at favorable terms, you in essence subsidize that company
and therefore you have another customer who has a legitimate beef against you.

And so we don't see us as a viable source of funding for our customers. I
mean, our cash is there to be deployed to solve R&D problems that hopefully
enable our customers to sell value. We're not here to be a bank. And I think
to the extent there are large companies with really large cash reserves and
they choose to preferentially deploy capital to competitors in different
regions, that's a decision they make. We try to treat all our customers
evenhandedly.

**Operator**

Your next question comes from Timothy Arcuri - Citigroup.

**Timothy Arcuri - Citigroup**

Relative to the M&A activity that seems like it has to really happen in this
space, given your long history in the business, in prior cycles, when does M&A
activity usually begin from a cyclical point of view? As I recall it's kind of
one or two quarters into the upturn, so people want to see things getting
better before they would begin to go out and acquire assets. Is that right?

**Rick Hill**

I think that's probably an accurate description of what historically has
happened. I think that one could reasonably expect to see some players in this
industry, due to their cash position and the inability to secure financing, I
think you could see people go out of business this time around. And that's
something that's not happened in the last 30 years in the industry. And so
there is somewhat of a change, so the timing may not be the same.

**Operator**

And ladies and gentlemen, that is all the time we do have for questions today.
At this time I would like to turn the conference back over to Rick Hill for
any additional or closing remarks.

**Rick Hill**

Thank you very much for joining us in this third quarter conference call. We
hope that the end of the fourth quarter will show renewed sunshine in the
technology sector and in the overall economy. And I hope all of you who are
probably suffering a lot worse than we are, I hope things improve for all of
you. Thanks very much. Take care.

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39,100116-linear-technology-corporation-f1q09-qtr-end-09-28-08-earnings-call-transcript.html,Linear Technology Corporation,LLTC,technology,2008.0,,regular,"October 15, 2008",11:30 am,2008-10-15T15:30:00.000Z,88071,18977,69094,3,19,"['Paul Coghlan - Chief Financial Officer', 'Lothar Maier - Chief Executive Officer', 'Robert H. Swanson, Jr. - Co-Founder and Executive Chairman']","['Doug Freedman - American Technology Research', 'Ross Seymore - Deutsche Bank Securities', 'Craig Hettenbach - Goldman Sachs', 'Tore Svanberg - Thomas Weisel Partners', 'John Pitzer - Credit Suisse', 'Craig Ellis - Citigroup', 'Auguste Richard - Piper Jaffray', 'Christopher Danely - JP Morgan', 'Uche Orji - UBS', 'Joanne Feeney - FTN Midwest Securities Corp.', 'Craig Berger - Friedman, Billings, Ramsey & Co.', 'Steven Smigie - Raymond James', 'Krishna Shankar - JMP Securities', 'David Wu - Global Crown Capital', 'Sumit Dhanda - Banc of America Securities', 'Robin Lee - Spherix Capital', 'Dan Murphy - O’Connor', 'Alec Berman - AMPAC Research', 'Steve Rosston - Glynn Capital Management']","**Operator**

Welcome to the Linear Technology Corporation Fiscal 20089 first quarter
earnings conference call. (Operator Instructions) At this time, for opening
remarks and introductions, I would like to turn the call over to Paul Coghlan,
Chief Financial Officer.

**Paul Coghlan - Chief Financial Officer**

Today I am joined by Bob Swanson, our Chairman, and Lothar Maier, our Chief
Executive Officer. Welcome to our call. I will give you a brief overview of
our recently completed first quarter in fiscal 2009 and then address the
current business climate. We will then open up the conference call for
questions to be directed at Bob Swanson, Lothar and myself. I trust you’ve all
seen copies of our press release which was published last night.

First, however, I’d like to remind you that except for historical information,
the matters we will be describing this morning will be forward-looking
statements that are dependent on certain risks and uncertainties, including
such factors among others as new orders received and shipped during the
quarter, the timely introduction of new processes and products, and general
conditions in the world economy and financial markets. In addition to these
risks, which we described in our press release issued yesterday, we refer you
to the risk factors listed in the Company’s Form 10-K for the year ended, June
29, 2008, particularly management discussion and analysis of financial
condition and results of operations. Secondly, SEC regulation FD regarding
selected disclosure influences our interaction with investors. We’ve opened up
this conference call to enable all interested investors to listen in. The
press release and this conference call will be our forum to respond to
questions regarding our estimated financial performance going forward.
Consequently, should you have any questions regarding our estimates of sales
and profits, or other financial matters for the upcoming quarter, as well as
how they might impact our income statement model and our balance sheet, this
is the time we are free to respond to these questions.

As you can tell from our press release there is a significant difference
between our actual performance for the September quarter and our guidance for
the December quarter. The company had a solid September quarter with growth in
sales and profits. Operating income was 49% and profit before tax was 46% of
sales. The company grew revenues for the sixth consecutive quarter and has
continued to increase its positioning in industrial communications
infrastructure and automotive end markets while diminishing its presence in
margin-sensitive consumer-related end markets.

However, the extraordinary negative developments in the world-wide financial
markets in recent weeks will undoubtedly impact business spending and
confidence. We have already seen a slowness in our bookings in the month of
October. How long and how deep this impact will be is very difficult to
forecast. As managers we can control spending and deploy our talent to best
position Linear growth and profitability when the markets return.

As a reminder, in 2001 Linear managed its business through the dot-com bust.
We remained highly profitable as a percent of sales and continued to be cash-
flow positive. As we stated in our press release, we expect similar execution
now and believe profit before tax, even in declining revenues, can remain
above 40% of sales and that we can generate positive cash flow in this
environment.

Strategically, we believe industrial communications infrastructure and
automotive will be attractive markets, driven by the advances in
communications capabilities, industrial innovation, and the need for energy
and fuel efficiency.

I would now like to spend a few minutes discussing the quarter we just
completed. In a difficult economic environment, but before the financial
markets melt-down, we had a reasonable quarter, as we grew sales, remained
highly profitable and continued our strategic emphasis of focusing on
traditional analog markets.

Sales increased 1% from the previous quarter within the range of flat to 2%
that we had forecasted in our last conference call. Revenue was $310.4
million, up from revenue of $307.1 million for the previous quarter.

Net income increased 4.3% and earnings per share 4.3%, also, being $0.48 up
from $0.46 last quarter.

On a pro forma basis, without the impact of stock-based compensation, EPS
would have been $0.53 versus $0.51 and net income would have been $118.4
million versus $114.4 million in the June quarter. So the impact of stock-
based compensation was 10% of net income, or $0.05 at the EPS level.

For the quarter just ended our GAAP return on sales was 34.7% and our pro
forma return on sales was 38.1%.

Operating income increased in absolute dollars and as a percentage of sales,
improving from 47.1% last quarter to 48.6% this quarter.

Gross profit decreased by 3/10 of a point, primarily due to lower ASPs
associated with increased shipments into consumer-related markets prior to the
holiday season. This was more than offset by a reduction in legal expenses.

The company also benefited from a discrete tax item, as the company reached a
negotiated settlement with the IRS on the treatment of its ETI, which is
extra-territorial income, benefits in past years. Consequently, the company’s
tax rate for the quarter was 25%, down from its ongoing projected tax rate of
29.5%.

During the quarter the company’s cash and short-term investments increased by
$55.2 million, net of spending $23.1 million to purchase 737,000 shares of its
common stock. For the 90th consecutive quarter the company had positive cash
flow from operations.

The Board of Directors again authorized the company to pay a cash dividend of
$0.21 per share. The dividend will be paid on November 26, 2008, to
stockholders of record on November 14, 2008. At current stock prices this
represents a yield of greater than 3%.

In summary, we continue to have an excellent business model and are therefore
able to remain both highly profitable and cash-flow positive. Our return on
assets was 25%.

In April of 2007 the company entered into an accelerated share repurchase, or
ASR, which enabled it buy back 27% of its shares outstanding. This ASR, and
the associated debt, has improved our returns on equity and invested capital.
Our debt is modest to our cash generation capabilities and our current ratio
is 6.4 to 1.

Our ending on hand inventory of distribution is within historic turns levels
and lead times have remained unchanged at 4 to 6 weeks.

Now I would like to address the quarter’s results on a line-by-line basis,
staring with bookings. Bookings were down marginally from the prior quarter
and our book-to-bill ratio approximated, but did not equal, 1. Compared with
the prior quarter, international bookings were unchanged while absorbing the
summer vacation impact in Europe. In the USA, however, bookings were down
modestly as the deteriorating economic environment impacted both U.S. OEM and
distribution business.

At this time every quarter we give you a breakdown of our bookings percentages
by end markets to give you insight into those markets that drive our business.
We continue to strive to improve the accuracy of this market data and have
made some improvements going into fiscal 2009. These improvements have been
primarily in the area of international distributor bookings. To help you to
continue to focus on trends I will give you the previously reported Q4
numbers, new Q4 numbers, and Q1 numbers done on a similar basis as the new Q4
numbers.

Industrial and communications continue to be our largest areas. Industrial was
previously reported at 33% of our Q4 business. This has been restated to 36%
and the percentage for Q1 was down 1 point to 35%. This decrease is primarily
attributable to U.S. distributions.

Communications, previously reported at 36%, was restated at 30% and was down
one percentage point to 29% on a comparative basis in Q1. The major change
between methodologies here was in the cellular handset area, which was
restated from 11% to 7% in Q4. This change resulted from more accurate
distributor data. Q1 at 7% was similar to Q4 restated in the handset area.

Going forward, we are combining communications infrastructure and networking
as large customers are evolving to serve both of these areas. This area
decreased marginally from 23% in Q4 to 22% in Q1.

Computer was previously reported as 12% of our Q4 business. This has been
restated to 10% and the percentage for Q1 rose to 12%. This area is generally
seasonally strong going into the return-to-school and the holiday seasons.

Automotive was previously reported as 8% of our Q4 business. This was restated
to 9% and the percentage for Q1 was 8%. This is an area that is suffering in
the economy now, however, given the move to more fuel-efficient vehicles, it
is an area of emphasis for Linear. We recently introduced a part for data re-
monitoring in hybrid and electric vehicles, which has received early acclaim.
In addition, we continue to distinguish Linear as a high-quality supplier in
important international manufacturers.

Consumer was previously reported as 5% of our Q4 business. This has been
restated to 9% and the percentage rose to 10% in Q1. Certain customer
installable automotive after-market products, such as GPS systems we believe
more properly belong in the consumer category. This increase of 1% again
related to product build up by customers prior to the holiday seasons.

Finally, the military space and harsh environment products remained unchanged
at 6% for both Q4 methodologies and for Q1.

In summary, we believe the data is now more accurate and we continue to have
very good diversity by end markets, which contributes to our leadership
positioning in high-performance analog.

Note that 54% of our bookings were created internationally, up slightly from
last quarter.

Moving from bookings to sales, product sales grew 1.1% from the prior quarter
and 10.3% from the similar quarter in the prior year. Sales were down modestly
in the USA in both OEM and distribution. However, this was more than offset by
growth internationally.

Asia was our strongest area, improving from 38% to 42% of our sales. USA
decreased from 29% to 27% of sales, Japan remained at 13%, Europe decreased
from 20% to 18%, in line with normal seasonal flows.

Gross margins. Gross margin was 77%. This impressive number validates our
strategy of selling unique, high-performance analog semiconductors into a
broad customer base. This gross margin percentage decreased by 3/10 of a point
this quarter. This decrease was largely due to a decrease in ASP, from $1.61
last quarter to $1.47 this quarter, in line with the increase in consumer-
related sales prior to the holiday season. The strengthening U.S. dollar was
marginally helpful in the gross margin area.

R&D. R&D at $50.9 million decreased by $1.0 million and also decreased as a
percentage of sales from 16.9% to 16.4%. Labor increases were more than offset
by decreases in stock compensation charges, mask costs, and other expense
items.

SG&A. Selling, general, and administrative costs, at $37.1 million, decreased
significantly by $3.5 million and concurrently decreased as a percentage of
sales from 13.2% to 11.9%. Legal expenses were abnormally high in Q4 and as
projected, returned to more historic levels in Q1.

As a result of the above, operating income increased by $6.2 million, or 4.3%.
Operating income as a percentage of sales increased from 47.1% to 48.6% and
continues to be at industry-leading levels.

Interest expense, at $14.4 million, was similar to last quarter. Interest
income of $7.0 million decreased $2.1 million due to a gain in Q4 from the
sale of a strategic investment in a private company.

Within the interest income line, increases in funds invested offset decreases
in the average interest rate. As the government responds to the economic
crisis by lowering interest rates, this will probably result in a reduction in
interest income next quarter.

Pre-tax profits as a percent of sales improved from 45.4% to 46.2% of sales.
Our tax rate was 25% versus 26% last quarter. Both quarters had an ongoing
effective rate of 29.5% and each quarter was impacted by non-recurring
discrete items. In Q1 the company negotiated a settlement with the IRS on the
deductibility of its export tax benefits, referred to as ETI, for several
years under audit. Going forward, we will be favorably impacted by the
resumption of the deductibility of the R&D credit, which was recently re-
enacted by Congress. Our ongoing effective tax rate should decrease to 28.5%
from 29.5% last quarter.

This quarter we should also have a discrete tax benefit relating to the
retroactive reinstatement of the R&D credit. This discrete item would bring
our overall tax rate for the upcoming quarter in line with the 25% tax rate
shown for Q1.

The major tax-savings items that will support our effective rate are: the
benefits from our tax holidays overseas; our tax-exempt interest; our domestic
manufacturing tax benefits; and the R&D credit.

The resulting net income of $107.6 million is an increase of $4.5 million from
the previous quarter, due largely to the increase in sales, lower legal
expenses, and a lower tax rate. The resulting return on sales improved to
34.7% from 33.6% reported last quarter.

The average shares outstanding used in the calculation of earnings per share
decreased by 923,000 shares during the quarter. During the quarter the company
bought back 737,000 shares in the open market. Also, the reduction in the
company’s stock price during the quarter reduced the number of diluted shares
outstanding. These reductions were partially offset by stock option exercises
during the quarter. The resulting EPS, or earnings per share, was $0.48, an
increase of 4.3% from the prior quarter, and an increase of 20% from $0.40 in
the first quarter of last year.

Moving to the balance sheet. Cash and short-term investments increased by
$55.2 million. During the quarter the company bought back 737,000 shares of
its common stock for $23.1 million. $145.4 million was provided by operations.
$47.4 million was paid in cash dividends, and $23.1 million was used to
purchase fixed assets. Our cash and short-term investment balance is now
$1.022 billion and represents 61% of total assets.

Accounts receivable of $163.2 million increased by $1.8 million from last
quarter. This increase was mostly a function of the increase in sales. Our day
sales in account receivable were 48 days, similar to last quarter.

Inventory at $55.5 million decreased $551,000 from the $56.0 million reported
last quarter. Most of this modest decrease was in raw materials and finished
goods. Our inventory turns was 5.1x, similar to the last several quarters.

Deferred taxes and other current assets increased by $12.0 million from the
June quarter, primarily due to an increase in pre-paid taxes on our inter-
company transactions and an increase in our interest income receivables due to
the timing of our quarter end.

Property, plants, and equipment increased by $12.7 million. We had additions
of $23.064 million and depreciation of $10.345 million. Most of the additions
were for fab equipment and for building improvements for clean-room expansion
in our Milpitas fabrication plant and for test equipment in our foreign
plants.

We had planned to spend $65.0 million on capital additions in fiscal 2009 and
now believe that will be reduced to roughly $50.0 million and have
depreciation of roughly $41.0 million for fiscal 2009.

Other non-current assets totaling $77.2 million were largely unchanged.

Moving to the liability side of the balance sheet. Accounts payable increased
$1.1 million, primarily due to increased capital equipment purchases. Accrued
income taxes, payroll, and other accrued liabilities increased by $33.1
million. The largest items here are profit sharing accrual, income taxes
payable, and accrued interest payable on our convertible debt.

The largest impact within the quarter was in accrued income taxes. No tax
payments on the current year’s liability were required in the first quarter,
whereas two payments are required in the second quarter.

Deferred income on shipments to distribution decreased this quarter, as our
shipments to U.S. distributors were roughly $2.0 million less than they had
shipped out to their end customers. Our accounting on shipments to U.S.
distribution is conservative. We do not record a sale nor income in our
results of operation until the distributor ships the product out to its end
customer.

We continue to closely control our inventory of distribution to properly
position the inventory without any unneeded build-up.

Deferred tax and other long-term liabilities decreased by $5.1 million due to
several tax-related items.

Changes in the stockholder equity accounts were primarily the result of the
usual quarterly transactions for net income, dividends paid, and employee
stock activity. The company announced that it will again pay a $0.21 per share
quarterly cash dividend, having raised it in January of this year from $0.18
to $0.21 per share. The company began paying a dividend in 1992 and has
increased it every year since and currently now pays a greater than 3% yield.

Looking forward. I would like to close out our introductory comments by re-
visiting our guidance. The credit crisis has had a big impact on our guidance.
As recently as early September our business was tracking to have a positive
book-to-bill ratio and we were expecting to again guide to flat to low-single-
digit revenue growth.

However, once the credit crisis hit and began to deepen, more of our customers
became cautious and began to curtail their orders. Data on diminishing factory
utilization rates and on rising unemployment claims was published. These
dramatic changes have made forecasting difficult.

Field sales personnel forecasted reduced sales in the 10% range, however they
cautioned whether their customers had yet fully adjusted to changing economic
events. We have begun to receive some cancellations and push-outs from
consumer-oriented customers, adjusting their expectations of likely holiday-
season sales. Automotive retail sales have been off dramatically and this is
bound to have a ripple effect on the economy.

Given the negative impact of the credit crisis in the past few weeks, even
though the major governments have taken steps to improve the situation, we
believe it will take some time to restore business confidence and that has led
us to increase our range of quarterly impact from 10% to 20%. We believe this
is a change in demand patterns and not a case of losing production or design
opportunities at our customer base.

We want to emphasize that in a similar difficult economic period in 2001,
during the dot-com bust, we remained very profitable and cash-flow positive.
Many of our expenses are variable and we have had experience at adjusting
these costs to meet current demand.

Even at the forecasted diminished sales ranges, we forecast profit before tax
remaining above 40% of sales.

I would now like to open up the conference call to questions to be addressed
to either Bob, Lothar, or myself.

","**Question-and-Answer Session**

**Operator**

(Operator Instructions) Your first question comes from Doug Freedman -
American Technology Research.

**Doug Freedman - American Technology Research**

It’s clearly a very challenging environment. Can you offer us a little bit
more color on, anything you can offer as far as geography, who is seeing this
credit crunch first, what does sort of the sellout look like already? Any more
color you can offer on what your customers are telling you as far as how this
is changing their behaviors would be helpful.

**Lothar Maier**

Maybe I can add a little bit of color to that. From a geography standpoint,
the issue really for us, I think, showed up first in North American. So North
America was probably where we sensed this reduction in business first. But
reasonably quickly, as we got into the current quarter, we’re seeing the
orders slow down not just in North America but it’s spreading pretty much to
all the locations that we sell into. And pretty much we see it in most of the
end markets that we sell into, as well.

So I would say it was maybe first detected in North America but we are seeing
it pretty much around the globe. And if there’s any one bright spot, it may be
China out there still. But in general, it’s pretty much all of our end markets
and all of our geographies.

**Doug Freedman - American Technology Research**

Can you offer, what is happening, is it any difference between OEM and
distribution? Are you seeing distribution not want to carry inventory here?
How much of this do you think is sort of an inventory pull down versus a
demand pull down?

**Lothar Maier**

We think it’s more a demand pull down than an inventory correction. Although
we see it equally distributed through OEM and through distribution, so we
haven’t seen an inordinate emphasis coming from distribution. So we think it’s
pretty balanced but if we had to lean one way or the other, it would probably
be more OEM-related.

**Doug Freedman - American Technology Research**

And are you seeing a change in behavior, not just from the order rates, but
sort of on the engagements with your engineers? Is there like a complete lack
of urgency on new product introductions? Any color you can offer as far as
your customers’ response in terms of the way in which they’re going to run
their business.

**Paul Coghlan**

I think from an engineering standpoint it’s still pretty much business as
usual. We have sensed nothing changing from how engineers are willing to
engage with us. This will probably cause some programs to be pushed out a
little bit but in terms of willingness to meet with you and talk to you,
there’s been no change.

**Lothar Maier**

And I think, judging from past down turns, a lot of times companies try to
invent or innovate their way out of these down turns and be well-positioned
when the markets pick up with new products that would be attractive to the
purchasing customer base.

**Doug Freedman - American Technology Research**

Paul, if you could, take a swag at what you think the impact to gross margins
is going to be as a result of the lower shipment levels.

**Paul Coghlan**

Well, there’s going to be some impact throughout the lines on the income
statement. What we said in our introductory comments and in our press release
is that the income before tax line we had 46% income before taxes, a percent
of sales. And we think we can maintain that above 40%. Now how that
distributes among the lines, it remains to be seen as to what the sales level
is and how we handle our reduction in costs. But judging by previous periods,
I don’t think it would be very dramatic at the gross profit margin.

**Operator**

Your next question comes from Ross Seymore - Deutsche Bank Securities.

**Ross Seymore - Deutsche Bank Securities**

Can you give us a little more color on why you’re sure it’s broad-based and
nothing Linear-specific, as far as losing design wins, etc.

**Paul Coghlan**

Sure. We are a broad-based supplier. We go through what our end markets
distribution are every quarter. Lothar, in response to the first question,
told you we are seeing the downturn in consumer-related businesses,
automotive-related businesses, and other businesses. We also commented on in
our introductory comments that we don’t know of any programs of any
significance that we’re out of other than the normal recurring things and that
by and large all of the programs we’re in we’re remaining in. And it’s just a
general demand pullback we sense.

And maybe it’s more noticeable to us because we are such a broad-based
supplier, compared to a lot of our competitors and more evenly distributed
through end markets, that we’re seeing it across all of those markets.

**Lothar Maier**

I think the other point is that the abruptness of the change. We were tracking
throughout last quarter pretty much right on track in terms of having an even
book to build and the change occurred really in the last couple of weeks of
September. You’re not going to get designed out across broad market areas in a
two week period. So it was just a very abrupt change.

**Ross Seymore - Deutsche Bank Securities**

Then I guess given that you talked about the bookings slowing in October as
well, can you give us just a rough idea, even by the largest sub-segments of
your end market bookings, how those may look for the December quarter?

**Paul Coghlan**

That’s difficult to do at the moment. I think the area we’re seeing the most
pull back initially would be in consumer-related type end products, as they’re
quickly adjusting what they think this holiday sales period will be for them.
So I think that’s the area we’ve seen the most initial response. But we are
seeing it somewhat across the board.

**Ross Seymore - Deutsche Bank Securities**

And could you just give us a rough idea of kind of fixed versus variable costs
on your op-ex lines just so we can get an idea how to model those?

**Paul Coghlan**

No. I can tell you that, as I said earlier, we think that profit before tax
will remain above 40%, so that’s not a very dramatic change from the 46%. And
depending on what the sales level, it could be close to the 46%. So while
we’re talking about relatively small changes, I think, in each of these
operating lines, but how we pare back our expenses and which directions we go
to do that, you might have some subtle changes in the lines but I don’t think
it will be dramatically skewed one line towards the other.

**Operator**

Your next question comes from Craig Hettenbach - Goldman Sachs.

**Craig Hettenbach - Goldman Sachs**

Paul, all these cycles have different nuances. Any similarities, or
differences, in this cycle compared to prior ones in terms of how business is
developing?

**Paul Coghlan**

Yes. I think that prior cycles were more concentrated to particular events.
Like if you go back to the dot-com bust, a lot of that was in the networking
area. It was very, very much centered in high tech and if you will, our
industry kind of caused that to happen. You go back into the 90s, you had the
kind of the Asian currency meltdown. That was very brief, that downturn. This
one is really caused by a credit crunch so this is caused beyond companies. We
weren’t the ones that pushed this boulder off the ledge. This was done within
the credit markets.

And you’ve had a massive reaction among not just the U.S. government but all
the Western governments and other governments are starting to follow trend.
You know I’ve got gray hair, I’ve been doing this for a long while. This is
unique to me, this particular down turn. And then the impact it’s having
across communities. I mean, I have lots of friends that keep talking to me
about their 401k plans. And I just think this is of a different nature, this
particular turn down.

Now I think companies are generally pretty strong. You have companies have
pretty good balance sheets. You have companies in pretty good cash positions.
So we’ll have to see, if credit frees up, how quickly people can get back to
somewhat business as normal.

**Craig Hettenbach - Goldman Sachs**

If this environment remains difficult, particularly within higher-volume
consumer-type markets, would you expect to kind of de-emphasize a bit in terms
of where that meets your gross margin profile? Or how would you approach in
just a kind of near- to intermediate-term basis if pricing gets more difficult
in some of those end markets?

**Paul Coghlan**

We’ve always been very profitable. And the only way you can be very
profitable, comparatively, to your peers is that you sell unique parts, and
that those parts have a demand. So that even in down markets, if you go back
to the dot-com bust for example, Linear Technology’s sales at that time, and
that’s the most dramatic turn down we’ve ever seen, our sales in the course of
a year went down 47% then. We’re not saying that’s going to happen this year,
but just as a frame of reference.

And our return on sales went from the low 40%s to 38%. So although we had a
turn down in demand in that time, we were able to maintain our margin
structure. So I think that any products we’re in, even presently in now, where
competitors had an equal solution but would sell it much more reasonably,
particularly in the consumer area, we would not have been successful there
currently.

So I think we’re going to continue our strategy of having unique parts,
continue to try to sell them at their market value, and hope that the end
customer enjoys this differential and it’s technology and it helps it
differentiate in its market place.

**Robert H. Swanson, Jr.**

Yes, there’s absolutely no point in taking a piece of business that doesn’t
make money. In any market.

**Craig Hettenbach - Goldman Sachs**

Lothar, in the automotive market, given the turbulence there, how quickly
would you expect, from a design in process, to see an adjustment in terms of
new designs for automotive?

**Lothar Maier**

I think the design in processes in automotive is fairly long. It takes usually
a couple of years for designs to take place. So the design in activity, I
believe, is going to continue and it’s going to continue to be strong. Really
for a couple of reasons.

One is every automotive customer that we deal with has got very active and
very aggressive programs. They’re implementing hybrid and electrical vehicles.
And so that’s going to, I think, continue to go forward independent to what
happens in the market place. And we’ve got a lot of great products that are
lined up to service those markets.

And I think the overall contents, electrical contents, electronic contents, of
a car is going to continue to grow. It may slow a little bit in the short term
but that march is going to continue to march strong going forward.

So I think the design in activity is going to continue to be strong. I think
there may be some shorter-term impact where there’s just fewer cars being sold
that’s going to have a near-term impact. But the analog and electronic
contents in cars is just going to continue to grow.

**Operator**

Your next question comes from Tore Svanberg - Thomas Weisel Partners.

**Tore Svanberg - Thomas Weisel Partners**

Your guidance range is quite wide. I assume that’s tide to the level of turns
business that you’re expecting, or is there anything else in that assumption?

**Paul Coghlan**

Well, the biggest difference for us is just what’s going on in the credit
markets. Normally we give you a tighter range because the macro economic
conditions are similar quarter to quarter and we have a pretty good sense of
customer bookings we’re expecting to receive. Our lead times have remained the
same. They’re four to six weeks. But now you’ve got, on top of anticipating
bookings beyond our lead time, within the quarter, there’s this overhang of
how are people going to react to the macro economic events. How are they going
to react to the credit crunch? Are they going to feel that their business is
going to be curtailed? So that’s hard to project.

As I said in my introductory comments, our sales forces thought we would be
down by

going to happen, that caused us at the management level to expand that
probability, to keep it in the range of 10% 20%.

So we’re just less sure, to be quite frank with you.

**Tore Svanberg - Thomas Weisel Partners**

And then also you mentioned you had the ability to manage some costs going
forward. Is the company overall now moving into a very conservative scenario
where you’re expecting this potential downturn to last quite a while or are
you now just focused on the next quarter?

**Paul Coghlan**

I think initially we’re focusing on next quarter. I mean, it’s hard to project
how far this will go. So we’re looking at some ways to be economical and then
next quarter. We’ve done this in the past, and done it successfully. And then
I think we’re kind of at a turning point now. So we want to see how the
quarter plays out, we want to see what the macro economic responses are, we
want to see what overall business confidence looks like at the end of the
quarter. And then if we need to make further adjustments at that time, then
we’ll make them.

**Tore Svanberg - Thomas Weisel Partners**

And lastly, and just out of curiosity, what triggered the re-classification of
bookings this quarter versus other quarters?

**Paul Coghlan**

We actually have gotten better data. So when we looked at it, actually the
catalyst behind it was Bob Swanson, to be frank with you. He said he thought
the data probably could be updated a little bit. And we looked at it, and
particularly our international distributors. We had been taking data from them
and we got deeper into their business a little bit and deeper into how it was
actually distributed among end markets.

So this is never precise because it’s based on us allocating customers to end
markets. And technologically we’re getting a little better at the front end of
an order in trying to ascertain what end market it belongs in. We had these
improvements, we wanted to wait until a year end and a new year to bring them
forth. So that’s why we issued them this quarter.

**Operator**

Your next question comes from John Pitzer - Credit Suisse.

**John Pitzer - Credit Suisse**

Paul, just a clarification so I understand clearly, the bottoms-up sales
forecast is looking down 10% for December but you are kind of implying a more
conservative tops-down view of the world, is that the right way to look at
things?

**Paul Coghlan**

That is. That is absolutely correct. But the sales guys also caution with
theirs that they talk to purchasing agents and they say they hope these folks
have incorporated into their estimates the general macro economic events. And
they kind of said they’re not sure if they have or have not.

So what we did is we looked at the roll up sales forecast, we pulsed the sales
guys a little more, we looked at the October activity, we did what we think
reasonable manages would do. We looked at that and that’s what cause us to
broaden the range.

**John Pitzer - Credit Suisse**

And Paul, I know this is probably a little bit of an unfair question, but if
you look at the small sample size of companies that have reported in semis,
including Intel, Maximus, and Altera, you guys are giving significantly worse
guidance. You talked a little bit about you being maybe more broad-based and
that’s the reason why. I’m just kind of curious, you’ve been through a couple
of cycles now. Why do you appear to be an outliner here? Is it your shorter
lead times just giving you a more accurate picture of real term and so we’re
going to see companies come out and you’re not going to be an outliner or is
there something else going on?

**Paul Coghlan**

Well, I mean, first sticking with the current facts and then I’ll project as
to whether we’re still an outliner a quarter from now than we thought. But
starting initially, one of the areas we had some improvement in was computer
and that was about the only area. If I told you our bookings quarter-to-
quarter, on the new methodology, increased in computer from 10% to 12%. So
Intel is very strongly in the computer business. Maximus is probably more in
that business than we’re in that business. So I think that we’re kind of the
first broad-based supplier to come out.

Secondly, I think you need to look at all of the competitors and look at
relative lead times among competitors. Our lead times are typically the
shortest among all of our competitors. So that there’s a shorter reaction time
between when we have a sales down turn and when the market sees it.

Now, we think that’s the best way to run your business because you don’t build
inventory inappropriately and etc., but in dramatic shifts like this we’re the
first to notice that impact. So I think it’s probably a little early to say
that we’re an outliner and will remain an outliner. But we’ll have to see what
the other companies say, both this quarter and next quarter.

**John Pitzer - Credit Suisse**

And help me understand the strategy around managing inventory on your own
balance sheet and fab loadings and how do you think the disti channel is going
to react relative to an inventory draw down? Clearly in the last several
quarters we’ve all been under the assumption that inventory has been lean. But
now that demand is softening here, what would you expect?

**Lothar Maier**

Maybe I can comment on the factory inventories. Certainly we’re going to
adjust the output of our factories, both our wafer fabrication assemblies, to
more closely match what the sales are. So we will make adjustments to that and
manage that and we’ve shown in the past that we’ve been able to do that very
well. And we plan to react very quickly to the changes.

**Paul Coghlan**

And I think from a distributor standpoint, you know, I told you our deferred
income got reduced last quarter because we shipped less into the U.S.
distribution channel than it shipped out so I think distis to some extent are
already trying to react to what the realities of the market place are.

On the other hand, distis are, they have a responsibility to us, that they
have adequate inventory that they can supply the customer base. So I think
wherever you have companies that are highly leveraged, there will be a little
more pressure on them managing their balance sheets and their payables, and
companies like us, from an inventory standpoint, we don’t want to build excess
inventories in our factories and Lothar addressed that.

**Robert H. Swanson, Jr.**

You know, a lot of our shipments go to both distributors and contractors. And
both of those businesses are cash-sensitive businesses. So we know that they
are going to take a very hard look at running their business to conserve their
cash.

**John Pitzer - Credit Suisse**

And Paul, in this type of uncertain environment it’s always good to have a
nice cash cushion on the balance sheet, but given that you guys tend to
generate cash in just about every environment, any strategy around the debt
and convert here or is this just not the environment that you’re going to
think about potentially buying some of that stuff back?

**Paul Coghlan**

I think we’re always open-minded with our cash. It’s good to have cash. We’re
always open-minded at looking to best deploy it. You know, not too long ago we
bought back a lot of stock in the open market. This is also a time, though,
when cash is kind of king. So that you want to be well positioned with your
cash going into a down turn. So I think those are decisions we make on an
ongoing basis and we’ll continue to look at those.

**Operator**

Your next question comes from Craig Ellis – Citigroup.

**Craig Ellis - Citigroup**

Paul, could you provide a little bit more color in terms of what the company
is seeing presently from an order-intensity standpoint? Our check showed, and
I think you guys have said this, that order intensity just moderated as we
went through September, but have we kind of bottomed out and are things
stabilizing here, or do you continue to see just a lower and lower level of
order activity?

**Lothar Maier**

Yes, we saw the business slow down in the second half of September and it’s
kind of tracking along that path. But it hasn’t changed dramatically from that
level. But on the other hand, we’re trying to make decisions here on a very
small amount of data. You know a couple of weeks in this quarter doesn’t make
the entire bookings for the quarter. But it dropped down, and as Paul said, we
bracketed our guidance between kind of what the run rate business is and what
the guidance we got from our field sales.

**Craig Ellis - Citigroup**

Okay, Lothar, so for now it feels like we’re bouncing along the bottom. And
can you just refresh us on how we should think about the linearity of the
quarter as we go through October, November, and December?

**Paul Coghlan**

Let me just interject one thing, to supplement Lothar’s comments. He
emphasized we have only had a few days of data points in October. And it’s
difficult to extrapolate because you have definitely had a downward trend but
there are a couple of days that up-an-up strong so you get a little bit
optimistic and then you have another day that’s down a bit. So it’s not a
steady line downward. On the other hand, the overall trend has been down.

And then relative to linearity going forward, it’s just very, very hard to
project in this environment.

**Craig Ellis - Citigroup**

Can you draw any parallels between where we are versus the 2001 time frame? If
we look back at our models, then the first quarter of the down turn wasn’t so
bad, it was really the second quarter that was the most painful. As you guys
look at the business now, what’s the risk that that’s the type of environment
that’s unfolding?

**Paul Coghlan**

I don’t know the answer. I will tell you that in 2001 it was much more
concentrated in technology. Particularly in networking areas and
communications infrastructure. There had been a massive over-build out and
lots of inventory in isolated customers. Whereas other parts of the economy
were pretty much immune to it.

So that I think comparing this to that, for us, we think it will be different.
This one, on the other hand, this is a situation where a lot of business
people, a lot of consumers, both in each category, have been spooked by this
down turn in credit. And people don’t know what to expect in credit and don’t
know what overall economic spending patterns will be, not just in the U.S. but
in Europe and Japan for sure, and potentially Asia.

So I think this one is going to be different. If you pin me to the wall, my
guess is it wouldn’t be as dramatic, as short, as the one in 2001, but it
might be longer. But I’m not an economist and I don’t know and we’re not
making plans in that regard yet. We’re just kind of seeing how this plays out.

**Robert H. Swanson, Jr.**

You know, in 2001 we saw the bubble building. And so what happened was we
basically tried to get customers to be realistic. And we got to the point
where we had 16 weeks of non-cancellable backlog. So it’s true that when the
bottom fell out, we had an extra quarter of back log that could not be
cancelled. So we were able to basically buck the tide for a quarter then
reality hit home to us.

That’s not what happened this time. A different cause of the problem and at
this time we had a normal backlog, not one that was insulated with three or
four months of non-cancellable backlog.

**Craig Ellis - Citigroup**

For many in the sector, rising raw materials prices were pressuring gross
margin, earlier this year. How long will it take before some of the commodity
price decreases that we’ve seen turn around and become a tail wind, as it
were, to gross margins?

**Paul Coghlan**

Well, certainly the currencies are starting to get more favorable. The U.S.
dollar is becoming stronger. Relative to commodities, I think it’s early to
say whether they will soften. One big commodity for us is gold because we put
gold on almost all of our chips. And that was something we had mentioned to
you in earlier quarters. Our cost had risen pretty dramatically. Gold
stabilized a bit but at a very high price because in these economic uncertain
times gold becomes an area of investment, not just an area of raw material.

**Lothar Maier**

Again, the only thing that we’ve already factored in is the increases we’ve
seen in energy costs, so as energy costs maybe turn back around again we might
see a benefit from that. But those are really our largest sort of raw material
costs.

**Operator**

Your next question comes from Auguste Richard - Piper Jaffray.

**Auguste Richard - Piper Jaffray**

Over the last 15 years, I think I recall in 1998 and 2000 and now you’ve had a
pretty dramatic reduction in guidance going forward, and the other analogs are
going to be a little more gradual as numbers come down, and I was just
wondering is there a reason for this? It’s just an observation I’ve had.

**Paul Coghlan**

Well, I think our lead times are shorter than most other guys and that
therefore we would see it sooner. Now, in 2001, as Bob mentioned, we actually
saw this freight train coming and told customers to either adjust their order
patterns or they needed to give us 30 and sometimes longer commitment for us
to build the product. It’s been different this time.

So I think we’re broad-based, which in this particular environment, with low
lead times. And maybe that’s why we’ve seen it sooner.

We like to think it’s because we manage our business well. It looks like in
this individual quarter, to you, when we forecast that maybe we don’t, but we
actually think we’re managing it well. We stay pretty close to what’s going on
in the external environment and to us it shouldn’t be surprising that with
what’s going on in the credit markets that that would be having an impact on
business confidence.

So we were, frankly, surprised that people weren’t forecasting that there
might be a big hit right around the corner for some companies.

**Robert H. Swanson, Jr.**

It’s this massive, massive credit problem that affects all of our businesses,
virtually all of our businesses. If this doesn’t have an impact on everybody,
then maybe we are over-reacting.

**Auguste Richard - Piper Jaffray**

Not to beat a dead horse, when I look at your performance relative to your
peers over the last four to five quarters you guys have been outperforming.
This guidance kind of brings your year-over-year numbers closer to your peers.
Is this a regression to the mean? Is that a possible explanation?

**Paul Coghlan**

I would think not, in the following vein only. This has been a reaction to the
credit crisis. If the credit crisis hadn’t of happened, we told you that at
the start of September we were tracking to a positive book-to-bill ratio and
we were going to guide flat to up for this quarter. So I think we still would
have been cumulatively ahead of the pack.

What happened is this massive curve ball came in, which is this credit crunch.
And I think that’s going to readjust the markets for everybody. So we’re not
seeing that we’re losing market share, we’re not seeing we’re losing design
ins, we’re not seeing that we’re less popular with our customers. We’re not
seeing any of that.

What we are seeing is a customer base that’s been shaken by the credit crisis
and a customer basis that’s saying that’s going to impact their businesses,
their cash flows, and their reaction to it. And we’re seeing that reaction and
we’re reporting that to you.

**Operator**

Your next question comes from Christopher Danely - JP Morgan.

**Christopher Danely - JP Morgan**

Just a couple of quick clarifications. Paul, did you say you will try to hold
op-ex roughly flat in terms of dollars going forward or were you trying to
reduce it?

**Paul Coghlan**

No, we will probably reduce it. What I did say is we would maintain our
return, our pre-tax return on sales above 40%.

**Christopher Danely - JP Morgan**

Maybe I misunderstood but you guys have seemed to focus on keeping those gross
margins pretty high whether business is good or bad. Assuming this down turn
lasts for a while and pricing gets fairly competitive throughout next year,
will you continue to maintain your gross margins in the 76% to 77% range or
would you look to maybe get a little more aggressive and keep your market
share?

**Paul Coghlan**

Well, there’s certainly fixed costs that I can’t adjust. I told you that we
have a good variable cost structure but we don’t have total only variable
costs. So to the extent of that, and I mentioned to you, we spent $23.0
million on fixed-asset additions this quarter to do certain plants expansion
that had we known this credit crunch was coming we might have delayed.

So I’m going to have some depreciation and other fixed costs that will impact
my gross margin because I will have a reduced sales number to offset them
against. The variable costs within those categories, I think I will able to
adjust those pretty well and maybe adjust those to what’s going on in sales,
give or take a little bit and that’s why I gave you the 40% guidance.

Relative to pricing, we are often in a situation where what we are we have a
part that’s it’s a proprietary situation. So as long as to the end customer
there’s still value in his end product that our part goes in, there shouldn’t
be a lot of price attrition for us.

**Lothar Maier**

And let me just add that chasing low-margin and no-margin businesses is not
something that we’re going to do because of the business conditions that are
here right now. So we’re going to sell into markets where we can distinguish
ourselves and continue to get the types of margins that our business has
typically generated.

**Christopher Danely - JP Morgan**

Okay, so you guys have pretty much toed the line on gross margins previously.
No change to that thesis?

**Robert H. Swanson, Jr.**

It’s not like the company has been unaggressive in pricing. We’ve always been
aggressive in pricing. We just don’t take business that makes no profit. And
so we don’t see any point to change that now.

**Christopher Danely - JP Morgan**

I was just wondering if there was any change to your sort of gross margin
model, gross margin attitude, and it sounds like there’s none.

**Paul Coghlan**

Right. But we’re trying to share with you our approach in that area is
probably more complex and more varied than you have considered in the past. I
think many of you folks think we’ve got some cross-over line we never go below
and none of us make a decision, it’s just a computer program that does it.

So the reason you’re getting a long-winded answer to your question is you’ve
phrased it too simply. As though it’s a very un-complex approach we take.

**Operator**

Your next question comes from Uche Orji – UBS.

**Uche Orji - UBS**

Can you just talk about each of the segments in terms of your guidance, how
should we think about the range for each of the segments? Will they all be
equally down more than 10% in Q4 as your guidance would account for or will
there be areas that will perform and areas that will not perform?

**Paul Coghlan**

That’s very hard for us to do. We’re so broad-based, it was hard enough for us
to do this on a global basis. But one thing we will say is that the consumer-
related businesses, which are usually strong going into this holiday period,
those are usually weaker in the March quarter. So those ones will probably be
more impacted. But to break it down more finely than that, by each end market,
that’s difficult for us to do.

**Uche Orji - UBS**

In terms of the buy back you have outstanding, given that most companies are
kind of going into the cash conservation mode, will you still be on track to
do those buy backs or will you kind of take your foot off the gas pedal right
now a little bit?

**Paul Coghlan**

You know, we had a massive buy back a year and a quarter ago, a year and a
half ago. And since then we’ve been buying back not as aggressively, a little
bit per quarter. So I think we’re going to look at all of that and look going
forward as to how best manage our cash. You know, we have a lot of cash, this
is a good time to keep a lot of cash. It also might be a good time to do some
opportunistic things. So we just have to decide how to do that but we haven’t
made those decisions yet.

**Uche Orji - UBS**

Now, within what you’ve seen so far, what’s happened to lead times in general?
Can you quantify that by any chance?

**Lothar Maier**

Certainly our lead times have remained the same. We typically keep short lead
times. In general, normally in a down market, lead times for everybody
contract but our will stay relatively short.

**Operator**

Your next question comes from FTN Midwest Securities Corp.

**Joanne Feeney - FTN Midwest Securities Corp.**

I’m wondering, you’ve spoken a lot about the credit constraints and I’m
wondering two things. One, are you actually hearing from your distributors or
your OEMs that they themselves are currently credit-constrained and therefore
cannot purchase your parts, or do not want to add them to inventory because of
those constraints, or is it more that they perceive that the broader credit
constraints our there are going to reduce demand from their customers?

**Paul Coghlan**

First of all, no customer ever tells us that they are in a credit bind,
because they would be scared to death what we would do at that point in
shipping to them, to be frank with you. On the other hand, the sense we’re
getting is they’re not just, they’re certainly telling us that they think this
overall credit crunch is going to impact their customer base. I think implicit
in their comments to that is that they also have to manage their cash.

So those customers or those folks in a distribution or a contract
manufacturing basis that typically run on small margins with a fair amount of
debt, I think we suspect and that they’ll be as careful as they can and what
we want to make sure is that they’ll continue to grow our business or treat
our business fairly and that they will be a good channel of distribution for
us.

But I think that whole dynamic will become a little tighter.

**Joanne Feeney - FTN Midwest Securities Corp.**

And then on a separate point, on the communication side, are you able to
determine or sense whether there’s a greater or lesser slow down on the
wireless infrastructure versus the networking side of the business?

**Lothar Maier**

I’m not sure that we’ve got the resolution in our data to say that. I mean,
we’ve seen things generally get slow but between wireless and networking I’m
not sure I could tell you much difference.

**Joanne Feeney - FTN Midwest Securities Corp.**

Can you perhaps elaborate then on infrastructure in general versus Smartphone,
because you talked about that going well last quarter.

**Lothar Maier**

As Paul said, consumer is an area that if we have to comment where things have
slowed down a little bit more than business in general, and to us, we kind of
categorize cell phones, at least in our business thinking, as a consumer item.
And I would say that’s an area where business has slowed down a little bit
more.

**Operator**

Your next question comes from Craig Berger - Friedman, Billings, Ramsey & Co.

**Craig Berger - Friedman, Billings, Ramsey & Co.**

Can you help us understand the sensitivity of your revenues to global GDP? If
global GDP falls a point next year, what’s the impact on your revenues?

**Paul Coghlan**

No, I can’t answer that. We don’t have economists on staff and that’s just
tough for us to do. We’re $1.0+ billion company, $1.2 billion at the run rate
last quarter, and it’s just, we sell high-end, kind of unique parts. To be
frank with you, we don’t spend much time at all worrying about global GDP.

**Craig Berger - Friedman, Billings, Ramsey & Co.**

I know you said lead times are stable as far as six weeks, can you comment on
your ability to service turns requests and is there a possibility that people
are just stripping orders our now while things are falling but may inevitably
come back to you with turns requests?

**Lothar Maier**

Yes. We generally, in the past are very good at responding to turns request.
With 4 to 6 week lead times, generally we have got to be able to turn the
business very quickly. Our manufacturing times are much longer than that.
We’ve got some internal practices that allow us to keep the turns very quick.
But just even under normal circumstances we normally are dependent on 50% to
60% of our sales in any quarter are tied to turns and it has made us pretty
agile in being able to respond to customers’ orders. Even though our typical
lead times are 4 to 6 weeks, on an expedited manner we can sometimes do much
better than that.

**Craig Berger - Friedman, Billings, Ramsey & Co.**

What are your current times and what might they go down to and what’s the
impact on gross margins there?

**Lothar Maier**

Lead times for us we’re forecasting to be in the order of 4 to 6 weeks, which
is what we’ve historically had. It’s kind of hard for me to predict how that’s
going to change throughout this particular quarter.

**Craig Berger - Friedman, Billings, Ramsey & Co.**

I’m sorry, can you answer that on fab utilizations? What are fab utilizations
now, where might they go and what is the impact on gross margins?

**Lothar Maier**

Fab utilizations, typically our factories are utilized pretty much at the run
rate of the sales. So if our sales, we are running virtually at full
utilization of our wafer fabs and if sales drop, we’re going to become
proportionally less utilized but we’re going to make adjustments to the
outputs of those factories to compensate for the reduction in demand. So if
sales go down like 10% we will adjust the output of our factories to
compensate for that.

**Craig Berger - Friedman, Billings, Ramsey & Co.**

So what would be the impact on gross margins?

**Paul Coghlan**

We’ve already told you on the profit before tax we think we can stay above 40%
and we were at 46% last quarter. All of that is distributed through the income
statement. I think we’ve given you some guidance on how we think that will
come out.

**Operator**

Your next question comes from Steven Smigie - Raymond James.

**Steven Smigie - Raymond James**

Looking at op-ex in the last cycle, it seemed like you kept the dollars on the
R&D a little bit stronger in terms of percentage of revenue versus the SG&A.
It seems like you took SG&A down a little bit more aggressively than R&D. So
would that sort of be the general pattern you follow here and do you see any
weakness and opportunities for a strong such as yourself to continue with high
levels of R&D to continue to win client business?

**Paul Coghlan**

R&D is very, very labor-intensive, as you might imagine. There are costs, mask
costs, etc. but it’s very labor intensive. SG&A, although labor-intensive, has
a lot of other. It’s kind of a catch-all area. You have legal expenses,
advertising expenses, you have a plethora of areas where if you want to
tighten your belt, and in times like this when people do tighten their belts,
there are some opportunities there to reduce your costs.

Now there are still opportunities in the R&D area. We have some variable costs
as they relate to our labor costs and in the past we have been able to do some
there. But that’s how we think we will treat both of those lines.

**Operator**

Your next question comes from Krishna Shankar - JMP Securities.

**Krishna Shankar - JMP Securities**

You indicated that the credit crisis has impacted you dramatically. Can you
talk about what percent of your revenue mix is with OEM and distributors and
to what extent is this due to distributors being unable to finance inventory?
And could you just give some color on the impact on the distribution channel
and their smaller customers about financing their inventory?

**Paul Coghlan**

Well, we don’t know of any situations yet where a distributor said to us that
they can’t buy any more from us because they can’t finance their inventory. On
the other hand we do know that credit is tightening and we do know that the
distributors who deals mostly with smaller clients, especially here in the
U.S., that the distributors are nervous about their client base and we think
will try to manage their assets as best as possible.

But if your question is do we have a list of guys we can tell you, not naming
them but specifics, who have called us and said they are now out of money and
the bank won’t give them any, we don’t have that yet.

**Robert H. Swanson, Jr.**

But again, to repeat something I said earlier, a lot of OEM sales go through
contract manufacturers. And they are the ones that pay us and our sense is
that is a cash-sensitive business, also, so we just anticipate that everybody
is going to looking at their cash and trying to figure out how to optimize it.
One way is to make sure their inventories are not one day longer than they
need to be.

**Krishna Shankar - JMP Securities**

As you [inaudible] the recent actions the government took to help credit
improve, what end markets do you think will recover more quickly coming out of
this down turn? Is it telecom networking infrastructure, high-end hardware,
can you give us a flavor for the rate of recovery in different end markets
that you see for the next three to six months?

**Paul Coghlan**

To be frank with you, no. I mean we don’t know how these government actions
are going to take place, whether they will be more market-specific, one market
to another. We don’t really know the answer to that. What we do know is what
the governments are trying to do is say that they’re going to try to free
credit up, so that if you have a reasonable business, you’ll be able to get
credit. That probably means if you have a marginal business it’s going to be
more difficult to get credit. And those marginal businesses and strong
businesses are going to permeate all different end markets. So I mean, we
really don’t have the economic granularity to answer the question you’ve
asked.

**Krishna Shankar - JMP Securities**

I was just asking about your direct conversations with OEMs. Do you sense that
they are putting major new say telecom networking infrastructure programs on
hold or new consumer high-end projects. Do you sense that design activity has
pushed out or cancelled or any of those conversations that you’ve had?

**Paul Coghlan**

No, we don’t think design activity has been pushed out. What we think is this
has caused a degree of real concern and what’s happening is that customers are
just pausing. They’re curtailing what they’re doing. They haven’t come to us
and said they’ve made massive, strategic changes in the past two weeks. On the
other hand, they’ve definitely said they are going to slow down their orders
and see what happens.

So this is very much in flux at the moment, but the overall trend is slow it
down and that’s what we’re seeing.

Now a quarter from now there may be more specific projects where people tell
you what they’ve done specifically, but the moment we think that the cry from
the bridge down to the boiler room is slow it down.

**Operator**

Your next question comes from David Wu - Global Crown Capital.

**David Wu - Global Crown Capital**

I’m just wondering, two things, quickly. I forgot to write down the percentage
of your business going through distribution in the last quarter. And the other
thing I was wondering is usually in the March quarter, in particular in the
U.S., the distributors for industrial products tend to be better, on a
seasonal basis, relative to your December quarter. In past recessions do those
seasonal trends go out the window entirely or do they merely get moderated?

**Paul Coghlan**

It depends on the nature of the recession. So that in the dot-com bust a lot
of our distributors who sold into the industrial environment, and a lot of our
industrial customers, didn’t have as big an impact on down turn in sales as
networking and communications infrastructure people did. This one feels a
little more broad-based, the one we’re in now.

On the other hand, you’re correct. March is normally a quarter where companies
that are strong in industrial and communications infrastructure environment
typically do better. Distributors have more days to sell, Europe has less
vacation days, that’s usually the start of a budget period for a lot of
companies that have calendar year ends. So we think that will probably
continue to prevail, that in the March quarter you will have more strength in
those areas and less strength in consumer once you’ve gone out of the holidays
season.

**David Wu - Global Crown Capital**

How big is your distribution business, by the way, the last quarter.

**Paul Coghlan**

That’s been hard for us to quantify because we have different natures of
distributors. For example, in the U.S. you have your kind of classical
distributor where you ship to him, he ships out to little guys.

In places like Japan, we do almost all of our business through distributors,
more because they’re a logistic channel for us than that they go find
customers. We actually have a big sales force in Japan, finds a lot of the
customers, including the very big customers, but it gets booked through a
distributor.

And then Europe tends to be a little bit more like the U.S. I guess their
distributors.

So we have this kind of blend of distributors. But if you said, well, the guy
has got the name distributor, I don’t care what variety he is.

**David Wu - Global Crown Capital**

Classical distributors, which does not include Japan, what roughly would the
business be as a percentage of total in Europe and the U.S.

**Paul Coghlan**

It would be about 50%.

**David Wu - Global Crown Capital**

So roughly half, outside of Japan.

If we have a long recession, but not as deep as the one in 2001, I assume that
allows you more time to adjust your costs. Am I correct?

**Paul Coghlan**

Yes, you’re correct. But we’ve been pretty adroit at adjusting costs
relatively quickly. So I mean, we haven’t told you that it’s going to take us
a long time to adjust our costs. We think we can react pretty quickly.

But if it’s a longer recession, what adjustments you make, you’ll have to keep
those in place for a longer period of time. And also, if it turns around
quickly, we’re also very quick to react. So our hope is it turns around, but
at the moment, certainly going into the next quarter, we don’t see that
happening quickly.

**David Wu - Global Crown Capital**

So this is basically, to summarize this conference call so far, what you’re
telling us is that you’re the leading canary in the coal mine, telling us that
there’s a freight train coming. Relative to the people who have reported so
far. Yours is by far the worst.

**Paul Coghlan**

Yeah, we’re at the front. We’re broad-based, which would support that thesis
you have. We have low lead times, which supports that thesis you have. So
we’re just telling you what we are. We’ll leave it to you to extrapolate
whether we’re the canary.

**Operator**

Your next question comes from Sumit Dhanda - Banc of America Securities.

**Sumit Dhanda - Banc of America Securities**

Paul, a couple of questions for you. Did you indicate what the turns
requirement would be for this quarter relative to last quarter to hit the mid-
point of your outlook?

**Paul Coghlan**

It’s about the same. It’s the high 50s.

**Sumit Dhanda - Banc of America Securities**

The other general question I had for you was on your cancellation or your
reserve policies to distributors. Is it any different than what it is for
other companies? In other words, do you have stricter cancellation policies?
Is that possibly a reason why you typically see a steeper fall off, if I look
at history versus other peers within the analog group?

**Paul Coghlan**

I would doubt that. We’re pretty disciplined so distributors know us, that
we’re disciplined with our receivable, and we’re disciplined within the
contracts that they have stock rotation rights and they need to stay within
those and we don’t allow them to expand those.

But I don’t know all my competitors, how they deal. But I don’t know of
distributors telling me that I’m radically different than the other analog
guys. So I would think I’m probably a little more disciplined maybe, but still
pretty close to the other guys.

**Sumit Dhanda - Banc of America Securities**

In terms of Linear strategy, you’ve gone through a process de-emphasizing the
consumer segment, refocusing on other places where you think there’s content
growth opportunities, where you can differentiate yourself. But assuming that
expectations are normalized across the board here, your December 2008 revenues
are going to be flat with what they were two years ago, suggesting over a
normalized period of time, basically the lack of any growth. And so how do we
think about that because that suggests underperformance or maybe just in-line
performance versus the industry at best. As an investor, how do we think about
the actions that you’ve taken and why they’re not really bearing significant
fruit, at least on the surface?

**Paul Coghlan**

Please be patient with me with this. I don’t know, you’ve picked one data
point for your comparison, which is the December 2008 forecast, in the teeth
of a huge world-wide credit crunch. And you’ve taken that and drawn an
extrapolation.

**Sumit Dhanda - Banc of America Securities**

No, I have not done that. That credit crunch impacts your entire peer group.
And we can pick whatever point you want to pick. We can pick 2008, an 2007, in
aggregate, and compare that to 2008 and 2007, for everybody else in your peer
group. I don’t think that the conclusion necessarily changes unless you want
to disabuse me of that notion. I’m just curious as to why, despite all these
efforts, it seems like we’re, at least based on the data and the forecast
you’re giving, we seem to be back to square one.

**Robert H. Swanson, Jr.**

Let me weigh in on that a little bit. Several years ago we had a very high
percentage of business in both what everybody considers consumer business and
if you throw in handsets, it was a significant piece of our business,
approaching 1/3. Today it’s much less than that. So it is true that in the
last two to three years the company has been focusing on markets like, re-
focusing on markets like the industrial, the communications market. And sort
of a new engine of growth for us, the automotive market, while de-emphasizing
those markets that weren’t contributing, they weren’t defensible, they weren’t
contributing any profit and so two and a half years later the company
continues to be, remains very healthy, from a profit and cash point of view.

Now maybe one of the unfortunate things is one of the markets that is a long-
term market for us, a market that is normally less volatile and we believe
will pay us good margins for our products, is automotive. Now who would have
guessed that automotive would have been hit with a credit crisis? But
automotive is one of those businesses that unfortunately is very sensitive to
credit. So maybe that’s bad luck in the short term but it’s certainly where we
want to be in the long term.

**Paul Coghlan**

And you made a comment, you said pick any period I want, I think because I
challenged that you included December. If you back out our December guidance
and you look at the last six quarters, we’ve grown each of the six quarters
and none of our competitors have done this. So if you want to compare us with
the analog guys over the last six quarters, I think you’ll see we’ve grown
better, we’re at the top end of the pile. Or very close to the top end.

**Robert H. Swanson, Jr.**

And on the surface, while those two data points show flat sales, there has
been a significant substitution of business that wasn’t defensible, quickly
becoming non-profitable, replacing business that is defensible and is
profitable.

**Sumit Dhanda - Banc of America Securities**

Let me just shift gears. Any color you can offer on the sell through rates
that the distributors have been seeing recently, ever since the slow down
started to occur? I’ll call it the middle of September through the middle of
October. Has that mirrored the booking patterns you’ve seen? Have sales been
poorer or maybe slightly better versus a [inaudible] ?

**Paul Coghlan**

Well, U.S. distribution, I think the sell through has been a little less in
the last quarter than the previous quarter. And I think U.S. distribution will
be anticipating sell through this quarter will be less than it was last
quarter. And then other distributors, depending on geographic areas, some are
like that and some in some geographic areas are having a little better sell
through.

The U.S. for sure has been getting poorer.

**Sumit Dhanda - Banc of America Securities**

Can we safely assume that the tax rate stays at about the 25% level for the
foreseeable future?

**Paul Coghlan**

The effective tax rate, as I said, will be 28.5% for the foreseeable future.
You have these discrete items that come in and out. Now, there’s a new
accounting pronouncement a few years ago, 1048, and it has resulted in a lot
of these items every quarter. So my guess is we’ll be in and around that range
for a couple of quarters, but I think the effective overall rate is 28.5%.
Next quarter I do know of some discrete items relative to the R&D credit.
Quarters out, those discrete items depend on timing.

**Operator**

Your next question comes from [Ali Pharr] – Spherix Capital.

**[Ali Pharr] – Spherix Capital.**

I just have a question. There is sort of a crisis of confidence and I think
this guidance that you’re giving, for lack of a better word, is disastrous.
It’s sort of fueling the fears that investors have that are we at the middle,
are we at the end, or at the beginning of this slow down. Now, every company
that has reported so far, Maximus, Altera, Intel, as one of my peers pointed
out, they have experienced the weakness, they talked about it, everybody
acknowledged the impact of this credit crisis in our industry. But again, your
guidance of down 10% to 20% is just too high.

And then some explanations that are put out there is that some of the other
companies are saying they have sort lead times, Altera has short lead times.
They saw the weakness of this economic slow down earlier in the year. That’s
why we’re seeing a decline in their revenues. Like Maximus down 5% year-over-
year, PI down 3% year-over-year, ATI up slightly. And even if you take the 15%
down for your December quarter, you’re year-over-year revenue is up 8%. So
their explanation is that they saw the slow down first, you are seeing it
last. The reason you are seeing it last is because you have a lot of
proprietary products that distributors and contract manufacturers, that
finally they are sort of trying to take their inventories down. And also as
management, you tend to be more conservative.

So again, just to rebalance, and this may be a tough question in terms of
what’s your judgment, can you just sort of give us a real picture. Like there
were some discussions that maybe you’ve bought some shares both in a
networking company and a consumer company here in Silicon Valley. Maybe that
has had a disproportionate impact. And the fact that internationally you
recognize your revenues fell in through distributors. So sort of give us a
balanced perspective, if you can, because I’m telling you, a lot of people are
reading into this just disastrous guidance that you’re giving.

**Paul Coghlan**

Well, that’s a long and well-thought out question. I think some of it is how
you perceive it. Bob mentioned earlier that if you go back two years or three
years, Linear started a process of de-emphasizing to some extent, those parts
of consumer business that weren’t keyed towards high performance and were
really more commodity in nature and where the end customer cared less about
the actual performance of a product and more about the price of it. And where
that encompassed about 1/3 of our business, or a little more back then, it’s
now much more down towards the lower 20% bracket of our business.

And we had started that several years ago and in the early time frame we were
growing not as quickly, or just about the average of analog guys, and people
were saying to us, gee, are you falling behind? And we said, no, we think
we’ve got a right strategy, look a the profit lines and the answer will be
there.

And then the last six quarters we’ve outperformed folks. And what we’ve done,
is we have really good products, we’ve done really well, we think, in that
time frame. Now, because there’s a big credit crunch, and now because of short
lead times, we’re adjusting our forecast in December, Ali, you’re saying, well
gee, those last six quarters, maybe they really didn’t happen that way.

Maybe in those last six quarters was all your competitors saw the down turn
coming sooner than you did. And they had some clairvoyant sense that there
would be these credit crunches and issues like that and business was softening
and you didn’t. We don’t think that’s accurate. We think we actually did
outperform in that period.

We think now, relative to this particular period, your question as to whether
is it a Linear-specific issue [on this], or could you be seeing it first more
accurately than others. We do have low lead times, we do have lower lead times
than other folks. We have been operating that way for years and think it’s the
best way to run our business.

So that we do think in this short period now, where everyone is reacting to
the credit crunch, we might see it sooner. And we think that’s why we’ve given
you, to use your term, this disastrous forecast for December. We think the
range is an accurate range.

So these things you can spin it whatever way you want, I guess. You can say
let me just look at December like an earlier caller said, well, let me take
the quarter of December guidance and compare that with two years ago and say
you guys have made no progress and done nothing in the interim.

So you can spin these things any way you want. The bottom line from us is we
have remained very profitable, very cash-flow positive, outperformed our peers
in those metrics. We’ve also outgrown them in the last six quarters, except
the one we’re in now.

Now the one we’re in now, the December quarter, because of this credit crunch,
it’s going to be a difficult quarter for us. We should probably have this same
question three quarters from now and see how everybody’s doing there quarters
from now. And then you maybe have a better sense of balanced data as to
whether other guys saw something happening before we did or whether they
didn’t, we just outperformed them and now everybody is going to have a credit
crunch problem.

**Operator**

Your next question comes from Dan Murphy – O’Connor.

**Dan Murphy – O’Connor**

Two questions on things that are in your control I think. The first one, when
your customers look at your balance sheet, do they look at your gross cash on
the balance sheet or do they look at your net cash, cash minus debt?

The second question is, and you talked about it earlier in the call when you
forecast interest income for the December quarter, can you weight for us the
pros and cons of continuing to invest in low-interest rate securities on the
balance sheet, buying back debt, I guess the bonds putable in 210 are yielding
close to 12% if not more, buying maybe the longer-term convertibles, and then
buying back stock. And the pros and cons for the company for doing either of
those three?

**Paul Coghlan**

The first question, I think most customers when they look at us they look at
our products we sell, our payables records. I don’t know too many of them that
look at the cash and compare it to the debt and do a debt-to-cash analysis of
us. Maybe those that are initially giving us credit would look at that. But
the debt, I think most people think we have the cash generation capabilities
to easily handle the debt.

Relative to your second question, what we have had, we have bought back a lot
of stock. I’ve told you that, you’re aware of that. Times like this, when your
stock is under a lot of pressure, and your debt is under pressure, those could
be opportune times to do something in either of those two areas. These are
also times when pressure arises because cash is very critical. And people are
saying keep your powder dry and as you make your way through difficult times
make sure you have plenty of cash and plenty of headroom there because it
would be very difficult to raise it, external to the company.

So I think your question is a very good question and I think as a company we
would look at all three of those alternatives and as we made decisions a while
ago to buy back some stock, we made about six quarters ago, we will keep
looking at these and decide what’s the prudent thing to do in the time frame.

**Dan Murphy – O’Connor**

If you thought that this cycle might be longer than the dot-com cycle but not
quite as severe, you have a maturity in 2010 that’s trading substantially
below par. Wouldn’t using some cash to buy that back below where it’s going to
mature in 2010 be a smart decision?

**Paul Coghlan**

One could certainly argue that that would be a smart decision, to do something
like that. Again, you have to look at when you said that I said that the dot-
com bust, that this would be less steep but maybe a little longer, I certainly
wasn’t holding myself out as an economist. I don’t know how long this is going
to be. The dot-com thing lasted a while.

But certainly when you just look at it from a cash utilization point, if
you’re very, very confident you could keep all your cash or grow your cash,
using some of it if you thought you had excess cash, this would be a prudent
time to do that.

**Robert H. Swanson, Jr.**

I’m certainly not an economist either and I probably shouldn’t even weigh in
on this, but the dot-com bust was a real collapse of demand. This is a problem
of credit, a credit crunch, and a loss of confidence. If that loss of
confidence gets corrected quickly, then the improvement could be quick also.
But how in the heck would we know what the right answer is to that question?

**Dan Murphy – O’Connor**

One might also argue that your convertible bonds due in 2010 trading in the
80s might also be a loss of confidence and one of the things in your control
would be to take advantage of that by buying some back. I mean, to hold on to
your cash, you’re going to have to pay them back at that put date at 100 or go
out of business. I don’t know, if this is a rationality and just a pause in an
air pocket with the credit cycle, maybe one of the ways to take advantage of
that is on your balance sheet.

**Paul Coghlan**

That’s a good input.

**Operator**

Your next question comes from Alec Berman- AMPAC Research.

**Alec Berman – AMPAC Research**

You talked before about the proprietary products and their large percentage,
can you say approximately how of the designs you’re going after right now, if
you look at the whole catalogue, what percent of those do you think are things
where you sit down with a customer and it’s really just you and that one
customer working on a specific design versus where there actually is another
person competing for the socket?

**Lothar Maier**

I think it’s very rare that there’s a pin-for-pin replacement part for an LTC
product. That’s not very frequent. There are more likely comparable solutions
that a customer can put together that solves whatever problem they’re trying
to solve. So the fact that there are not a lot of pin-for-pin parts, you know,
some of our consumer stuff, where people have copied them, over time there
might be a few. But for new products and for the majority of our products,
there really isn’t a direct replacement.

Most of the competition is really how the implementation of the customer is
done. And so one of the strengths that we have is we’ve got a really, really
strong analog field applications organizations and that’s how we get our
proprietary parts designed in and that’s one of the advantages that we have.
That’s been a strength in the past and I think going forward, as the economic
times get more difficult and many of our customers have less and less analog
expertise in-house, that we will continue to be successful in helping
customers design in our products. And once they’re designed in they really are
in a proprietary position.

**Operator**

Your next question comes from Steve Rosston – Glynn Capital Management.

**Steve Rosston - Glynn Capital Management**

You made a good point about the transition in your business two to three years
ago where you focused more on the industrial and more traditional analog
products and less on the commodity-consumer products. Can you give us a little
more data than you have in terms of how much of your business needed to roll
off and where are you now and where will you go in the future in terms of
taking away less profitable revenue on the consumer side and how long will it
take to ramp up the longer lead time to production, industrial products and
auto products, that you’re replacing that consumer business with?

**Lothar Maier**

Over the last few years, as Bob mentioned, we’ve de-emphasized a lot of the
consumer business and replaced it with a lot of what we think is much more
defensible business. To the outside investor it kind of looks like things were
a little bit flat, but behind the curtain a lot of changes took place. I mean,
we talked about earlier how the consumer portion of our business went from
being 1/3 to closer to 20%, where it is presently. And you’re looking at
$100.0+ million worth of business that we used to have and that we used to
sell into the consumer market and which we’ve now replaced with more
defensible business.

**Steve Rosston - Glynn Capital Management**

Can you expand beyond that? Because I know that sometimes it takes two to four
years for your more traditional analog products to get to production. That
wasn’t the case with the shorter time frame to consumer products. Given the
design talent you shifted, what do you expect the change to be and when, from
the shift of that design talent from the consumer products two to three years
ago to the industrial products that are now more coming on line?

**Robert H. Swanson, Jr.**

When we look at our data, the involvement in handset and other consumer
products hit a peak in our FY2005. It was at the beginning of 2006 that we
said, look, we need to make some changes here for the long-term strategic
health of the company and we did that. Now, looking in at 2009, we expected
the consumer and handset business to fall even more. In fact, fall to half of
what it is now. We expected industrial and automotive and some other key
markets that we believe are in the better long-term alignment with our
strategy to improve. And we expected our total sales to improve.

The credit crunch was a curve ball that we weren’t anticipating. But whatever
the sales are, the mix, at the end of 2009 and 2010, will be more in the
direction of the shift that we started way back in 2006. So, it’s a two to
three to four year cycle.

**Steve Rosston - Glynn Capital Management**

But that cycle started two years ago.

**Robert H. Swanson, Jr.**

That’s right. And we were feeling real good about 2009, about both the level
of sales and the mix of sales, and then out of the blue came this credit
crunch, that certainly was not on any our radar screens.

**Steve Rosston - Glynn Capital Management**

So, Bob, just so I understand I make sure I understand what you’re saying, in
the consumer are, you expected it to drop it from now about 20% to
significantly less as the more business rolled off, but your design ins were
strong enough in the industrial and auto area that that would have been more
than replaced in the fiscal 2009 period?

**Robert H. Swanson, Jr.**

That’s exactly right. And I think in FY2008 not only did we replace maybe as
much as $100.0 million worth of business, not only did we backfill that, but
we grew by another $92.0 million. Internally we were hoping, and had
expectations that we might be able to put together a similar year in FY2009.

**Operator**

Your final question comes from Doug Freedman – American Technology Research

**Doug Freedman – American Technology Research**

I received a couple of questions, Paul, on your comments about turns orders,
saying it’s the same percentage. Just for clarity, can you explain how that
works for people and I take that to mean that you’re basically going to book
and ship and maintain your backlog at a constant level and if anything, your
backlog coverage of the percentage of dollars might actually increase. Would
that be fair?

**Paul Coghlan**

What I do is I look at what I estimate the sales for the quarter will be and
then I look at how much of that I have already in my backlog. And then I take
that percent and the reciprocal of that is the turns that I need. And normally
the number approximates lead times. So if I have a high-50%, say 55% to 60%,
that approximates the lead time. And my lead times are 4 to 6 weeks out of a
13-week quarter. So what I do is I look at the estimated sales we have and
then compare that to the backlog that’s going to ship in the quarter and
that’s how I come up with the turns number.

**Operator**

There are no further questions.

**Paul Coghlan**

Thank you very much for your attention today. It was a good call. You asked a
lot of intelligent and perceptive questions. Going forward, we would like you
to concentrate on we know we gave guidance that was different than you may
have expected, and we think our guidance is going to prove that it’s accurate
throughout the economy. We think that this is going to be a time when a
premium is placed on good solid companies, companies that have good cash-flow
generation, good income generation capabilities, we have a dividend which is
greater than 3% of our stock now, so we think we’ve been through times like
this before, we’ve done well in those times and come out stronger, and we
think that will happen this time as well. And we wish you all a good day.

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42,100119-spansion-inc-q3-2008-earnings-call-transcript.html,"Spansion, Inc.",SPSN,services,2008.0,,regular,"October 15, 2008",4:30 pm,2008-10-15T20:30:00.000Z,40365,13797,26568,3,5,"['Ken Tinsley - Director of Investor Relations', 'Bertrand F. Cambou - President, Chief Executive Officer, Director', 'Dario Sacomani - Chief Financial Officer, Executive Vice President']","['Daniel Berenbaum - Cowen & Company', 'Shawn Webster - J.P. Morgan', 'Bobby Gujavrty - Deutsche Bank Securities', 'Betsy Van Hees - Caris & Co.', 'John Pitzer - Credit Suisse First Boston']","**Operator**

Welcome to the Spansion third quarter 2008 earnings results conference call.
(Operator Instructions) At this time for opening remarks and introductions, I
would like to turn the call over to Ken Tinsley, Director of Investor
Relations.

**Ken Tinsley**

With me here today are Bertrand Cambou, CEO, and Dario Sacomani, our CFO.

Before we begin today’s discussion I’d like to remind you that during this
call we will make forward-looking statements that are made pursuant to the
Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995
including but not limited to statements regarding expected fourth quarter and
fiscal 2008 operating results, anticipated capital expenditures and reductions
of costs, expected net sales from SP1, expected inventory declines, efforts to
improve the company’s capital position and long-term cost structure, expected
benefits from our EcoRAM technology, expected benefits from potential
strategic transactions including the anticipated joint venture with ASE.

Investors are cautioned that forward-looking statements in this conference
call involve risks and uncertainties that could cause actual results to differ
materially from the company’s current expectations. For risks that the company
considers to be important factors that could cause actual results to differ
materially from those set forth in the forward-looking statements, we urge you
to carefully review the risks and uncertainties listed in the company’s
Securities and Exchange Commission filings including but not limited to
Spansion’s quarterly report on Form 10Q for the fiscal quarter ended June 29,
2008. The company disclaims any duty to update forward-looking statements.

With that let me turn it over to Bertrand.

**Bertrand F. Cambou**

We had a solid Q3 in spite of the challenging environment for the memory
industry. Revenue grew to $631 million up quarter-on-quarter and year-on-year.
These results were achieved through market share gain. We now command nearly
40% market share compared to 33% last year and meet 20% of the formation of
Spansion.

Even though our prices are relatively stable, we were impacted in the third
quarter by overhead pricing pressure in the memory segment. To mitigate this
ASP drop we are focusing on the highest margin part of the business, raising
prices for select segments and exiting non-profitable product lines.

As part of this strategy we decided to exit the 90 nanometer content delivery
card business in the third quarter comprised of our 4 bit [preserved] flash
memory device built in our mature fab 25 factory. As a result of the set of
actions that we taken, total inventories are down significantly quarter-on-
quarter and fab 25 is essentially full. We are dedicating most of this factory
to profitable business that we have.

In the third quarter revenue generated from product built in our 300
millimeter SP1 factory was lower than expected for the two following reasons.

First, the Japan cell phone business that consumed the majority of our 2 gig
ONAND devices out of SP1 dropped in the third quarter to less than half our
expectation. This decline was due to changes in regulation in Japan which has
cut subsidies to subscribers.

Second, the qualifications of our 112 volt wireless NOR device to our biggest
customer was a couple of months behind schedule. As a result revenue from SP1
was in the low double-digit millions of dollars for the quarter.

Please note that we were able to mitigate any potential sales impact of those
delays by continuing shipments of the 90 nanometer NOR.

Progress on customer qualifications across the board in SP1 to a full range of
customer including our biggest NOR customer allowed us to build inventory
ahead going into Q4. We are now on track with our SP1 factory quals including
1.8-volt wireless NOR in our market, 3-volt customer NOR devices, MirrorBit
clips and EcoRAM solutions. At this rate we are planning to realize full
revenue from Sp1 productions around Q2 of 09 at which time we expect to add
further capacity by ramping up these products at SMIC to meet customer demand.

Now let me switch and explain the performance of our two main business
divisions. The wireless system division or WSD had a strong revenue upside to
$320 million driven by share gain at our largest OEM accounts. In fact the
third quarter rate was the second highest quarter on report for our largest
wireless account. Particularly strong for that division were sales in the US,
Europe and then both Korea and China went up. Why? Japan was down for reasons
already discussed.

I’d like to mention that quarter-on-quarter the number of units shipped in
wireless went up by 10 million from 85 million in Q2 to 95 million in Q3.
Interesting enough the low density least profitable segment in wireless went
down in units quarter-on-quarter while 256 megabit and 512 megabit revenue was
up by 33%. WSD expects significant 65 nanometer NOR revenue from Sp1 in Q4.

For the consumer, set top box and industrial division or CSID revenue was
slightly down to a respectable $305 million. We are again very pleased with
the performance of this division.

Year-to-date CSID has enjoyed very large segment share gain leveraging high
density MirrorBit devices. Quarter-on-quarter revenue from high density
MirrorBit product in that division greater than 128 megabit went up 7% while
the last profitable commodity floating gate product went down.

CSID is now going also full speed in qualifying 65 nanometer NOR from SP1. We
expect revenue for that division this quarter as well.

The deployment of our newly-announced EcoRAM technology for data center and
search engine is right on time. We now have our first server in the hand of
our customer and expect firm orders this quarter. EcoRAM will be built in SP1
first and also SMIC for additional capacity.

Also note that last month we announced the extension of our agreement with
SMIC to include our new 43 nanometer MirrorBit ORNAND2 out of the Wuhan XinXin
Semiconductor company to serve value-added NAND portion of the integrated
market.

Before I let Dario describe our financials in detail, I’d like to give a brief
update on cost-cutting and restructuring efforts. This morning we announced a
very significant MOU, Memorandum of Understanding, for the creations of a
joint venture with ASE group to jointly own and operate Spansion’s flagship
Suzhou factory. This factory has 1,100 employees dedicated to assembly and
test mainly for cell phone memory multichip modules. The purpose of the
alliance is to leverage ASE’s expertise and economy of scale to further
accelerate our cost advantage over our competition.

We are currently in discussions with other potential partners to create
similar arrangements for other final manufacturing facilities and material
with the fabrications. We are also making progress in forging alliances with
other leading corporations to reduce our R&D costs.

Altogether we are now on the path to create a focused Spansion while
leveraging our high valued $2.3 billion of fixed assets that we own as well as
our very strong intellectual property, which approximately count 3,000 patents
and patent applications.

To notice that short-term we are taking more actions to rapidly cut all
spending and reduce the need for cash. This includes salary reductions,
cutting capital expenditures, freezing headcount and reducing administrative
expenses. In manufacturing we are engaged in a relentless race to cut subcon
and foundry expenses and push for productivity in all areas. As a result costs
went down in Q3 and I expect them to decline further this quarter and beyond.

Now I’d like to turn the call over to our CFO, Dario Sacomani.

**Dario Sacomani**

I’ll review a few specifics of our financial performance for the quarter and
then I’ll provide some detail on our outlook.

As Bertrand mentioned, Q3 was solid in light of the overall memory segment.
Net sales in Q3 were $631 million, up 3% compared to Q2. Overall pricing was
stable in the third quarter which contrasts sharply with the rest of the flash
memory industry. Sequentially from Q2 ASP per megabit declined approximately
10%. However in our core NOR business it was only 8% to 9% ASP per megabit
decline. Therefore, overall I’m pleased with the relative stability in our
core NOR business.

The biggest impact on margins this quarter was from our 90 nanometer content
delivery business which we decided to exit in Q3. Even with these lower ASPs
we were able to grow the top line. As for gross margin, there were three
primary drivers regarding third quarter margin of 14%.

The core NOR pricing decline of 8% to 9% I mentioned caused about a 150 basis
point incremental gross margin decline.

During the third quarter Spansion elected to exit the 90 nanometer content
delivery business as Bertrand mentioned by monetizing the inventory and
writing down certain related assets. With mainstream NAND price declines of
over 40% since the third quarter alone, we made the decision to exit this
business which cost us about 200 basis points of gross margin.

Finally, gross margin was also impacted by approximately 150 basis points due
to lower-than-expected SP1 utilization as explained previously by Bertrand.

Due to the volatile economic environment our outlook for Q4 gross margin is
uncertain. Our current expectation is that gross margin in Q4 will be up but
could be flat depending on how demand for Q4 and Q109 affects factory
utilization through the quarter.

On the expense side, excluding restructuring charges, op ex totaled $171
million down $6 million sequentially and slightly better than our expectation.
Our outlook for the fourth quarter for ongoing operating expenses is a further
decline of approximately $10 million reflecting the impact of cost reduction
measures implemented in the third quarter as Bertrand discussed.

If we are successful with certain partnerships and restructuring activities,
we may have additional expenses associated with those transactions. We expect
to see additional savings from restructuring initiatives next year.

Moving on you’ll note an uptick in our income tax provision in Q3 due to more
profit in our Japan subsidiary. We expect future provisions to be in the range
of $3 million to $5 million per quarter.

Net loss for the quarter was $119 million or $0.74 a share and included $13
million in charges related to our exit of the 90 nanometer content delivery
business. EBITDA for the quarter was $76 million and included the $13 million
of exit costs and a small restructuring charge of $1 million.

Moving on to the balance sheet, DSOs were up slightly to 57 days from 55 in
Q2. Days payable declined to 104 from 111. Inventory days were 103 down from
115 in Q2 reflecting results from our overall inventory reduction plan
including continued reduction of external foundry and subcon support of
approximately $15 million. We expect the inventory to decline slightly in Q4.

At the end of Q3 our cash and short-term investment balances were $259
million. This amount included $107 million of auction rate securities which we
temporarily impaired from $122 million or 88% of PAR. Last week UBS offered to
buy-back these securities at 100% of PAR in June of 2010. From now until then
we might be able to receive 75% of the PAR value of these notes in the form of
a short-term loan against these securities at the same interest rate we are
currently earning on these securities. We are currently working with UBS to
realize this liquidity.

In addition to our cash and investments, revolver capacity at the end of the
quarter was approximately $100 million bringing total liquidity to $359
million. The ASE transaction discussed by Bertrand should result in cash
proceeds to Spansion, and we have several other similar opportunities that we
are pursuing.

Cap ex for the third quarter was $110 million, flat from last quarter. The
majority of the cap ex spend in the quarter was 65 nanometer and 45 nanometer
300 millimeter development. Now that the initial investment in SP1 is complete
we’re significantly reducing our capital spending to maintenance levels. For
Q4 we expect capital expenditures to be roughly $40 million. Our previous
outlook for 2008 was cap ex to be under $500 million so with this reduction we
are now expecting approximately $435 million of capital expense for the year.
That excludes the $50 million lease in Q1 bringing full year to $485 million.

In summary, our sales growth in the quarter was impressive considering the
memory market conditions, our inventory levels are moving in the right
direction, we remain cautious in this environment and are taking aggressive
actions to align our operations accordingly to ensure our long-term success.

With that I’ll pass it back to Bertrand to wrap up.

**Bertrand F. Cambou**

Let me wrap up and come back again on our guidance. We are very confident in
our ability to solidify our segment market share position in Q4 as we are
ramping up a new wireless account and pushing high density MirrorBit across
all businesses. However we have to carefully consider the uncertainty in our
business. The size of the total available market may actually shrink and we
will offset this reduction somewhat by gaining share. Altogether we are now
thinking about a slight reduction of revenue in Q4. Dario has already said
gross margin at that point to be flat to up and all of our expenses to go
down.

Let me assure you that the primary objective of management in this difficult
environment is: First, cash preservation and the relentless cost-cutting
effort. Second, we are pursuing a successful commercial strategy to gain
share, a strategy to count. And third, we are focused on a flawless execution
at SP1 to fully leverage this strategic asset.

Spansion’s competitive position significantly improved again in Q3 and our
factory had outstanding performance. It is time now to get the job done and
deliver on our commitment.

With that, let’s open up for questions.

","**Question-and-Answer Session**

**Operator**

(Operator Instructions) Our first question comes from Daniel Berenbaum - Cowen
& Company.

**Daniel Berenbaum - Cowen & Company**

You mentioned about your total liquidity. Do you think that cash balance has
bottomed in this quarter? Do you expect to have to tap the revolver? As far as
any leasing agreements for equipment that you might have or other financial
arrangements in the fab, how has the ongoing credit crisis affected that and
could there be any issues with actually operating the fab because of
tightening credit requirements?

**Dario Sacomani**

The credit crisis obviously affects everybody, but the truth is even before
the credit crisis at single B there wasn’t a lot of credit available to us
anyway. Since there really is no credible financing sources for alternatives
given our stock price and yield rates on our bonds, we’re really focused more
on the fundamentals to start with, which as Bertrand enumerated significant
amount of cost-reduction activities, capital spending reductions to
maintenance levels, inventory control, improved DSOs and vendor terms. If you
assume looking forward that in Q4 we get our days of inventory at around 103,
DSOs of 53, and DPOs of 111, that should drive us to free cash flow in Q4.

Obviously we spend a lot of time focused on the auction rate security
liquidity options and there are to your question alternative leasing
opportunities to us.

I think one of the benefits of Spansion is we do have a global footprint so we
aren’t tied to only being able to obtain credit in the US, and we’re
leveraging that global footprint all the time.

I think on top of that the ASE, the alliances for manufacturing in R&D we’re
focused on and we’re also focused on continuing to pursue other non-strategic
asset sales. That’s kind of how we’re addressing liquidity.

**Bertrand F. Cambou**

I’d like to rebound on Dario here. I have to say that I am very, very pleased
by the overall trajectory that we have as a company right now. With cost-cut
reductions, capital cost reduction everywhere and we are already seeing some
tangible and if I look at our results you see things that has been worrying
like the inventory of tough control six months ago, that is fixed. The
spending that we had that was high, done. We’re not spending any more. R&D
costs are going down. SG&A is going down.

Now to add on what Dario said, we currently have very, very [inaudible]. I was
quoting here this $2.3 billion and that’s a prime asset. The Suzhou factory
that we had the transactions is currently the largest MCP factory in the
world, the most modern one and a factory of very advanced, very well run, very
well kept and we think that right now this is a perfect timing to join forces
with a leader like ASE to retransform Spansion into a smaller Spansion, more
focused on our core competencies and to leverage that asset into improve our
liquidity.

**Dario Sacomani**

I just want to make sure you guys are clear. I answered that and I talked
about alliances as it came up in liquidity, but like Bertrand talked about
earlier this is a long-term strategy. This is not something that we did just
for liquidity. We expect costs from someone who does this for a living to go
down significantly in the long term. So I mentioned it in the context of
liquidity but I think Bertrand had previously talked about the fact that from
a long-term perspective this is going to be a cost advantage for Spansion.

**Daniel Berenbaum - Cowen & Company**

On the op ex cuts, you said you expect Q4 to be down about $10 million. How
much of that’s R&D and how much is SG&A and how much more can you cut both of
those if you have to? And obviously I’m particularly concerned about R&D. That
trajectory’s been down. What’s your minimum R&D level to support some of the
Eclipse development, the charge-trapping development?

**Bertrand F. Cambou**

On the R&D we actually have two opportunities there. First, a lot of the 65
nanometer 300 millimeter SP1 development is behind us. We had a lot of costs
in [inaudible] six months ago that we don’t have to incur anymore. It’s
fundamentally now our cost is lower than what we used to and our technology is
very focused. We are essentially walking on MirrorBit, one technology it is
very much focused here and we think that we have an opportunity to further
reduce it and not that it will result in any compromise whatsoever on pursuing
our technology leadership.

We have a second opportunity on cutting R&D which is alliance. There are
currently some companies that we are discussing with and of course this is not
the right time to disclose what it is but there is opportunity there as well
to do some R&D sharing at that point, which means that between the fact that
the fundamentally we are currently going down because of R&D. We are going to
accelerate that and find a true alliance to go even lower here. Like I was
saying to my previous discussion in the last quarter, this is a priority. That
has to go down.

We are taking actions. You are going to see a significant piece of this $10 is
going to be R&D and going forward this is an area that you can assume here
that we like to be at the $100 million ladder or so for R&D costs in Q4 and
then to go way sub $400 next year; way sub [inaudible]. The train has left. We
are now in an efficiency mode and we’re not going to compromise our leadership
position.

**Dario Sacomani**

I’ll just comment a follow on to what Bertrand said. He talked about R&D and
I’ll just talk a little bit about SG&A because we talked about it last
quarter. Again we have a very global footprint and in addition to salary cuts
and discretionary spending cuts as it relates to SG&A overall efficiency in
administration, we’re also doing a significant amount of movement of
centralized functions to low-cost regions. That’s going to give us a lot of
leverage as it relates to SG&A.

Additionally we talked a little bit about ASE. That’s a lot of employees and
at the end of the day there’s a lot of SG&A associated with the maintenance of
those kinds of facilities that having joint ventures like we’re proposing are
also going to allow us to reduce the amount of SG&A we spend.

**Operator**

Our next question comes from Shawn Webster - J.P. Morgan.

**Shawn Webster - J.P. Morgan**

I’d like to ask some questions on your restructuring initiative, but first can
you share with us what your book-to-bill is and how lead times are
progressing? You mentioned one of your factory’s utilization rates was low,
but can you talk about your total utilization rate trends this quarter and
next?

**Bertrand F. Cambou**

I was actually mentioning that our utilization is high. The factory
[inaudible] right now is totally full. Our JV3s is also full which mean we
don’t - absolutely we have a great situation here in our factory. We currently
have an installed capacity that is lower than our current revenue rate, which
means that we are on the contrary in a very, very good position as far as
being able to like Dario said further cut inventory going forward and we have
monitored here because let us say six to nine months ago a big portion of our
capacity was coming from foundry which means that we think we have on the
contrary the asset being well in line to the alignment.

**Shawn Webster - J.P. Morgan**

So your utilization rates were full in Q3 and you expect them to remain full
in Q4?

**Bertrand F. Cambou**

We absolutely are currently running, not only that we are full but with the
current revenue outlook, we are not able to produce demand. The SP1 I went in
growing detail explaining the SP1 situation here and we think that this is a
situation of wrapping up all the qual but as quickly as they are, we’re going
to be short and we need to use SMIC as quickly as we are massively qualifying.

On your questions on the book-to-bill, interesting enough in the environment
our backlog is not bad at all. The month of September that was supposed to be
a catastrophe in the industry as far as we are concerned, we had a very strong
September. Our book-to-bill technically is slightly below one and that
obviously we anticipate that to be the case because the customer lead time
right now has been reduced. Our customers in general are more prudent. They
place their order at the last minute but if we actually grow and as we are
doing monitoring the true demand of our product on the run rate, again the
backlog that we have right now has been pretty strong. September was a good
month in all aspect.

**Dario Sacomani**

Just to add to that if I could real quick, as it relates to factory
utilization what I said about gross margin was really that when we start to
understand the full demand; there is some uncertainty; but a lot of what we
build in the fourth quarter is associated with the first quarter. So seeing
what happens in the fourth quarter as well as starting to feel out where we
think the first quarter is going is really what’s going to help us determine
what kind of utilization rate we’re going to have in Q4. That’s why I said our
gross margin could be flat because it’s unknown at this point in time.

**Shawn Webster - J.P. Morgan**

Did you write down inventory in the quarter?

**Dario Sacomani**

No we didn’t really write it down. We actually got out of the quad 90
business, which had a significant amount of inventory. We didn’t get a whole
lot of revenue for it but we actually tried to monetize as much as we possibly
could. Every quarter we have inventory write-downs you guys don’t know about
called standard changes but there was nothing really significant. The
significant impact in the quarter was exiting the 90 nanometer business.

**Shawn Webster - J.P. Morgan**

When you say you monetized that line of business, do I read that as you sold
it for really low prices?

**Dario Sacomani**

That’s why we said in the NAND business, the price declined by 40%. I think
considering holding on and expecting prices to go up was the wrong thing to
do.

**Bertrand F. Cambou**

What we had is the fab 25. We have been kind of using some of this card
delivery business as an early way to set up the technology right because with
this ORNAND technology in general is easier to ramp up. And when we started we
had some ASP assumptions and we had some kind of a piece of the fab 25 use.
Obviously the factory right now is running very well. We don’t need that type
of thing anymore and that’s why we elected to essentially sell at whatever
market price was there to write off. We had [inaudible], [taxiture], some
things around it and we elected to clean all of that up and then to start
fresh for Q4.

**Shawn Webster - J.P. Morgan**

Do you see pricing pressure from any particular competitors out there or
geographies?

**Bertrand F. Cambou**

Now we’re talking about the main NOR business. In the NOR business Dario was
turning to you here but on average the price decrease per bit was around 8% or
so, which is a bit higher than what we model because we essentially were
modeling 6% to 7% and that’s in all this 150 basis point that Dario was
eluding to.

In the overall grand scheme of things if you look at what is going on in the
memory segment, we’re pretty pleased that the prices are holding pretty well.
In some cases, in particular in some of the Asian markets, we raised price in
Q3 with success. In other cases we are holding price firm, which means that on
average we see an average selling price a bit more intense than the model but
nothing compared with what’s going on in the memory segments right now in the
mainstream device.

Going forward we are still back to the same things; high density MirrorBit is
solid because we have less competition there. We have a competitive edge on
our technologies and when you go to the low end commodity, then that’s where
you have a lot of pressure right now all across the board because the entry
level is so low that it is hard to stick with a price in the current
environment.

**Dario Sacomani**

I just want to add one point of reference to what Bertrand said if I might,
and that is just that the environment has actually been pretty stable for a
while but back in Q1 and Q2 of ’07 we were talking about 12% and 18% price
declines per megabit. It’s definitely less volatile than it was.

**Shawn Webster - J.P. Morgan**

For the ASE initiative Dario, what is the kind of depreciation associated with
that that’s running through your P&L right now?

**Dario Sacomani**

Actually we can’t talk about the details of the deal at this point. It’s a
little too early.

**Shawn Webster - J.P. Morgan**

Can you talk to us about what you expect your debt requirements to pay down
your debts in the next six months are? I see you had about the $277 million on
your balance sheet but maybe you could walk us through what the actual
paybacks you have to do for the next let’s say three to six months for your
debt.

**Dario Sacomani**

The only thing that’s actually debt amortizing right now is what was about a
$360+ million facility in Japan, which now we’re already down to about $260
million on. We started amortizing that in Q2 and it’s at about approximately
$30 million a quarter. Between the leases that we have and the GE deal in
Japan, those are the only two things that really are amortizing in the
upcoming period. It’s not until really 2013 and 2016 that the floating rate
notes or the senior notes or anything significant happens. So you have to
count on about $30 million a quarter.

**Operator**

Our next question comes from Bobby Gujavrty - Deutsche Bank Securities.

**Bobby Gujavrty - Deutsche Bank Securities**

You mentioned that you’d like to bring inventories down. What do you think is
a reasonable number of inventory level to run your business given that revenue
like you mentioned [inaudible] might actually decline this year?

**Bertrand F. Cambou**

The current inventory that we have right now is not bad at all. We were at 120
days six months ago and now we bring it to 103. That’s almost a 20% drop in
six months, which is good. We have in this business 15 weeks of lead time.
Between the time we start the materials to the time we ship it, our
manufacturing cycle time is 15 weeks. If you do the math of what that will
mean, the optimum build of inventory I really like to be at 85. That would be
kind of awesome. 95 is not bad at all. With one or three we perhaps would have
a slight [inaudible] but quite frankly the inventory reductions.

Let me say it differently. The increase of inventory we had a year ago was due
to foundry. We bought foundry. We had a big contract on foundry but now that
we don’t have any foundry that the manufacturing is actively running below our
rate of sales, we think that we’re in a pretty good position. To add on that
topic of [financially] here, don’t forget on the current inventory now that
we’re still carrying a bit heavier inventory in SP1 because this is kind of in
a startup mode. If you take the non-SP1 situation here right now, we are
actually pretty good.

**Dario Sacomani**

I would just [inaudible] where that die can go with respect to what customer.

**Bobby Gujavrty - Deutsche Bank Securities**

Did you have any asset sales in the quarter, maybe older equipment or
something like that?

**Dario Sacomani**

No. Nothing significant. We had some sales of scrap wafers but nothing
significant in relation to equipment.

**Bobby Gujavrty - Deutsche Bank Securities**

It sounds like your op ex cuts you’re implementing in 4Q, they’re sustainable
through ’09 and you might even see further declines in each of the categories
both R&D and SG&A then.

**Bertrand F. Cambou**

I can tell you that not only are the cuts sustainable but this is just the
first step. We’re currently looking at cutting much, much deeper and there was
a lot of opportunity for cutting now like I was explaining to a colleague and
friend Daniel here early on. We are on the R&D suite used to have a lot of
investment to start up SP1 300 millimeter. That’s done. The 65 nanometer is
done. Our 45 nanometer is looking extremely done. We have now a focused
organization. We can spend less. We are going to have alliances going forward
which means that we are currently thinking about how to go much, much lower
than where we are right now.

**Operator**

Our next question comes from Betsy Van Hees - Caris & Co.

**Betsy Van Hees - Caris & Co.**

In the past you have provided us with the revenue breakout for ORNAND and
MirrorBit or maybe percent of business. I was wondering if you could tell us
how much ORNAND shipped in the quarter and MirrorBit?

**Bertrand F. Cambou**

On the MirrorBit we did very high; higher than 80%; between 80% and 85% if my
memory is good. The reason that we don’t keep reminding everybody on that one
here is because it’s so high that when you get to this level here, the
floating gate at the end of the day for us right now is left to some of the
CSID business. We essentially don’t have any significant in the wireless.

If you look at the slide number three in the package we sent you, you can see
here that that information has been provided. MirrorBit revenue was $511
million which is an all-time high on the graph for the quarter which is
probably almost 85%. 81% Dario said.

Concerning the ONAND, obviously what we had, the plan was to sell in the $50
million range in ONAND for Japan. What we have has been a collapse of that
market here and it has nothing to do with ONAND. What you had in Japan is
essentially the authority elected to discontinue subsidies for cell phones. In
Japan the cell phones are very expensive. In the past people were just buying
the phone and paid back on the subscription and not exchange. As a result the
renewal rate just went down the tube and this year, in particular in the
second half of this year, the entire wireless Japan is cut.

That has been impacting our ONAND sales this quarter as being low. We expect
that number to stay pretty low right now in the short term because the ONAND
has been excellent to startup SP1 but very soon Sp1 is going to be totally
full with NOR and then the next time we are essentially going to do ONAND is
at 45 nanometer and to notice that we already have are walking 45 nanometer
ONAND as we speak are going to essentially offer it to the customer pretty
soon and use it as a debugger of the 45 nanometer six to nine months ahead of
NOR.

**Betsy Van Hees - Caris & Co.**

You did a great job of explaining what happened to your gross margins and why
they were so much lower than I think everyone’s expectations were going to be.
I’m just trying to understand as I look at Q4 and you’re saying that gross
margins are going to basically be flat to slightly up. What are we looking for
that’s going to contribute to that because we’re not going to have the write-
off that you had of the 90 nanometer content delivery business?

**Bertrand F. Cambou**

What Dario has been alluding to is we think that the margins actually are
going to go up a couple of hundred basis points in Q4 unless we take the
decision to slow down some of our factory because the outlook of Q1 will turn
out to be bad. We all our watching the financial meltdown and the consumer
spending and all these type of things, and if it turns out in the quarter that
we have a softening of Q1, we are going to then take actions to cut our run
rate as we should because like we say we are committed to control inventory,
and by doing that it’s technically going to reduce our gross margin. And in
this case the gross margin will be approximately flat which would be
essentially the result of first taking action if the economy was to go down.

But like Dario was eluding to, the most likely if everything is moving okay,
then we assume now that the consumer is eventually going to somewhat recover a
bit, not great, and we keep getting share, then we have an opportunity to
actually increase a couple of percent the margin in Q4.

**Betsy Van Hees - Caris & Co.**

Switching gears a bit, could you give us a little bit of an update on how
things are going with MirrorBit Eclipse in terms of design wins and when we
can expect revenue contributions from that?

**Bertrand F. Cambou**

In the case of Eclipse we have two families of Eclipse. The family that was
essentially going to use as a way to upgrade our NOR performance by offering a
much faster NAND like writing performance. Right now this technology’s mature
is in the customer hand, multi-customer which means that is moving on track.

Then there is a second version of Eclipse which is the EcoRAM, and that one is
actually moving extremely well. Like I was saying on my prepared remarks, we
have [alpha] server that has been tested by customers. The performance we’re
getting with EcoRAM for [inaudible] is actually as expected; way superior to
any other memory technology in existence. We are expecting a firm order this
quarter and revenue either this quarter or next quarter which means this is
moving. That’s a 2 gig Eclipse type device for server application.

**Operator**

Our next question comes from John Pitzer - Credit Suisse First Boston.

**John Pitzer - Credit Suisse First Boston**

Bertrand, just as a follow on to that EcoRAM. Is that multiple customers or is
this a single customer? And can you help me understand; is EcoRAM usable both
within an AMD server environment and an Intel or just an AMD?

**Bertrand F. Cambou**

The customers that we have are multiple and we have actually layers of
customers. What you have here is the first customers to use it are going to be
final Internet companies in Asia. First customer to use it.

Then there is a second layer of customers which are a little bit more
conservative but are the big box makers. That one essentially built the server
and they’re not going to sell it across the board. Those people are also
evaluating our technology very successfully right now but we don’t think that
those people are going to place firm orders in the near term because they have
their own quality process and then that’s a bit longer here which means that
we see the first order to come from the Asian Internet company to be followed
early next year by the big boxes, and then we see the Internet companies in
the US to place orders as well in the late Q1 type of schedule.

As far as the implementations, we’re not at that point disclosing what CPU is
to be used. Obviously our strategy is to support the two but the timing and
the road map has not been made public at that point.

**John Pitzer - Credit Suisse First Boston**

Bertrand as you try to look inside this market for ’09, what kind of numbers
do you think are appropriate to use?

**Bertrand F. Cambou**

This type of business is very big, which means that for us definitely as a
company we’re going to reassess at the right moment here, but we are thinking
about the triple digit millions of dollars revenue for ’09. And the way we’re
going to plan for it is obviously because there’s a lot of unknowns, this is a
new technology, could be much bigger, who knows?

What we have right now is we have dedicated a piece of SP1 for it, and then
we’re going to essentially use external manufacturing as a valuable way to
support it which means that we are currently qualifying it in the two areas,
which is the SP1 or SMIC, to put some flexibility into the system as a
function of the size of the business.

Back to your question here, for us we’re thinking about a hundred million
dollar type of number here for ’09, and of course a much higher number after
that.

**John Pitzer - Credit Suisse First Boston**

I’m sorry if I missed this or if you talked about this, but just relative to
the outlook of the Japanese handset market into December, what’s the view? It
was clearly disappointing in September. Do you think that it continues to be a
disappointment?

**Bertrand F. Cambou**

We think it’s going to be very low. What you have right now is the handset
company in Japan has been kind of building inventory the first six months of
the year and their shelves are just full and the phones are not selling which
means the inventory right now that we have in Japan is essentially in the form
of a phone already built. We don’t have any flash inventory in the system but
their phone has been overbuilt. Now there are some new models that essentially
are going to create some revenue in Q4 which is not going to be zero but
definitely with Japan right now, it has to sort out that situation.

As you know things can change. In Japan you may have tomorrow morning a new
minister policy that essentially is going to reverse the things to try and
reactivate the national cell phone industry, and that business would just
explode around the holiday season. It is not up to me to guide you on that
one, but as far as Spansion is concerned right now we are planning no recovery
whatsoever in the next six months.

**John Pitzer - Credit Suisse First Boston**

When you look at the market share gains, which have been impressive, how much
of the near-term market share gain would you attribute to disruption around
[Pneumonics] integration and how worried do we have to be that once those two
entities kind of iron out things and get up and running that the competitive
environment gets a little more difficult again?

**Bertrand F. Cambou**

We believe that actually the market share gain is the beginning because the
way we’ve been gaining has been to get deep engagement with the strategy
customer. And with those strategy customers when you are in, you are in.
They’re not going to play. In those places, Spansion was not there. Now we
have a big foot in the door and where we are now we’re going to put the second
one and then we have an aggressive technology and we are aggressive people. We
like that business. We like those customers and we’re going to make
[Pneumonics] like [inaudible]. That is a beginning.

Now in the CSID business, this is a bit of a more fragmented business indeed
here but right now we are so much ahead we are like twice as big as they are.
They’re currently suffering because obviously now it has been published by our
supply that [Pneumonics] is so much smaller than us. They don’t have our
economy of scale. They don’t have a company that is focused like we are. They
are still worrying about the integrations, and the integrations task is not
done, it is not behind them. They will now have to go and it is going to take
them some time before they can be effective.

That is definitely our strategy right now to delight our customer. We enjoy
about 40% market share compared with 33% last year and we have a big ambition
and appetite to keep pushing it to the higher number.

**Operator**

That does conclude the question and answer session. I’ll turn the conference
back to management for any additional or closing remarks.

**Ken Tinsley**

Thanks everybody for joining and hope you have a great evening.

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45,100121-kinder-morgan-energy-partners-lp-q3-2008-earnings-call-transcript.html,Kinder Morgan Energy Partners LP,KMP,basic-materials,2008.0,,regular,"October 15, 2008",4:30 pm,2008-10-15T20:30:00.000Z,97827,38774,59053,3,6,"['Richard D. Kinder - Chairman and CEO', 'C. Park Shaper - President', 'Steven J. Kean - EVP and COO']","['Darren Horowitz - Raymond James', 'John D. Edwards - Morgan Keegan', 'Noah Lerner - Hartz Capital', 'Rajul Aggarwal - MarathonAsset Management', 'John Tysseland - Citigroup/Smith Barney', 'Yves Siegel - Wachovia']","**Operator**

We would like to welcome everyone to today's Third Quarter Earnings review.
All participants' lines will be on a listen-only mode until the question and
answer session of today's call. [Operator Instructions]. We would also like to
inform everyone that today's call is being recorded. If you have any
objection, you may disconnect at this time.

It is now my pleasure to turn the call over to Mr. Rich Kinder, Chairman and
CEO of Kinder Morgan. Thank you sir, you may begin.

**Richard D. Kinder - Chairman and Chief Executive Officer**

Thank you, Mary and welcome to the Kinder Morgan third quarter investor call.
As usual, we'll be making statements within the meaning of the Securities Act
1933 and the Securities and Exchange Act 1934.

Also, as usual, I'll give an overview of the quarter and strategic issues
affecting the company, and then Park Shaper, our President will follow with a
detailed look at the numbers for both the quarter and year-to-date. And then
we'll take any and all questions that you may have.

Let me just start by saying that I think it's easy to get distracted by order
of certainly tumultuous events that are occurring in our economy and then in
the stock market today. And I just want to start out by reassuring you that
this management team is going to stay focused on what we do best, and that is
to continue to produce solid and growing cash flow at Kinder Morgan to benefit
both our investors and our debt holder.

Now let me start with the third quarter and year-to-date results and just give
you an overview, and Parker, as I said, will give you all the details behind
the numbers.

Today, we approved an increase in our distribution per unit to $1.02 or $4.08
annualized. That's up from $0.99 last quarter, and it represents a 16%
increase over the third quarter of 2007 distribution which was $0.88 or $3.52
annualized.

Probably a more important number is distributable cash flow per unit before
certain items this quarter was $1.09. That's up 14% from the $0.96 per unit
for the comparable period last year.

Through nine months of 2008, Kinder Morgan has now produced distributable cash
flow of $856 million. That's up 37% from about $623 million for the same nine
months last year. I think it's also important to point out that the excess of
distributable cash flow before certain items above that distribution for the
first three quarters was about $97 million. Or put another way, our
distributions per unit have gone to $297 million for the first three quarters
of 2008 versus $256 million for the first three quarters of 2007. And even
with that increase, we still accumulated excess cash flow of $97 million.

We had a strong third quarter, despite really a lost business associated with
the two hurricanes that was about $21.5 million that we add in our segment
results. We had decreased demand from gas... for gasoline during the quarter.
We had a dreadful economy. We had increases in construction and fuel costs
that impacted both our existing operations and our capital expansion program.

And if you look at all this and certainly while we face our share of headwinds
on a going forward basis, I think these results demonstrate that our
diversified portfolio, a very stable assets is capable of generating
consistently strong cash flow, even in these extremely difficult market
conditions.

The results that we produced during the quarter and really for the year-to-
date were led by three of our segments: our CO2 segment, our Natural Gas
Pipelines and our Terminals segments.

Now let me start with an overview of the Products Pipelines. We had earnings
before DD&A of about $141 million. That's down about $14 million or 9% from a
year ago. Of course, we had the North System in our numbers during the third
quarter a year ago. And if you exclude that, it had roughly $11 million of
earnings before DD&A in the third quarter.

If you exclude that, we were down about $4 million from a year ago. Virtually
all of that had been... some was at SFPP where we had lower throughput. SFPP
was off about $9 million from a year ago. The rest of the group made up about
$5 million of the shortfall. So we were down about $4 million from a year ago
or about 3%.

The downturn of SFPP is overwhelmingly attributable to just lower throughput
on our system out on the West Coast. We did have improved results in this
segment by our Southeast Terminals, our West Coast Terminals and our Central
Florida Pipeline when you compare to the third quarter of 2007. Those groups
of assets benefited as we had some upgrades and modifications of our
facilities which enabled us to generate more revenues by handling more
ethanol. That's become a nice return benefit for us.

If you look at the total refined products revenues for the quarter, they were
flat. The volumes were down about 7.9% compared to the same period a year ago.
If you strip out the hurricane impact on volumes, it was about 6.9% down.

Through the nine months of 2008, products revenues are actually up a little
less than 2%, volumes down a little more than 7%, some mix pretty much down
across the country. Las Vegas and all places are still positive both for the
quarter and the year by about 1%. And the gasoline volumes in the Central
Florida, around Orlando looked like they're down but actually Florida mandated
10% ethanol this year. So, quarter-on-quarter, we're down by probably about 2%
or 3% in the Central Florida. So, those are isolated pockets where demand for
gasoline still seems to be pretty strong.

Turning to our Natural Gas Pipelines segment, they had third quarter segment
earnings before DD&A and certain items of $177 million. That's up 25% from
$142 million in the third quarter of last year. And the results there were
driven by two things. We had a nice return from our Rockies Express project,
compared to last year, plus about $23 million for the quarter even after
taking into account the hydrostatic testing that we had during the month of
September which shut a big portion of REX down for most of that month.

And then the Texas Intrastate Pipeline Group continues to perform very well.
It was up $14 million quarter-over-quarter. And the same trend lines are
really positive for the year as a whole. It's important to note that again,
there was some negative from the hurricanes in this business segment also at
our Intrastate pipelines, a little less than $4 million of negative impact
from the hurricanes.

Our CO2 segment delivered third quarter segment earnings before DD&A of $203
million. That was up 47% from the $138 million a year ago. And that segment
sustained about $11 million of lost business as a result of hurricane Ike. And
you may wonder why does the CO2 business... that's primarily operational in
Colorado, New Mexico and Western Texas. Why would it have a decrease as a
result of hurricane Ike. And the reason is that we had a decrease in NGL sales
volumes due to third-party fractionation facilities being shut down. Now this
will continue, we think, into early November when the main fractionator of our
largest customer is scheduled to start up at the Volmont [ph] refinery
complex.

So even overcoming this $11 million, they had a very good quarter in the CO2
segment. And that was driven by a little bit stronger than expected oil
production at the SACROC Unit by increased CO2 sales and transport volumes and
by higher hedge prices and higher oil and CO2 prices.

Among the important statistics, I think, in CO2 is the fact that our average
oil production for the quarter at SACROC was just short of 28,000 barrels per
day, up about 2% from the same period last year. Our average oil production at
Yates was just a little over 27,000 barrels a day, a flat with the third
quarter of 2007, and our CO2 delivery volumes were up 14% compared to third
quarter of last year. And that's due to the expansion projects in the
Southwest Colorado that are virtually complete and that have increased our CO2
production that we can move down to the Permian Basin across our Cortez
Pipeline.

We now expect our CO2 production... I mean our oil production at SACROC and
Yates, both to be slightly above our plan for the year, and I think that's a
promising outlook.

And our Terminals segment, their third quarter earnings before DD&A and
certain items was $132.4 million. That's up about 21% from year ago. The great
bulk of that growth came from organic opportunities or organic expansions with
the other 25% attributable to acquisitions. The expansions that resulted in
internal growth included pretty major expansions at our large liquids
terminals on the Houston Ship Channel in New York Harbor, at our North 40
Terminal near Edmonton, in Alberta, Canada and our Vancouver Wharves terminal,
in Vancouver British Columbia. They also faced some hurricane damage as part
of this $21.5 million I referenced earlier. And their damage was about $6.3
million in terms of lost business during the third quarter.

Total bulk tonnage was up about 9% for the quarter compared to the third
quarter of 2007, led primarily by strong coal volumes at several of our
terminals.

Our fifth business segment, Kinder Morgan Canada, which we formerly referred
to as Trans Mountain, had DD&A of about $40 million, up 79% from the same
period a year ago. And those results primarily reflect completion of the first
portion of the Anchor Loop expansion of the Trans Mountain pipeline. So, we
were able to boost the throughput capacity of Trans Mountain from 260,000
barrels a day in the third quarter a year ago to 285,000 barrels per day now.

The final phase of that expansion is now coming on service. It will be online
by November 1st, just a few days ahead of our plan. And we'll take the
capacity up to 300,000 barrels per day and certainly to increase earnings and
cash flow at Kinder Morgan Canada.

Now, let me talk about the outlook. You'll notice, those of you who read the
press release carefully that last quarter we had said we expected to exceed
our target of $4.02 in distribution. I remember through the first three
quarters were $2.97, so just to meet the $4.02 would mean $0.05 in
distribution per unit in the fourth quarter.

Last quarter, we said we expected to exceed that target. We now say we expect
to meet or exceed that target. Let me explain that.

We still expect our distribution... our distributable cash flow per unit to
substantially exceed the $4.02 target that we have for the year but given the
hurricane impact in the third quarter and additional impact of probably in the
neighborhood of $10 million or a little more in the fourth quarter, we're
going to wait for the fourth quarter results to see just how much excess
coverage we want and is appropriate for the fourth quarter.

So we'll either meet or exceed our target and we will post you on that
obviously at the end of this quarter.

Now let me talk about some of our major projects, which a good part of the
press release is devoted to. Now a lot of these projects are coming in on time
and on budget, particularly on our Products Pipeline and Terminals segment.
But if we do face continued cost escalation on some of our major pipeline
projects in the natural gas segment, as is due to additional regulatory
requirements put on us, additional and rising construction and material costs,
of weather delays, among other things. We remain extremely focused on managing
these increases and on identifying ancillary opportunities to offset them.

Our total forecast of capital expenditures on our major projects are now up
about 22% from the numbers we shared with you at our January investor
conference. Most of that increase in the last quarter, as I said, has been on
our major natural gas pipeline projects and why we would rather not see these
increases obviously. We remain confident that large projects like Rockies
Express and Midcontinent Express will still deliver attractive returns to our
investors.

As we've said before, when we evaluate these projects at the get-go in order
to make capital investment decisions, we conservatively estimate cash flows
which leads to a lot of opportunities to outperform. To give you one example,
on REX, we're already providing ancillary services to our shippers which
generate revenues well in excess of the contractual revenues on which we base
our expected return.

Now I will say that on our Kinder Morgan Louisiana System, that does not look
like an attractive return at this time. We're working very hard to improve the
revenue line on that project, and we're actually finding some opportunities to
do exactly that.

Now we've described a whole bunch of our projects and acquisitions in our
earnings release. So I'm not going to go through all of them. You can read
them yourselves. But I do want to mention just three of the newer ones that
have occurred since the last time we spoke.

The first is that we announced today that we've entered into a purchase and
sale agreement to buy a liquids terminal in Phoenix, Arizona from
ConocoPhillips for about $29 million. This is a liquids facility that has tank
capacity of about 200,000 barrels per day. It's located adjacent to our... the
existing terminal in the Phoenix complex. It will increase our storage
capacity in that market by about 13%. We expect to close that in early
December. It will be immediately accretive to cash flow available for
distribution to our unitholders.

We also... since we last talked, have announced a new $1.3 billion natural gas
pipeline project together with Energy Transfer Partners. We announced that on
October 1, and that's the Fayetteville Express Project. It's a 42 inch, 187
mile pipeline that will begin in Conway, Arkansas and end in Quitman County,
Mississippi. We have ten-year binding commitments that now total a 1.85
billion cubic feet per day out of the initial capacity of 2 billion cubic feet
per day.

Pending regulatory approvals we expect to be in service by late 2010 or early
2011. And we expect all of that capacity to be fully committed prior to the
time that we begin construction on the line.

In addition, since we last talked, KMP acquired two pipeline systems from
Knight Inc., the private entity which owns a general partner of KMP. That
purchase includes Knight's one-third interest in the Express-Platte crude oil
pipeline systems that runs from Alberta Canada down to Illinois and a jet fuel
pipeline that serves the Vancouver British Columbia Airport.

KMP paid now at approximately 2 million KMP units. So, it's all equity
transaction, and those units will work about $116 million for those assets.

Now, the 500 pound gorilla in the room is obviously the volatility in the
capital markets. Let me just address that head on. I think it's worth
discussing, how we expect to fund our expansion projects. Several factors
here: the first and most important factor is the strength of our existing
assets and our expansions.

Our diverse set of energy infrastructure assets will generate about $2 billion
of cash flow that can be distributed to our partners in 2008. We expect that
number to increase in 2009. And let me be cleared that $2 billion is after all
operating expenses debt service and sustaining capital expenditures. That's a
very important factor in the strength of our capital structure.

Number two, our expansion projects in aggregate will generate attractive
returns on our investments, using conservative projections secured by
contracted customer commitments even after the crossover loans, we talked
about it.

Third, we have ample access to short-term funds through unused capacity at our
credit facilities. Let me talk about those.

At year end, even if we don't put out any additional capital between now and
year end, we will still have undrawn capacity on our KMP line of well over
$600 million on 12/31/2008. And we will have substantial amounts on our J.B.
credit facilities. At REX, we expect to have well over $500 million and at
Midcontinent Express well over $200 million of undrawn capacity at year end,
without raising any additional capital, equity or debt between now and year
end.

Our common units KMR shares and debt have performed relatively well, although
I am reminded of that old citing, In the land of the blind, the one eyed man
is king. But they've performed relatively well compared to our peer group over
these last several months. That's allowed us to raise $3.4 billion of long-
term debt over the last 15 months and $843 million of equity over that period
of time.

Now if you included the KMR distributions, which is essentially an automatic
distribution reinvestment program, we've raised approximately 1.2 billion of
equity over that same 15 months. That gives us a lot of confidence that we'll
be able to access these market to raise new capital. But fourth, in addition,
our general partner Knight Inc., the general partner of KMP, has substantial
financially resources. This year, Knight will have EBITDA of over $1 billion
for calendar year 2008 and we have a debt to EBITDA ratio of about 2.6.

We're prepared to use those financial resources if necessary and the Board of
Directors of Knight today indicated its willingness to contribute up to $750
million to purchase equity from KMP over the next 18 months if necessary to
support KMP's capital raising efforts.

So I think in summary what we have at KMP, we expect to be able to continue
our 12 year tradition of generating strong and growing cash flow, maintaining
a strong balance sheet and providing excellent long-term returns to our
investors.

And with that, I'll turn it over to Park.

**C. Park Shaper - President**

Alright, thanks Rich. And as is typical, I'm going to go through the financial
slides that are attached to the press release, so hopefully everybody has
those and can look at them.

Now the first page that you see should be the face of the income statement.
And again, it was a very strong quarter, it's been a very strong year at KMP
and expect that to continue. You will see at the bottom of kind of the first
section, so up from the bottom section, the declared distribution per unit of
$1.02; that's what the Board had declared today to be paid in November, up 16%
from the $0.88 a year ago, and that leads to $2.97 of distribution year-to-
date, up 16% from the $2.56 that was distributed a year ago.

Now on the top, mostly on the next page, which is where you can break out the
segments and see how we actually earned distributable cash flow per unit of
$1.09 for the quarter, and you will find that as the second to last line above
the footnotes on the second page. You'll see the $1.09 of DCF per unit up from
$0.96 a year ago. That's a 13% increase in DCF per unit and year-to-date
$3.35, up from $2.65. That's almost a 27% increase above where we were at
2007.

So, again, tremendous growth out of the asset as we expected for 2008. And not
only that, but our excess cover is just way ahead of our expectations. You may
recall that in our budget, we had about $10 million of excess coverage for the
year. Through three quarters, we have $97 million of excess coverage, and
that's in the face of losing $21.5 million of lost business to the hurricanes.
And so if not for the hurricane, then we would be $21.5 million ahead of that.
For the quarter, the excess coverage was $18 million, and again that was
impacted by the $21.5 million. So that number would have been almost $40
million if not for the hurricanes. So again, even in the face of the
hurricanes, which did have some impact on our business, our assets performed
very well.

Moving up from the DCF per unit before certain items, there is the net income
per unit before certain items. Don't believe that's as relevant as the DCF per
unit. You have the total DCF before certain items, as Rich mentioned, $282
million, up almost 23% from the $230 million in the third quarter a year ago
and year-to-date up almost 37% to $856 million.

The line right above that, sustaining capital expenditures for the quarter
about $43 million compared to $32 million a year ago third quarter and year-
to-date $120 million compared to $95 million through the first three quarters
of 2007. We are on track to be right around our budget of about $196 million
of sustaining capital expenditures. But you'll see in order for us to hit $196
million, we will have significant sustaining capital expenditures in the
fourth quarter. That is our current forecast. But it a little bit
disproportionate relative to how we budgeted the fourth quarter. Now I'm going
to talk about that more in a minute.

Now immediately above that, the difference between book and cash taxes, you
will see that cash taxes were less than book taxes by about $8.5 million in
the quarter. A year ago, cash taxes were less than book taxes by almost $15
million. Now year-to-date, 2008 cash taxes have actually exceeded book taxes
by a little over $10 million. And you may recall that our budget called for
the full year of 2008 cash taxes to exceed book taxes by almost $9 million. We
except that we'll end up right around that level, $8 million or $9 million of
cash taxes in excess of book taxes. Then above that, you have DD&A and then of
course net income, general partner share of net income and then the net income
before certain items.

Again, they're all building up to what we believe is the most relevant number.
The DCF before certain items, and in that number DCF per unit before certain
items, again showing nice coverage over our distribution.

Now so how are we driving that? What's driving the growth? If you jump up to
the top of that second page, you can see the segment earnings before DD&A, and
this is before certain items as well. And Rich really talked a lot about the
segments. I'll touch on them again briefly.

Our products pipeline under last year both for the quarter and year-to-date,
but a lot of that is the fact that the North System was sold at the beginning
of the fourth quarter a year ago. And so if you back that out for the third
quarter, Products Pipelines just a hair under last year and year-to-date
basically consistent with last year. Rich talked about the volume impacts that
we're seeing there. We did have a minor impact from the hurricane on the
Products Pipelines segment of a little bit less than a million dollars. We do
think that because of the lower demand for refined products, the Products
Pipelines segment will be under its budget for the full year.

Natural gas pipeline had a very strong quarter again, up about $35 million
from a year ago, up about $126 million from... during the first nine months
relative to the nine months of 2007, driven largely by the addition of Rockies
Express or the growth in Rockies Express really a function of bringing REX-
West into service and then significant performance in the Texas Intrastate.
Now natural gas pipeline did overcome about $3.6 million of impact from the
hurricane. But even with that, we expect the natural gas pipeline to be
significantly above budget for the full year.

CO2, up about $65 million for the quarter, up $227 million year-to-date,
tremendous growth, significantly overcoming almost $12 million in impact from
the hurricane, again driven-off of the NGL volume issues that Rich mentioned,
which is assumption of fractionators being out of service and one in
particular still out of service.

SACROC volumes above plan for the quarter, slightly above plan year-to-date.
Yates volumes were a little bit below plan for the quarter or above plan year-
to-date. And clearly, we are dramatically exceeding our plan ex-CO2 [ph] and
expect to do that for the entire of the year.

Terminals is the next segment up about $23 million for the quarter, up about
$80 million year-to-date driven by a little bit of acquisitions, as Rich
mentioned and a significant amount of expansion projects. Terminals is more
impacted by about $6.3 million of our business from the hurricane and of the
fire. Again nicely over paying back [ph], although the terminals segment, we
do expect to be slightly under its budget for the full year.

Kinder Morgan Canada, which is Trans Mountain, but also includes the Express-
Platte system that we dropped down from the general partner in the third
quarter and the jet fuel line that we transferred to drop down in conjunction
with that, was up significantly from last year, both for the quarter and year-
to-date, largely as a function of the expansions that are going on Trans
Mountain, that the last piece of which... the last piece of Anchor Loop will
come on at the beginning of November. Kinder Morgan Canada, we expect to be on
budget but slightly below budget for the full year.

Where that gets you is segment earnings before DD&A is up about 22% to $693
million for the third quarter. Nine months, so year-to-date, almost $2.1
billion of segment earnings before DD&A, and when you look at the full year,
we will almost hit $2.8 billion of segment earnings before DD&A.

We will net be above budget for the full year. Again products will be a little
bit below. Terminals will be a little bit below. Kinder Morgan Canada will be
just slightly below, but that will be made up for by outperformance on the
Natural Gas Pipelines and the CO2 segments. So we expect we will be above
budget in terms of segment earnings before DD&A. And again those assets are
generating $2.8 billion of earnings before DD&A.

With that I'm going to drop below the DD&A and the segment earnings
contribution and look at G&A. You'll see it is up from last year both for the
quarter and year-to-date. It is also a little bit ahead of our budget. The
reason why we're above budget is in part due to the Texas margin tax, in part
due to incremental G&A at Trans Mountain, which is a function of insurance
costs and some benefits costs being above budget and then legal is also above
budget. We do think that G&A will be above budget for the year.

But interest, you'll see, is actually below where it was in the third quarter
of 2007 by about $3 million. That's slightly ahead of 2007 for the nine months
but well above or really favorable to the budget for the nine months and we
expect that overall for the year, essentially a function of rates being lower
than what we had in the budget. So, again we expect to get a nice tickup from
the interest line for the year.

Minority interest is essentially unchanged. Certain items are laid out below
that, just looking at the ones that had items in it for the quarter. The
allocated non-cash long term compensation. That is compensation expense that's
really a part of Nicolto [ph] that for accounting purposes has to be allocated
down to Kinder Morgan Energy Partners. KMP has no obligation to pay any of
that, will never pay any of that, not in the form of cash, not in the form of
equity. There is absolutely no obligation and will be no payments from KMP
related to that.

Now we talk about that every quarter. It will continue to show up at every
quarter, because that's how we have to account for it.

Legal reserves and settlements, you'll see about $9.5 million for the quarter.
That's largely related to a settlement of FFPP rates. And this amount relates
to some prior period being flowed through in this period. And so, that is that
item. Below that mark-to-market has certain upstream hedges. It's a positive
or a favorable $12.2 million that of course we're still showing in at the
certain items.

You may recall that in the second quarter, we talked about the hedges that we
have in our upstream operations. These are a little bit of processing in the
Rocky Mountains. And we had some hedges on there that for accounting purposes
were deemed ineffective in the second quarter. We had a charge that showed up
in certain items at that point in time. And we said at that time in July that
we would expect positive amounts to flow back through to offset that over the
next few quarters. Well this is the biggest piece of it, and so you see it's
over $12 million. And if you look the year-to-date on that line, it's negative
about $900,000. So almost everything that showed up there in the second
quarter has now come back to us. And really all we did is just didn't change
for how we account or really how things flow in terms of cash up at the
segment.

Hurricanes and fires, you will see a $15.5 million charge there for the
quarter. What this represents are asset write-offs, and so assets that are on
our books that were destroyed or otherwise hurt in the hurricane and then one-
time expenses associated with the hurricanes.

Now these amounts will clearly be offset in the future by insurance
recoveries. And when they are, those insurance recoveries have to be accounted
for as a gain at that point in time. And that gain will show up down here in
certain items. So again, expect a positive to come in the future that will
offset these amounts. Now it won't offset the full amounts because we do have
deductibles associated with our insurance programs. Other or a few smaller
items and then minority interest are... the minority interest amounts that are
associated with those certain items.

Really, that takes you back down to net income, which once you flow that
through, the depreciation, the book and cash taxes and the sustaining capital
expenditures, you get to your DCF before certain items $282 million for the
quarter or $1.9 hub [ph] or in our $1.2 distribution.

Briefly, I will go back to the first page, which is again the face of the
income statement. I don't think that there is a whole lot meaningful in the
face of the income statement. There are certain items that are scattered
throughout there that we pull out and identify for you on the second page. So
I think that's a more meaningful way to look at it.

I will point out that there is a new section. It's the bottom section of that
page. Segment earnings before DD&A and amortization of excess investments.
This is basically segment earnings before DD&A including certain items. And so
you can compare it to the segment earnings before DD&A at the top of the next
page, which excludes certain items. And again, the certain items are all
identified down below. We do believe how we represent it on the second page is
the appropriate way to look at it.

I mean I will say that if you look at it on the first page, you would think
that our growth is even stronger than what we are claiming. If you look at the
segment earnings before DD&A on the first page, you'd say total segments are
up 29%. We would argue they are only up 22%. And if you look for the nine
months, you'd say they are up almost 69%. And we're telling you they are
really only up 29%. Again, we believe the way that it is represented on the
second page is the correct way to look at it and to understand what these
assets are going to generate going forward.

Now before I go to the balance sheet, a couple of quick comments about the
fourth quarter. Again, as Rich said, we expect to meet or exceed our budget of
$4.02

of distribution for the year.

We have generated $97 million of excess cash flow through the first three
quarters due primarily to two factors. We actually think that that excess cash
flow will come down when we finish the year, meaning that we won't finish with
$97 million of excess cash flow; we'll finish with something less. And so what
that implies is that in the fourth quarter, there will not be excess coverage,
but rather, we won't fully cover the distribution.

Now the reasons for that are really two items that I have already discussed.
One is the shifting of sustaining capital expenditures from the first three
quarters into the fourth quarter. Now again, that number will be consistent
with our budget, but it will be higher in the fourth quarter than what we
expected. And then the second issue is continued impact of the hurricanes,
which we currently estimate to be about $11.5 million, and that's due to the
lower NGL volumes of CO2 and a little bit of continued impact at the terminal.

So again what I'm saying is we don't expect to end the year at a full $97
million of excess coverage. We do expect that we will have significant excess
coverage above our distribution. And so when you look at it for the full year,
we will have very significant excess coverage and will be well above our
budget now in terms of excess coverage for the entire year.

With that, I will go to the balance sheet, which should be the last page
attached to the press release and walk down that quickly. Our cash and cash
equivalents haven't changed, other current assets essentially unchanged. PP&E
is up, largely the assumption of expansion CapEx. Investments are up. That's
largely a result of the investment in Rockies Express from earlier this year
and the dropdown of Express which is equity accounted for, so it shows up on
this line.

Now reducing those amounts was the sale of Thunder Creek, which was also
accounted for as an equity investment and then the credit facility that we've
put in place at Midcontinent Express around the return of cash from
Midcontinent Express earlier in the year. And so that's reduced the amounts on
this line.

Deferred charges and other assets is up about $200 million. Part of that is
the note that we now have as part of our investment in Express and then the
other part is just the mark-to-market of our hedges that just flow through the
balance sheet. Total assets now about $17 billion. Notes payable and current
maturities, I will talk about that when I talk about total debt. Other current
liabilities essentially unchanged. Long-term debt, again, I will get to that
in a minute. Value of interest rate swaps just a function of the forward curve
for interest rates. Other is up about $200 million. That again is the hedge
balance sheet mark-to-market. Minority interest unchanged. Accumulated other
comprehensive loss, you will see it is up from the end of 2007. It is down
significantly from where it was at the end of June. Some of you may recall or
go back and look, we were at $2.95 billion at the end of June; now we are at
$1.5 billion.

So significant reduction, which is just a function of commodity prices during
the third quarter. Other partners' capital is up as a function of issuing
equity and then a little bit because of the Express transaction.

So taking a step down to total debt, you see we are a little under $8.3
million of total debt. That's up from about $7 billion [ph] at the end of 2010
and up a little bit from about $8 billion at the end of the second quarter.

In terms of debt to EBITDA, you'll see it looks like we're just hanging in
there at 3.4 times. You all can run this calculation if you want, but it's
taking out another significant digit, you'll see at the end of the year, we
were at 3.43 time. We're now at 3.35 time. So it's actually declining. It's
still roll... it's still round 3.4 times. At the end of the second quarter, we
were at 3.37 times.

Let's talk quickly about the change in debt. Year-to-date, it's almost $1.3
billion increase in debt. For the third quarter, it's about a $300 million
increase in debt.

And so what were the uses of that cash? What do we do with that cash that we
borrowed? Expansion capital, $1.8 billion year-to-date and in the third
quarter, it was $600 million. That's really what we've been doing. We've been
investing in those projects. Now we have spent about $130 million on
acquisitions. Now it's a little bit less than that in the quarter, a little
bit more than that year-to-date. We also made a contribution to Rockies
Express of about $300 million earlier in the year. So those are the large uses
of cash.

The sources of cash to help fund that. We had issued equity. The total is
about $500 million year-to-date. Now that's about $384 million that's been
raised in offerings and about $116 million that was issued to Knight, the
general partner in exchange for the Express and the jet fuel lines. So, again
that totals about $500 million of equity.

KMR distributions are essentially cash retention tool or more appropriately a
distribution reinvestment vehicle that raised cash of about $70 million in the
quarter, and almost $210 million year-to-date. The MEP credit facilities, I
mentioned before, allowed us to get about $63 billion back from Midcontinent
Express that didn't happen in the third quarter. It happened earlier in the
year.

We've generated about $50 million from divestitures in the year that was
largely the sale of Thunder Creek, again not much in the quarter but about $50
million year-to-date. The change in margin deposits generated about $250
million in cash in the quarter, about $40 million year-to-date. So, clearly
what that means is earlier this year we had cash going out from margin
deposits. We got it all back and more in the third quarter. So, again that's
almost $250 million in the quarter, about $40 million source of cash year-to-
date.

Excess cash flow, which we mentioned earlier, so this cash, it hasn't been
distributed. About $18 million in the quarter, $97 million year-to-date. But
couple of other things are really related to acquisitions; part of it was an
additional payment for expansion CapEx on Trans Mountain and the other with
just some cash associated with Express. We had source of cash of about $7
million in the quarter and about $30 million year-to-date.

And then working capital and other items were a use of cash of about $25
million in the quarter, about $40 million year-to-date. That's largely AR and
AP offset a little bit by other current assets and other current liabilities.
And then a couple of other minor items that are driving that use of cash,
again $25 million for the quarter, about $40 million year-to-date.

Now, clearly our expansion CapEx has been significant at $600 million in the
quarter, almost $1.8 billion year-to-date. Some of that has been in products;
about $30 million have been order of products, about $126 million year-to-date
at products. That's the Carson tanks and Miramar tanks and a couple of other
projects.

Natural gas, oil and we had big expenditures, $275 million of the quarter,
$676 million year-to-date. A lot of that is the Louisiana pipeline
construction. From the CO2 segment we've spent about $134 million in the
quarter, about $392 million year-to-date, clearly continue to expand at SACROC
and then a little bit at Yates and then also the Southwest Colorado expansion,
which is largely in service at this point.

On the Terminals side about $77 million of expansion CapEx in the quarter,
$278 million year-to-date, across a variety of projects, included our efforts,
our expansion of Houston Ship Channel. What we're doing on Louisiana, in the
New York Harbor and then of course, primarily earlier in the year, our North
40 Terminal in Edmonton.

Kinder Morgan Canada, about $96 million of expansion CapEx in the quarter,
about $312 million year-to-date. That is largely the Anchor Loop project to
expand Trans Mountain.

So again, if you look at the change and that is almost completely driven by
the expansion project, a little bit by the contributions to REX and
acquisitions. And we have raised a significant amount of equity $500 million
now year-to-date to offset those expansion activities.

And that is all I have. I will hand it back over to Rich.

**Richard D. Kinder - Chairman and Chief Executive Officer**

Okay and with that, we'll take any questions you might have. Mary?","

Question And Answer

**Operator**

Thank you. We will now begin the question and answer session. [Operator
Instructions]. Our first question comes from Darren Horowitz with the Raymond
James Company. Sir, your line is open.

**Darren Horowitz - Raymond James**

Good afternoon and thank you. Rich, I thought you did a good job talking about
being financially flexible and obviously liquidity and financing for growth is
on everybody's minds. So, that's going to be the basis for my questions.
First, when you talked about having the flexibility and obviously you're going
through your budgeting process for the forward 12 months. When you include the
projects like the Fayetteville line, can you give us some insight as to your
thoughts on what that projected CapEx number might be and more importantly the
impact that this higher cost of capital environment might have on your average
IRR?

**Richard D. Kinder - Chairman and Chief Executive Officer**

Well we really don't have the costs pinned down for the next year until we go
through the budget process. And strictly on Fayetteville obviously depending
on the regulatory work, we don't know how much of that will be spent yet in
2009 versus 2010. We have a good handle on the total costs and have locked in.
We and ATC have locked in the pipe costs already. And... but we don't know
exactly what the breakout will be between 2009 and 2010 on Fayetteville yet. I
don't know Park, you want to add anything to that?

**C. Park Shaper - President**

Well I think Darren, you asked about the impact of cost capital on IRR, I mean
I don't... cost capital itself doesn't actually impact your return. I mean, I
think the objective is to ensure that your earnings return that is well in
excess of your cost of capital. And clearly, we believe that we are doing that
just as we have historically. I mean, I think everyone who follows us, is
probably sick of hearing that we're going to say this but we have never done
projects that were right on top of our capital. We have always, whenever we
were going to do a project, looked for a nice cushion between the return that
we expected from that projects and our cost of capital. And I think we also
very conservatively estimate cash flows from our projects. And I think we are
seeing that on Rockies Express as portions of it come online, we are able to
generate more cash than we have in our projection. So remain very confident
that we are going to earn attractive returns well in excess of our cost of
capital on these projects.

**Darren Horowitz - Raymond James**

Park, let ask you a follow-up question because you touched on something that I
am curious about. Just for context, if you were to rewind 12 months and look
at your budgeting process towards the end of '07 and early '08, can you just
help us understand what... the spread above your cost of capital, what target
return on average you were looking for and how that may be changing now in
this environment as you look at the forward 12 months?

**C. Park Shaper - President**

Well I guess what I would say is in this environment where capital is more
scarce, no question and where cost of debt is backed up, cost of equity is
backed up. And I think what that leads to is less competition for a number of
these projects. We will be doing all that we can to lock in higher returns on
the projects that we commit to going forward and we think it's an attractive
environment for doing that.

**Darren Horowitz - Raymond James**

Okay, let me switch gears. When you talked about obviously maintaining a more
conservative approach to cash flow retention for working cap purposes, as you
look at the year ahead, how do you balance excess cash flow coverage versus
bottom line DCF growth?

**Richard D. Kinder - Chairman and Chief Executive Officer**

Well I think it is a balancing process and we're just going to look at that.
Our commitment for the last 12 years has been, and that's consistent with the
MLP rules, that we try to pass on to our unit holders the overwhelming bulk of
the cash that we generate after debt service and all other costs. Clearly, I
think we'll continue with an eye looking at the... we are entitled to maintain
excess coverage for purposes of setting up reserves and for future capital
needs. And I think we'll look at that very carefully as a balancing process
when we set our targets for distributions in 2009. And now course I think
something that ought to give all of you comfort, as you know, at our January
conference, we will spell out in detail what we expect our distributable cash
flow per unit to be and then how much we expect to distribute and what our
target is for the year.

You'll see all of that and then in addition, I guess I would mention that the
past does not necessarily prologue the future. But in the past, and Park
alluded to this earlier, we've almost always ended up with more excess
coverage. We've met or exceeded our targeted distribution every year in the
existence of this company except for one year... and missed by $0.02 in 2006.
But every year but that one year, we have had excess coverage that generally
has been greater once we total up the whole year than what we projected in
January at our analyst conference. So that gives us a little bit of comfort on
running RIM [ph]. But,certainly we will look at that. And we are not naïve. I
mean, clearly, in this kind of environment something you need to be looking at
is that what ratio of excess coverage is appropriate in this kind of
environment. And that's what we are going to look at on a going forward basis.
Park?

**C. Park Shaper - President**

I think that covers it.

**Unidentified Company Representative**

Okay.

**Darren Horowitz - Raymond James**

Thank you very much. I appreciate it.

**Richard D. Kinder - Chairman and Chief Executive Officer**

Thank you, Darren.

**Operator**

And our next question comes from John Edwards with Morgan Keegan. Sir, your
line is open.

**Richard D. Kinder - Chairman and Chief Executive Officer**

Hi John, how are you doing?

**John D. Edwards - Morgan Keegan**

Good, how are you doing?

**Richard D. Kinder - Chairman and Chief Executive Officer**

Well I'm doing fine. If I complain, it wouldn't do any good anyway, right?

**John D. Edwards - Morgan Keegan**

Right, right. Hey, Rich, can you talk about how much did the hydrostatic
testing impact in terms of the cash flow for the quarter?

**Richard D. Kinder - Chairman and Chief Executive Officer**

Steve, can you drive here, and he's got those numbers.

**Steven J. Kean - Executive Vice President and Chief Operating Officer**

Yes, we had an impact to our interest on RAC of about $6 million associated
with demand charges we weren't able to collect because we had five down for
most of the month of September. Now the impact turned out to be a little bit
less just because we did some ancillary services revenues that helped offset
that. So just looking kind of at the FD line, which is not the whole story on
the ancillary services, we got about 1.5 million of that back. But it was $6
million to our interest associated with foreground FD command charges
associated with that shutdown.

**John D. Edwards - Morgan Keegan**

Okay.

**Richard D. Kinder - Chairman and Chief Executive Officer**

And we had of course had that shutdown John. We did complete it and it went
fully back in service by October 1st.

**John D. Edwards - Morgan Keegan**

Okay, great. And then I know you went through it, Park. Again, what was the
total CapEx for the quarter?

**C. Park Shaper - President**

Total CapEx for the quarter was about 600, little over $600 million and then
year-to-date it's a little under $1.8 billion.

**John D. Edwards - Morgan Keegan**

Okay.

**C. Park Shaper - President**

Now that does include sustaining, but sustaining to weight out on the other
pages, that's just expansion.

**John D. Edwards - Morgan Keegan**

Okay, great. And then as far as at this point now, how much is left to spend
on ... at REX and at MEP?

**C. Park Shaper - President**

Well, I mean the remainder at REX and MEP for the life of the project clearly
goes beyond 2008 and into 2009. And I think that the remainder at REX is
probably about half the project that remains.

**Richard D. Kinder - Chairman and Chief Executive Officer**

About $2 billion... a third of the project, about $2 billion still to be spent
at REX. Now a lot of those costs have already been locked in, in terms of some
of that $2 billion is pipeline cost obviously.

**John D. Edwards - Morgan Keegan**

Right, okay. I am just trying to get an idea of... the total costs I think
you've said now is about 5.6 or so, and so you've spent about 3.6 so far. Is
that --

**C. Park Shaper - President**

It's about six actually, the total costs.

**Richard D. Kinder - Chairman and Chief Executive Officer**

And we've spent about four.

**John D. Edwards - Morgan Keegan**

Okay. All right. So, six total and about four spent. Okay. And then the same
for MEP?

**Unidentified Company Representative**

Spent 500 of $1.9 billion capital costs.

**Richard D. Kinder - Chairman and Chief Executive Officer**

You'd hear that John, we spent about 500 to date out of about 1.9 total. That
1.9, we've already expanded at once as you know and that includes about $200
million for the additional expansion that we did, all of which is fully
subscribed.

**John D. Edwards - Morgan Keegan**

Okay, all right.

**C. Park Shaper - President**

And all of those numbers are 888 and of course Rockies Express and MEP has
their own credit facilities. Rockies Express has its own debt that's
outstanding. We'd expect to continue to finance those at the project level.

**John D. Edwards - Morgan Keegan**

Right. And then, along those lines, I just wanted to confirm. You've got
project facilities that are available until 2011 as I understand it. And
you're not under any obligation to take those facilities out once you put
everything into service. I assume you have some flexibility with respect to
timing on any capital markets activities with respect to taking those out. Is
that a correct understanding?

**Richard D. Kinder - Chairman and Chief Executive Officer**

You're correct.

**John D. Edwards - Morgan Keegan**

Okay, great. And then last would be. As far as any injection of investment by
Knight Inc., what criteria are you looking at, if you could give a little
color on your thoughts surrounding that?

**Richard D. Kinder - Chairman and Chief Executive Officer**

Well, let me say. First of all that this is something that as the largest
owner of Knight, I will say straight Morris' [ph] mouth, obviously KMP is our
priced asset. We believe in it 101%. And we're just going to look at the
market and the market for both debt and equity and decide when and how much we
think we ought to be buying an equity from KMP.

And we'll just let that be our guideline and we are very clear with the Board
that we'll just evaluate that on an ongoing basis. We have absolutely no
immediate need for any cash, debt or equity. We've told you what our credit
facilities are at the end of the year even after all of the funds that we
expect to spend in the fourth quarter on these projects. And even assuming no
term up of debt, no issuance of equity whatsoever in the fourth quarter. So,
we'll just watch it on a month-by-month basis, looking at the market on both
the debt and equity side, and decide when we want to use that $750 million.

I think it's a little everything we tell you about Knight, obviously John is a
matter of public record and our securities tonnage of Knight but Knight after
the sell-out of NGPL of course is a very under levered company and it's shown
by the fact that the debt to EBITDA ratio is about 2.6 times.

We have an undrawn credit facility at Knight. We have a credit facility of $1
billion. At year-end, we expect to have virtually nothing drawn on that. Now
we do have a final tax payment on the NGPL sale that will come up right after
the first of the year of little over $200 million. So say it in round figure,
750 to 800 of undrawn facility, plus again we have all the cash flow coming in
at Knight for next year. We had EBITDA of over $1 billion this year. We'd
expect that to grow next year. So we have plenty of cash at Knight to hold in
reserve and KMP is our key asset obviously.

**John D. Edwards - Morgan Keegan**

Okay, great. I appreciate the color on that Rich.

**Richard D. Kinder - Chairman and Chief Executive Officer**

Okay.

**Operator**

And our next question comes from Michelle Nagi Marvin with Senate Cos Capital
[ph]. Ma'am, your line is open.

**Richard D. Kinder - Chairman and Chief Executive Officer**

Hi Michelle.

**Unidentified Analyst**

Hi thanks for taking my call. Just a general market question, I'm trying to
look for silver lining. How... do you think that the constraints in the
capital markets could create some downward pressure on construction costs? And
how long do you think it would take that to evolve?

**Richard D. Kinder - Chairman and Chief Executive Officer**

Well I think you are going to see some downward pressure for two or three
reasons. One is of course the overall utilization of steel worldwide, is
turning downward. You may have seen the latest numbers that China switched
from... over the last several quarters have been net importers of steel. They
actually at least what I have been reading, they actually were a net export...
they've been an importer, they were net exporter at least during the month of
September. And we would look for that likely to continue.

As steel production comes down, and steel demand comes down, I think you will
see at least a lessening of steel price. Now that steel has to translate into
the kind of steel that's used in pipeline construction, and it's too early to
tell when that will happen. I think also as we look out and look at all of the
projects going on in terms of new midstream energy construction, primarily
pipeline, it's a little bit like the pin going through the boa constrictor
that's coming through right now and over the next 18 months or so.

After that, we do see at least what we see a downturn and that will also lead
I think to contractors getting sharpening their pencil a bit on how they will
price future projects. That said, there are no guaranties in life and we'll
just have to wait and see. But I think our guess would be that there will some
downward pressure. Too early to tell when and how much.

**Unidentified Analyst**

Great, thanks.

**Operator**

And our next question comes from Noah Lerner with Hartz Capital. Sir, your
line is open.

**Noah Lerner - Hartz Capital**

Thank you. Good afternoon everybody.

**Richard D. Kinder - Chairman and Chief Executive Officer**

Good afternoon Noah.

**Noah Lerner - Hartz Capital**

Couple of real quick questions. First, regarding the reduction in the volumes
in the products and probably to some extent nat gas towards the end of the
quarter, I'm going to make a presumption. I'm wondering if you can give any
color on kind of what the velocity of the change intra quarter has been on the
utilization in the volumes. Or we picking up speed with the reduction in
utilization or has it kind of plateaued out and has kind of been consistent
over the last couple of months now?

**Richard D. Kinder - Chairman and Chief Executive Officer**

Yes, well talk about the products. It actually was I think the actual worst
month... I am looking at my sheet here... I believe was either July or August.
September was just a little bit better but not a lot of difference throughout
the quarter, but just a little bit better in September. My guess is we've
probably seen the plateau and what we are thinking is it will probably stay
down at about this level, about 7% through the fourth quarter. Again as I said
earlier, Noah, there are some hits and misses and there is surprisingly Las
Vegas, for whatever reason, is actually modestly up for the year. And on the
other hand, California has been down, although California September was I
believe a shade better than July and August. But I think we'll just have to
see.

Obviously, if you look at the glass half full, you would think that gasoline
prices having fallen as much as they have, $0.70 or so across the board and
probably more to come that you would see some pickup in demand. But offsetting
that certainly is... if we're in a recession, and I expect we are, how do you
weight the recession against... which is a negative for gasoline usage against
the positive of lower prices at the pump? And I just don't know. We're just
playing it very conservatively and obviously we have the... any increase in
those product volumes drop almost directly to the bottom line because we are a
high fixed cost, low valuable cost business on our Products Pipeline system.

Now aside from the impact, and Steve can contradict me, aside from the impact
of the hurricane late in the third quarter, we really haven't seen any
downturn in natural gas demand. And we look at this very carefully and I've
voiced some of this before. Our view of the overall demand for natural gas is
pretty darn bullish. And the reason for that is primarily electricity demand
that if you look at the alternatives to generate additional electricity that
this country surely needs as we go forward, there aren't a lot of other
alternatives. Coal certainly has a negative connotation right now in terms of
environmental issues. I think you are not going to see a lot of new coal
plants built. Nuclear, which I happen to personally believe is a big part of
the answer, I am one of these all of the above category people. I think
nuclear should be encouraged and hopefully it will, although our two
Presidential candidates seem to have different view points on that. But I
think that's probably 10 or 12 years off before you have any meaningful or
probably any new nukes at all built. So that's not the solution over the next
several years.

Certainly, we have abundant natural gas, the shale plays are coming to
fruition, producing a lot of natural gas. We have it and the key is to get the
connectivity between the supply sources and the demand sources. Certainly, we
also have alternative fuels. I am a little bemused and I know all you people
are smart enough to figure this out, but... and I think if we can find wind
power and solar power, that's great too. But don't be confused by the fact
that when you say we expect a 50% increase in wind power deliverability,
that's going from maybe a little less than 2% to 2.5% or 2.75%, say 2% to 3%
to round. So it's not like it's going to fulfill the growth that's inherent in
natural gas or replace any of the demand for fossil fuels on the electric
generation side. So I believe, like it or not, that we are going to have
fossil fuels and particularly natural gas as the prime driver of our
electricity needs over the next decade. And so we are very bullish on that.
You'll have ups and downs in natural gas usage too, but I think for the most
part, we feel very good and our numbers so far would show that natural gas
demand and throughput is holding up very well except when you have disruptions
from the hurricanes.

**Noah Lerner - Hartz Capital**

Okay, great. I guess if I can get just one other question from reading through
the press release, looks like you had some pretty good test results down in
Florida on the ethanol pipeline. I know we talked about this a couple of
quarters ago that with its limitations on long haul pipes from, I suppose. I
was wondering if you saw from the success of this any other opportunities for
short haul pipelines for you to add on to expand the opportunities with the
ethanol pipelines.

**Richard D. Kinder - Chairman and Chief Executive Officer**

Yes, that's a very good question. The tests on our central Florida pipeline
went very well. We are going to start offering that to our customers later in
the fourth quarter and we seem to have an awful lot of pent up demand for that
given the fact that the 10% Florida mandate now for ethanol. And right now of
course we have the terminal in Tampa, the terminal in Orlando and the pipeline
connecting the two. But right now, for the ethanol part of the demand, that
10% is being moved until we started this magic [ph] by truck from Tampa over
to Orlando, then put into tanks at our Orlando terminal and blended in at the
rack to produce the 10% mandated ethanol content. Certainly, it's much cheaper
to ship by pipeline even over this relatively short distance than it is to
ship by truck. So we think people are definitely going to take advantage of
all we can offer them on batching ethanol in Florida.

Now the next one that comes to mind is we have a pipeline system in Oregon,
part of SFPP that runs from Portland down to Eugene, Oregon, and we would
think that's probably the next place that we will implement this.

Now beyond that, on the long haul pipes, it's more difficult. We are looking
at how we do this, but I certainly would not want to promise that we'll be
batching major quantities of ethanol on plantation or on the two major
facilities on SFPP, the east line and west line. What I would say though is
that we've said this before on plantation, there may be the opportunity. We
have multiple lines running across the Southeast. There may be the opportunity
to segregate out ethanol, take one of those smaller lines and put it in
ethanol service on a going forward basis. And certainly that's easier to do
than batching ethanol, but some of the same technology making sure that you've
got the moisture out of the system, et cetera, et cetera that we've learned on
Florida will apply if we wanted to dedicate part of the plantation system to
ethanol. And that's something we'll continue to look at, and I think it will
probably be early 2009 before we're prepared to address that in more detail.

But clearly ethanol movement by pipeline is a positive. Another positive as
most of you know is that in the energy... the bailout whatever you call at
that. The bailout, the $700 billion bailout legislation in Congress, as part
of that as you know I think they did put in there that movement of ethanol or
biodiesel would qualify for MLP treatments. So, means we don't have to count
any revenues from ethanol or biodiesel handling against the 10% that we are
allowed to have come from non-qualifying sources.

So, that's a plus for us and for all the MLPs. It means that if you can
structure your lines in such a way that you could move large quantities of
ethanol, you can debottleneck a lot of the rail transportation issues in this
country. You'll laminate a lot of the unit trains. They are the primary movers
of ethanol now. And that cash will automatically qualify for MLP treatment.
And I think that's a big positive.

**Noah Lerner - Hartz Capital**

Great. One last real quick question, on the increase in the cost between REX
and MEP and everything, the press release said it looks like it's about 22%
over the number from January. Is that basically equal from both or is one
higher and one lower between the two projects with the excess costs?

**Richard D. Kinder - Chairman and Chief Executive Officer**

Steve?

**Steven J. Kean - Executive Vice President and Chief Operating Officer**

Yes. With the 22% number is taking the projects that we were looking at in
January which includes REX and MEP and Louisiana and that sort of thing. And
just looking at that project slate and identifying increase over, I think
whether that starts with... touches a little over $7 billion numbers. That's
22% instruments out, most of that, about 9% of that is in gas group. And a
vast majority of that is related to construction cost increase. We try to
break it down. And this is really kind of broken down to our share.
Construction cost, we've spent on REX of about 200 of that, MEP is about 110
and AMLP is about 281. That explains really most of that tight differential.

**Noah Lerner - Hartz Capital**

Okay, great. Thanks very much.

**Richard D. Kinder - Chairman and Chief Executive Officer**

Thank you.

**Operator**

And our next question comes from Rajul Aggarwal with Marathon Asset
Management. Sir, your line is open.

**Rajul Aggarwal - MarathonAsset Management**

Hi. Thanks for taking my question. A couple of follow-ups and couple of other
questions. One was just on this CapEx number. You had initially... on a
previous question, you gave the numbers on CapEx for REX that have been spent
and that is left to spend. Does that... were those estimates including the 22%
increase or were they before the 22% increase?

**Richard D. Kinder - Chairman and Chief Executive Officer**

Oh no. They are including everything. Our current estimate and again, when we
say, we have about 2 billion left to spend, don't think that's $2 billion of
Kinder Morgan money. That's $2 billion on aid age [ph] basis, we have
financing at the joint venture level, that will take care of the debt
component of that. And then the contribution from us Sempra and Conoco will be
for what's left over on the equity side. So part of the $2 billion comes out
of the facility. Part comes in equity contributions and our part of the equity
contribution is obviously 50% of whatever contributions necessary.

**Rajul Aggarwal - MarathonAsset Management**

Got it, that's helpful. On the $750 million potential equity infusion from
KMI, you said that KMI has $1 billion of EBITDA and it's significantly under
level I think what you say. The question I have was one, as and when you
receive distributions from KMP to KMI, does that cash accumulate on KMI or are
you just... just to really get further to the equity holders. And if it is...
if that is the case, how does that EBITDA help the equity infusion, I guess?

**Richard D. Kinder - Chairman and Chief Executive Officer**

Well the cash that comes up from KMP to KMI which comes of course both from
the standpoint of our general partner interest and also from the ownership of
the KMP and KMR units that we own it to KMR and Knight. That comes up pretty
clear [ph]. We also have NGPL distributions that come out of our remaining 20%
ownership of NGPL and that is the cash flow that we have. That is up to Knight
to decide what it wants to do with that. And we have the opportunity to either
distribute that up or we have the opportunity to pay down what debt is left at
Knight, or we have the opportunity to reinvest it back in KMP or some place
else. And so we have that in addition to the facility that is essentially
undrawn on. Does that answer your question?

**Rajul Aggarwal - MarathonAsset Management**

It does...

**Richard D. Kinder - Chairman and Chief Executive Officer**

It is really important that Knight is a very healthy company from a cash flow
standpoint. And all we have is the remaining debt up there. We have paid the
debt out. We have paid in taxes that occurred, otherwise it is free cash flow
for Knight to decide how it wants to use.

**Rajul Aggarwal - MarathonAsset Management**

No, I understood. The reason I was asking the question was, from what you
said, there isn't... in your view there was no need for the equity infusion
right now in the near future that you saw. In the next three to six months if
you get distributions and if you distribute amount to the equity holders of
KMI, then that wouldn't be... I mean in that sense, the only capacity of debt
would be the credit facility in some ways. That won't be cash sitting in
there. Have you taken any steps to prevent that cash from being distributed
out to the equity holders? That's just a fluent conversation at this point.

**Richard D. Kinder - Chairman and Chief Executive Officer**

Well let me go back again. We have no dividend policy at Knight, that's up to
the decision of the Knight Board. We can distribute zero to Knight. We haven't
distributed anything to Knight equity holders this year or we could distribute
all of that cash flow. Clearly given this situation, we'll look at that very
carefully before we make any distributions out to the shareholders in Knight
of which I am the largest shareholder. So, we're going to do what's right for
the whole enterprise, including KMP obviously.

**Rajul Aggarwal - MarathonAsset Management**

Got it.

**Richard D. Kinder - Chairman and Chief Executive Officer**

Does that answer your answer?

**Rajul Aggarwal - MarathonAsset Management**

It does, that helps. The other two questions I have, just there has been very
drastic change in the commodity price environment in the last three months or
so. And who knows where this is going. I just wanted to get color from you
last two, you've talked about the demand side of gas and how you're bullish on
that. How does the supply side reaction to this drastic correction in gas
prices impact your business if it has any impact... I mean does the outright
gas price have an impact on your business?

**Richard D. Kinder - Chairman and Chief Executive Officer**

Well I think everything probably has some indirect impact if you're a major
midstream player in the energy field but not a lot. The lower price of natural
gas, if you want to look the glass half full, you would say it will lead to
natural gas arguably recapturing some markets that otherwise would have lost.
You may have more production, more industrial use of natural gas in the United
States. I don't think those are big items one way or another but we have lower
prices. You probably have a little more use.

On the negative side, the glass half empty side you might say that some people
in some places producers may scale back a little bit on their production. I
think if they do that price will probably firm up again. But we don't think
that the change in natural gas prices is going to have any significant impact
on our business unless you had a fall to $2 or $3 and had producers cutting
back dramatically, in which case, I think you've got to have a B type recovery
in gas prices. So, I think that's kind of a non-event for us, the pricing of
natural gas.

**Rajul Aggarwal - MarathonAsset Management**

Okay. And in terms of oil price in the CO2 segment?

**Richard D. Kinder - Chairman and Chief Executive Officer**

In terms of oil prices, clearly, now as we said before, virtually all of our
volumes at SACROC and Yates, the oil production there is hedged under long-
term hedges. So we're not exposed to direct commodity price differentials up
or down there.

The two areas in which we are exposed to indirectly or directly to oil prices
are number one, most of our NGLs are not hedged. They are almost impossible to
hedge a very dirty hedge when you start hedging NGLs as a lot of people have
experienced. So we don't hedge those. So to the extent that the ratio of oil
prices and naturally the delta between oil prices and natural gas prices, both
of which have declined pretty dramatically as you know, to the extent that
that delta changes and it has impact on our NGL volumes that we produce out in
SACROC, about... we're averaging about 10,000 barrels, these are 8H numbers
now, not our share... about 10,000 barrels a day of that, 15,000 barrels when
we get the facility, when Exxon gets the facility at Beaumont back on line
that will have some impact depending on how that spread turns out.

So we kind of benefit in that particular segment from lower natural gas
prices, get hurt by lower liquids prices.

And then the final thing is that we set our prices on a number of our CO2
sales contracts to third parties. A lot of those are set with a floor price,
but upward escalation based on oil prices. Even though this is not a day-to-
day thing because most of those are set a quarter in advance. So, for example,
the set for the fourth quarter was the closing price on September 30th. The
price for the third quarter was the closing price on June 30th. But we are
exposed there in terms of the amount of our CO2, the value of some of our CO2
sales contracts.

So those are the two negatives. On the other side, if oil prices come down in
a sustained way, you probably have more product demand. I like to say that
we're essentially a huge toll road. That said, we're probably a little bit
biased. We are helped by higher prices a little bit in the scheme of things
and hurt a little bit by lower prices.

**Rajul Aggarwal - MarathonAsset Management**

Got it. Just one last question if I may, and this is more... you have and you
continue to spend quite a bit of money in infrastructure across U.S. And I
mean... from seeing... Iceland [ph] and it seems a lot of people are just
looking at the world and saying the world is coming to an end. I mean does
that make you nervous about all the CapEx that you are putting into the ground
as to what all this turmoil may have an impact in terms of market pricing
going forward and how that may impact your business?

**Richard D. Kinder - Chairman and Chief Executive Officer**

Well, let me start by saying I've been in this business about 30 years. I've
seen a lot of ups and a lot of downs. And generally, this economy and this
industry muddles its way through to pretty successful outcomes in the end. So
long term, I'm not that negative on the whole situation. But we could have
some short-term volatility as everybody knows or even short to medium-term
volatility. But let me say specifically on the infrastructure, what I like
about our game plan at Kinder Morgan is that virtually all of these major
construction projects are backed up by long-term contracts with the shippers.
And where we do not have long-term contracts with the shippers, we generally
have the kind of rate base treatment where if they don't ship, the rate to the
remaining shippers, or remaining volume shipped go up.

So, for example, on our Products Pipelines, while it has a negative short-term
input hit to us if volumes go down, in the long term, we can readjust those
tariffs to incorporate the lower throughput. So that's kind of the regulatory
part of it. On the less regulated, the natural gas pipelines, on virtually all
our projects. For example, REX, we have 1.8 billion cubic feet a day of
capacity fully subscribed for a 10-year period from the date of the final
finish of REX. So it really amounts to about 11.5 to 12 year contracts with
people like Conoco and BP and other, EnCana, other strong credits.

On MEP, we have all of our throughput fully subscribed for 10 year contracts
both on the base facility and on the recently announced expansion. All that
was fully subscribed to a number of shippers. So we have... and on the
Fayetteville project, as I just said, it's a 2 BCF a day. We haven't even done
the open... we are just in the open season now. We already have 1.85
subscribed. My people tell me they expect to have the rest of that subscribed
by the time we start construction in late 2009. So really, we are really
not... nothing in life is without risk. Don't get me wrong, but we think we
have protected our risk very well. We simply we won't build these projects
unless we have long-term throughput agreements. Steve or Park, anything you
want to add to that? Okay. Does that answer your question?

**Rajul Aggarwal - MarathonAsset Management**

Thank you so much.

**Richard D. Kinder - Chairman and Chief Executive Officer**

Yes.

**Operator**

And our next question comes from John Tysseland with Citigroup. Sir, your line
is open.

**Richard D. Kinder - Chairman and Chief Executive Officer**

Hey John, how are you doing?

**John Tysseland - Citigroup/Smith Barney**

Good Rich. Good afternoon. Thorough conference call as always. Quick question.
I guess most of my questions have been answered, but Rich, you seem to
emphasize that the amount of distributable cash flow KMP generates when you
are speaking about your financial flexibility, is that another way of saying
that if you don't get attractively priced capital even in today's like very
tight environment that you consider using the distributable cash flow as a
source of financing, because I guess if you were take a very negative outlook
on the capital markets longer term, KMP is actually... could finance the
growth or the CapEx growth with some distributable cash flow, which I think is
pretty unique among MLPs, especially ones that have as large of a CapEx budget
as KMP does.

**Richard D. Kinder - Chairman and Chief Executive Officer**

Well we certainly mentioned that because that shows that we do have tremendous
ultimate flexibility across the board. And as we said in the last part of the
press release, John, that we are committed to continue to build the long-term
future of this company and we just have a lot of flexibility. And we started I
think my very first point was the tremendous cash flow that the underlying
assets generate. I think we have all kinds of other flexibility too with our
credit facilities, with the ability of a very strong general partner to step
forward if it's appropriate.

And one thing we didn't mention, but we have actually in this process had a
number of a third party infrastructure players come to us and talk about
partnering up with us on projects, the very... these projects are very
attractive when you have long-term contracts for all the capacity. So I just
think we have an awful lot of flexibility, and I don't want to compare
ourselves to any other MLP, but we just... at Kinder Morgan have a unique set
of circumstances, strong general partner, good credit facilities,
extraordinarily good cash flow. And you put all that together, and I think
we're obviously well equipped to weather whatever the market throws at us.
Park, you want to add anything to that?

**C. Park Shaper - President**

Imean, the only thing I would say John I think, this was your point as well, I
mean when your own assets, that are stable, diverse set of assets that are key
for the energy infrastructure of this country, they have to operate, keep this
country running and they generate $2 billion of cash a year and growing. As
Rick said, you have a lot of flexibility, you are in a very strong position
and that's...I think that's what you said earlier that's what Rick said, that
what press release says. And in $2 billion cash, gives you that flexibility

**John Tysseland - Citigroup/Smith Barney**

Well...last question is I guess, when you look at the opportunities that you
have to further development infrastructure over the next several years and you
have spoken about this in a couple of presentations. Do you still expect to
spend the same amount may be on to CO2, if oil prices stay, where they are
today or I guess maybe a better way to ask that question is, where would you
consider scaling back CapEx should the current capital markets persist?

**Richard D. Kinder - Chairman and Chief Executive Officer**

Well, I don't think that we're going to have to scale back CapEx, again, for
all the reasons we talked about. I think as Park alluded to earlier, we're
clearly looking at higher returns now on the CapEx we do spend on new
projects. And again, we've been approached by a lot of the players on the
other side who now are interested in selling or joint venturing the assets
that they have that I don't think they would have considered doing before the
credit launch. We haven't pulled the trigger on it. I'm not saying we will.
But certainly there are going to be a lot of opportunities out there and
generally I think at higher returns, but still preserving the kind of
throughput commitments that we've come to expect on our pipeline projects.

As far as the CO2 is concerned, we evaluate that every year on a conservative
price deck, on the forward price of oil. If we don't see a very nice return on
that, we won't spend the money on it. And this year certainly CO2 is not only
a generator of a lot of cash, but even after you take off the... Park, I think
alluded to the fact in three quarters, we spent about $390 million, expect to
spend about $500 million for the year. Our cash flow, distributable cash flow
coming out of that segment is well in excess of that. So we're actually
generating a significant amount of free cash flow from our CO2 operation
today. Expect to do the same thing in 2009 and beyond.

**C. Park Shaper - President**

The only thing I would say consistent with what Rich said is, I mean of course
we'll continue to evaluate all future investment decisions based upon the
environment that we're in at that time using a conservative projection for oil
based upon where it trades at that time. We don't want to expect to really
curtail our existing activity at the CO2 assets. But I do think that it's true
that if oil prices stay low for a period of time that the cost of those same
activities will come down. We will naturally end up spending less on capital
with CO2 because the cost of doing the kinds of activity that we want to do
will decline.

**John Tysseland - Citigroup/Smith Barney**

That makes a lot of sense. Last question, Park, when you look at your credit
facility, can you remind me if that is... if you've swapped through a fixed
rate on that and when those swaps expire?

**C. Park Shaper - President**

We have not swapped to a fixed rate on our credit facility. And so it... when
we borrow on that, it floats.

**John Tysseland - Citigroup/Smith Barney**

And then when you look at fourth quarter, you said you were going to be
significantly below budget for the year. But if you look at fourth quarter, I
would assume --

**Unidentified Company Representative**

Significantly above budget, above budget for the year.

**John Tysseland - Citigroup/Smith Barney**

Okay, I'm sorry, I'm sorry.

**Unidentified Company Representative**

That's a little important there.

**John Tysseland - Citigroup/Smith Barney**

So when you look sequentially quarter-over-quarter to fourth quarter on
interest expense, I mean how much are you anticipating that to jump?

**C. Park Shaper - President**

And so interest expense will be favorable to budget, so the actual interest
expense will come in under what our budget was. So that's a favorable variance
that we expect for the year. And then I am sorry, John, what did you ask?

**John Tysseland - Citigroup/Smith Barney**

Right. When you look at the fourth quarter relative to third quarter, given
what near-term rates have done --

**C. Park Shaper - President**

Rates will be higher and we factored that into our expectation.

**John Tysseland - Citigroup/Smith Barney**

Okay.

**C. Park Shaper - President**

Rates in the fourth quarter will be higher than they were in the third
quarter.

**John Tysseland - Citigroup/Smith Barney**

Yes. Thanks for the clarity guys.

**Unidentified Company Representative**

Okay, thanks John.

**Operator**

And our next question comes from Yves Siegel with [indiscernible].

**Richard D. Kinder - Chairman and Chief Executive Officer**

Hey Yves. How are you doing?

**Yves Siegel - Wachovia**

Well, thank you. Good afternoon. Just quick follow ups if I could. Number one,
has the commercial paper market opened and what's your view on that?

**C. Park Shaper - President**

Well, the commercial paper market is open and we were issuing commercial paper
and have been consistently. Now I'm sure many of you felt this week that S&P
put its own negative outlook. And as part of that, they took our commercial
paper rating to A3. And as part of that, there is really not a commercial
paper market out there for that rating. And so we're now drawing on our
facilities.

**Yves Siegel - Wachovia**

Okay. And have you had discussions with S&P in terms of what they would like
to see in order to may be change that?

**C. Park Shaper - President**

Yes. And I'll let David comment as well. I mean he has directly spoken to
them. But I actually think the write up was fairly clear. It was clearly
instigated by the delay in putting Rockies Express in service. But I think
what they are looking for is for us to finance these projects going forward.
And I think that once we successfully do so, then my expectation is if
everything else stays the same, and everything else won't stay the same, and
so we'll have a discussion with them at that time. But my expectation is if
everything else stays the same, once we finance these projects, that negative
outlook would come up. David, is that consistent?

**Unidentified Company Representative**

Yes, that's consistent. I would agree with you on that statement, Park.

**Yves Siegel - Wachovia**

Okay, great. And then if I could just follow up with the CapEx. Was there any
reason why the Louisiana pipeline project seems to disproportionately have
more of a cost overrun than REX or the Midcontinent?

**Richard D. Kinder - Chairman and Chief Executive Officer**

I'm going to turn that over to Steve and let me say we have... go ahead,
Steve.

**Steven J. Kean - Executive Vice President and Chief Operating Officer**

Yes, I mean I think what we're... what we've experienced on the Louisiana
pipeline is really it stays the kind of three factors that are affecting
pipeline construction costs generally. We've had weather issues. We have
certainly experienced an increase in construction costs generally. We've had
materials quality problems there that we've had to remedy. And so that's
been... it's been unquestionably disproportionately impacted by increasing
construction costs compared to the others. Again, we're going to be looking
for whatever way we can to try to get some of that back and to look for
revenue opportunities. But I think, as Rich says, it's going to be hard to
make that particular project attractive when all is said and done.

**Unidentified Company Representative**

Actually, I want to clarify one other thing. In the answer to the question I
gave before, someone was asking about the difference between the 22% number.
And what I explained really was the difference between Q2 and Q3 in terms of
our project update. So the breakdown that I gave on the construction cost
increases on REX and MEP and Louisiana were geared for the Q2 to Q3 change
rather than a change from any other account.

**Yves Siegel - Wachovia**

Rich, you commented on the impact of commodity prices. Could also just comment
on the potential impact of the lower oil prices on what might be happening up
in Canada as far as the oil sands?

**Richard D. Kinder - Chairman and Chief Executive Officer**

Yves, I think, it seems to me that that most of particularly the larger
players up there are still very intent on carrying out their oil sands
projects even in the face of... they've experienced escalation cost and
clearly difference in pricing out. And I would expect that we've always said
we would haircut some of these dramatic growth projections that some people
come up with for Canada. But I think anyway you cut it, you're still going to
see a substantial and large increase in the amount of production that's coming
out of the oil sands.

But yes, I think the lower oil price will certainly have some impact on it.
But I think that so many of these projects are so far along now that they
really don't have any choice but to finish them up I think. And obviously, the
various joint ventures and contracts signed with refineries in the U.S. that
are retrofitting to accommodate the heavier oil just increases both the desire
and the contractual necessity of finishing some of these projects.

But we'll continue to watching this as you know we're finished and will be by
the end of this month with our expansion on Trans Mountain will be at 300,000
barrels a day capacity coming over to the lower mainland. And actually right
now in our numbers, we got very good volumes down in the Washington State. A
part of that goes out over the water from our facility in Vancouver Harbor.
Part of it gets consumed in the lower mainland. And then, a significant part
goes down to Washington State. And we've actually, I don't know how much of a
long term trend this is, but we've actually seen in the last two months, some
of the highest volumes going into Washington State, that we've seen at any
times since we've owned that asset. So, what that's a result of, I don't know.
But clearly we are seeing a lot of demand for it and a lot of demand coming
over the water also.

**Yves Siegel - Wachovia**

I have just two last ones. Richard you also went over the credit worthiness of
the guys on Rockies Express and Midcontinent. When you look at the
Fayetteville expansion or any other type of stuff, are you worried at all
about counterparty risk? And are you contemplating or are you getting right
now... that hasn't been built yet but letters of credit... can you just... has
the world changed enough that you are sort of worried about future projects
and credit quality?

**Richard D. Kinder - Chairman and Chief Executive Officer**

I think we are always worried about credit quality in any environment, and we
have and I really can't go into details on any of the contracts. But on
virtually all of our contracts across our pipelines, unless it's... with very
few exceptions, we do have letters of credit to back up in certain events on a
number of our projects including Fayetteville.

**C. Park Shaper - President**

The only thing I will add to that is we do the credit protection and always
consist, especially on FERC regulated pipelines, there are restrictions on
what we can get and can we live within the PERC guidelines on that approach.
And then, for these projects, I mean in Fayetteville as an example, I mean you
look beyond that as well and say, what actually would happen if a counterparty
got in trouble? Is this gas field going to be produced, and if it's going to
be produced, it's quite likely going to have to use the pipeline capacity
which means in that event your contract likely gets affirmed. But I'm not
saying that's always the case, I am saying we go to that level of analysis as
we're evaluating this.

**Richard D. Kinder - Chairman and Chief Executive Officer**

Yes. Before we try to build a pipeline away from a specific area, we look at
what the overall formation is going to produce, what the cost structure of
that is and what kind of market clearing price is, and of course so much of
this money that the producers are spending is upfront in terms of leasehold
costs. So actually you've to beat cost and a lot of cases are pretty minor,
not minor but pretty slight compared with the pricing even in today's market.

**Yves Siegel - Wachovia**

Okay. And here's the last one which you or may not want to answer, but in
terms of the acquisition opportunities or JV opportunities that may come your
way, are any of these significant step-out type of transactions as opposed to
the singles and doubles that you hit pretty well?

**Richard D. Kinder - Chairman and Chief Executive Officer**

You're right. I wouldn't want to a comment on that. Let me just say that we'll
be very careful before we do anything. And of course, one way of doing that is
if you did something, you might be something for equity. So it would be self
financing from a going forward standpoint. But it will just depend on the
circumstances. We will be very careful before we do anything. But there are
certainly opportunities out there.

**Yves Siegel - Wachovia**

Got it. Thank you.

**Richard D. Kinder - Chairman and Chief Executive Officer**

Thanks Yves.

**Operator**

And our next question comes from Ross Pixane with [indiscernible].

**Richard D. Kinder - Chairman and Chief Executive Officer**

Hey Ross, how you doing?

**Unidentified Analyst**

Hi guys. First question is, can you tell us how much of the quarter's crude
production was hedged and where you are for the rest of the year and for '09?

**Richard D. Kinder - Chairman and Chief Executive Officer**

Sure Park.

**C. Park Shaper - President**

Yes I mean the crude production for 20008 is essentially low 90% hedge, 93%
approximately and '09 we're about 82% hedged. Now that's predominantly that
doesn't include that NGLs and the denominator.

**Unidentified Analyst**

Okay, all right. Also, just want to make sure your most recent expansion
program was ATP, proximate to Intertops [ph] would plug to around 7 billion of
mile. Is that ideas where we're currently, give on the customer to see any
things more than three maybe four range?

**Richard D. Kinder - Chairman and Chief Executive Officer**

Well, what we've tried to do in the Fayetteville project is really hold in our
full experience with the cost increase experienced on our other project and
frankly that added some. So what you're seeing is hopefully something that has
some margin than margins for air in it but it does reflect kind of I think the
worst of what we seen so far in the pipeline construction.

**Unidentified Analyst**

Okay. And finally, if I can kind of get a number on where REX debt is, also
looking if you could comment on S&P's actions here, it's kind of interesting
that on the second of the mark day, you came out to talk about your
Fayetteville expansion, and said it will be over 4.5 times debt to EBITDA,
probably inclusive of REX debt, as they would look at a negative outlook and
they obviously move much quicker, if you can just give some color on your
thoughts of why they did move as quick and also if you can give us the REX
debt number? Thanks.

**C. Park Shaper - President**

The REX debt number is, we got $1.9 billion of debt out there, in terms of a
longer term debt, were $625 million, $1.3 billion of long term and then
outstanding on the credit facility is about $1 billion.

**Unidentified Analyst**

Okay. So that... was that 1.3 plus 600 plus 1?

**Unidentified Company Representative**

Yes, almost $3 billion.

**Unidentified Company Representative**

And then we put, and again these are on a 8H basis, and then within REX to
date, the partners have contributed about $1 billion of equity into the
project. So that's how you get to Richard's number earlier of roughly $4
billion in REX.

**Unidentified Analyst**

Alright. Any comments on the rating agencies?

**C. Park Shaper - President**

I mean, I think like I said before, it was prompted by the announcement around
the REX delay. And I mean I don't know that we have anything to add to the
comments before.

**Unidentified Analyst**

Okay. And Park, when you guys talk about the debt number, given that the
rating agencies are going to be looking at this, you're including the REX
EBITDA in your earnings. If you could maybe give us what the debt numbers are
at REX just when you are going through that, that would be helpful for us.
Thanks

**C. Park Shaper - President**

But the numbers that we give you at REX is after interest expense. All we do
is we take our net income or our equity and earnings and we'll add back our
DD&A. We are not adding back the interest expense.

**Unidentified Analyst**

Okay.

**C. Park Shaper - President**

I think it's better to look at it without including the REX debt. So what
we're trying to give you when we talk about our distributable cash flow number
is what we actually expect to receive out of REX in a distribution. And so
that's why we add back the DD&A and we take off the sustaining CapEx.

**Unidentified Analyst**

Sure.

**C. Park Shaper - President**

It's after the REX debt is already serviced.

**Unidentified Analyst**

Right, I understand that. Being on the debt side, we are just trying to look
at what the rating agencies are looking at from a total debt to EBITDA
standpoint inclusive of REX. That's why I was asking for that.

**C. Park Shaper - President**

Yes, I understand that they are looking at that, and we'll have some more
conversations with S&P about that. I mean Rockies Express is an investment
grade rated entity. It supports its own debt and we expect that it will going
forward. The $1.3 billion on it is non-recourse to us. We expect that there
will be additional debt on it that's non-recourse to us. And I think that's
consistent with their understanding.

**Unidentified Analyst**

All right. Okay, thanks guys.

**Unidentified Company Representative**

Thank you, Ross.

**Operator**

And our next question comes from Burt Zimmerman [ph] with Principal Global.
Sir, your line is open.

**Unidentified Analyst**

Thank you. Good afternoon guys.

**Richard D. Kinder - Chairman and Chief Executive Officer**

Good afternoon.

**Unidentified Analyst**

I just had a quick question. You mentioned what your credit facility was going
to look like at the end of the year. Could you just quickly run through what
those credit facilities have available now?

**Unidentified Company Representative**

Yes. And today at KMP, we have in excess of $800 million. We have almost $900
million at REX. We have about $650 million at MEP.

**Richard D. Kinder - Chairman and Chief Executive Officer**

And let me just say in case somebody has asked this, those are all net of any
commitment from Lehman, which was very small, about 3% of our total lines came
from Lehman. But we've netted those out even though I think in the end
Barclays may elect to take part of those. But at this time, that's not been
done. And so we've been I think conservative there and just netted off. It's
very minor, as I said, a little over 3% of the total commitment is from
Lehman. But we have netted that out and the numbers we are giving you are
without that.

**Unidentified Analyst**

Okay. So you had $800 million left on your KMP revolver now and you expect to
have $600 million left at the end of the year, is that right?

**Richard D. Kinder - Chairman and Chief Executive Officer**

We expect more... closer to $650 million, yes.

**Unidentified Analyst**

Okay. So you are only going to draw another $150 million it sounds like the
rest of the year?

**Richard D. Kinder - Chairman and Chief Executive Officer**

We have a little over $800 million and we're going to be a little under $650
million. So yes, $170 million... in that range.

**Unidentified Analyst**

Okay. Alright, thanks a lot.

**Operator**

And our next question comes from Rajul Aggarwal with Marathon Asset
Management. Sir your line is open.

**Rajul Aggarwal - MarathonAsset Management**

Hi, thanks for taking my second set of questions. Just on the facility, on
that $600 million floater that I think are recourse to you on the Rockies
Express, how do you plan to tackle that?

**Richard D. Kinder - Chairman and Chief Executive Officer**

Well we expect to refinance it, then of course there will be equity
contributions coming from the partners as well.

**Rajul Aggarwal - MarathonAsset Management**

Got it. So you think you'll be from between now and August of '09, you'll be
issuing $600 million debt for REX, is that fair?

**C. Park Shaper - President**

Yes, if there's a reasonable change for that.

**Rajul Aggarwal - MarathonAsset Management**

Got it. The reason I'm asking is I mean given what is happening in the credit
markets, you haven't given a thought to use the credit facility to find an
answer.

**C. Park Shaper - President**

Well, we could do that as well.

**Rajul Aggarwal - MarathonAsset Management**

Got it. At what point does the credit facility become too tight for the
ongoing CapEx at REX itself, or are you comfortable with the availability
right now you have of $900 million at that facility?

**C. Park Shaper - President**

I mean we'll look at that when we look at 2009 and see how the CapEx is going
to flow.

**Rajul Aggarwal - MarathonAsset Management**

And in terms of your own maturity, the 250 that you have in Feb of '09, how do
you plan to refi that?

**C. Park Shaper - President**

We'll either refinance it with long-term debt or we'll refinance it using the
credit facility or we'll issue equity.

**Rajul Aggarwal - MarathonAsset Management**

Thank you.

**Operator**

I'm showing no further questions at this time.

**Richard D. Kinder - Chairman and Chief Executive Officer**

Alright, Mary, thank you very much. It's been a long call. Again, as I always
say, if you have additional questions, feel free to call Kim or any of the
rest of our people and we'll try to answer any and all questions that you may
have. Appreciate your patience for a long call and we'll talk again soon.

![SeekingAlpha](https://static3.seekingalpha.com/assets/og_image_192-59bfd51c9fe6af025b2f9f96c807e46f8e2f06c5ae787b15bf1423e6c676d4db.png)

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47,100122-st-jude-medical-inc-q3-2008-earnings-call-transcript.html,"St. Jude Medical, Inc.",STJ,healthcare,2008.0,,regular,"October 15, 2008",8:00 am,2008-10-15T12:00:00.000Z,56148,26255,29893,2,6,"['Daniel J. Starks - Chairman, President and CEO', 'John C. Heinmiller - EVP and CFO']","['Robert Hopkins - Banc of America', 'Michael Weinstein - JPMorgan', 'Fredrick Wise - Leerink Swann Llc', 'Tao Levy - Deutsche Bank', 'David Lewis - Morgan Stanley', 'Vivian Cervantes - Rodman & Renshaw Llc.']","**Operator**

Welcome to St. Jude's Medical Third Quarter 2008 Earnings Conference Call.
Hosting the call today is Dan Starks, Chairman, President and Chief Executive
Officer of St. Jude Medical.

The remarks made during this conference call include forward-looking
statements within the meaning of the Private Securities Litigation Reform Act
of 1995 that involve risks and uncertainties. Such forward-looking statements
include the expectations, plans and prospects for St. Jude Medical.

The statements made on this conference call are based upon current
expectations, and are subject to certain risks and uncertainties that could
cause actual results to differ materially from those described in the forward-
looking statements.

Such statements involve potential risks and uncertainties, such as market
conditions and other factors beyond St. Jude Medical's control and the risk
factors and other cautionary statements described in St. Jude Medical's
filings with the SEC, including those described in the risk factors and
cautionary statement sections of the St. Jude Medical's Annual Report on Form
10-K filed on February 27, 2008.

St. Jude Medical does not intend to update these statements and undertakes no
duty to any person to provide any such update under any circumstance.

At this time, all participants have been placed on a listen-only mode, and the
floor will be opened for your questions following the presentation. It is now
my pleasure to turn the floor over to Dan Starks.

**Daniel J. Starks - Chairman, President and Chief Executive Officer**

Thank you, Regine and good morning and welcome to the St. Jude Medical third
quarter 2008 earnings conference call. With me on the call today are John
Heinmiller, Executive Vice President and Chief Financial Officer, Mike
Rousseau, Group President, Joe McCullough, Group President and Angie Craig,
Vice President of Corporate Relations.

I want to first ask John Heinmiller to conduct his normal review of our third
quarter results along with his typical update for the entire St. Jude Medical
business. I will then make a few comments and open it up for your questions.
Go ahead, John.

**John C. Heinmiller - Executive Vice President and Chief Financial Officer**

Thank you, Dan. Sales for the quarter totaled $1.84 billion, up approximately
17% over the $927 million reported in the third quarter of last year.
Favorable currency translations versus last years third quarter increased this
quarter's sales by about $40 million.

The favorable impact of currency on reported sales for the quarter was
approximately $10 million less, than we anticipated in July, when we provided
guidance for the third quarter, based primarily on the strengthening of the
U.S. dollar versus the Euro throughout the third quarter.

The federal research and development tax credit expired at the end of 2007 and
was extended for 2008 and 2009 earlier this month, retroactive to the
beginning of the fiscal year. Because the extension of this legislation
occurred during our fiscal fourth quarter, GAAP requires us to estimate and
record our effective income tax rate through the third quarter, assuming that
the research and development credit was not extended and to recognize the
retroactive benefit of this legislation during our fiscal fourth quarter.

For purposes of this conference call and our calculation of adjusted net
earnings however, we are presenting our results as if the tax credit was
extended for 2008, as of the beginning of the fiscal year. As a result,
comments referencing our third quarter results and our guidance for 2008,
including earnings per share amounts are presented, based on this assumption.

Earnings per share were $0.57 for the third quarter of 2008, a 24% increase
over EPS of $0.46 cents in the third quarter of 2007. Before we discuss our
third quarter 2008 sales results by product category with guidance for the
fourth quarter of 2008, let me comment on the currency exchange rates we are
currently using in our outlook.

The two main currencies influencing St. Jude Medical's operations are the euro
and the yen. On our conference call one quarter ago, we assumed that for the
second half of 2008, each euro would translate into about $1.54 to $1.58 and
that each 105 yen to 110 yen would translate into $1.

We now assume that for the fourth quarter of 2008, each euro will translate
into about $1.33 to $1.38 and that each 100 yen to 105 yen will translate into
$1. This change in assumption regarding currency exchange rates has the impact
of reducing total forecasted sales for the fourth quarter by about $30
million, $20 million of which relates to our Cardiac Rhythm Management product
sales.

In addition, as we mentioned in our last earnings call, our fourth quarter
this year will have 64 selling days, versus 61 selling days in the fourth
quarter of 2007 due to our 52, 53 week fiscal year convention. Given that the
Christmas and New Year's holidays both fall on a Thursday this year, we expect
the two of these three additional selling days to have little impact on sales
for the quarter.

Now for the discussion of sales by product category: For the third quarter,
total Cardiac Rhythm Management sales, which include revenue from both our ICD
and pacemaker product lines was $678 million, up 15% from last year's third
quarter.

For the third quarter, ICD sales were $381 million, up 20% from last year's
third quarter. U.S. ICD sales were $248 million, up 12% from last year's third
quarter. International ICD sales were $133 million, a 39% increase over the
third quarter of 2007, with $10 million of the increase due to favorable
foreign currency translations.

For low-voltage devices, sales for the third quarter totaled $297 million, up
10% from last year's third quarter. In the United States, pacemaker sales were
$134 million, up 2% compared with last year's third quarter. In our
international markets, pacemaker sales were approximately $163 million, up 17%
from the third quarter of 2007, including a $14 million increase due to
favorable foreign currency translations.

For the fourth quarter of 2008, we expect total CRM product sales to be in the
range of $680 million to $710 million. As I mentioned, our current exchange
rate assumptions versus those we were using one quarter ago, reduced our
guidance for fourth quarter CRM product sales by about $20 million.

Atrial Fibrillation or AF product sales for the third quarter totaled $135
million, up 35% over the third quarter of last year, including a $5 million
increase due to favorable foreign currency translations.

For the fourth quarter of 2008, we expect AF product sales to be in the range
of $140 million to $150 million. Total sales of cardiovascular products for
the third quarter of 2008 were $207 million, up 10% over the third quarter of
2007 including a $10 million increase due to favorable foreign currency
translations.

Within this category of products, sales of vascular closure products in the
third quarter of 2008 were $89 million, a 5% increase over the third quarter
of 2007. Sales of heart valve products in the third quarter of 2008 were $78
million, a 15% increase over the third quarter of 2007.

For the fourth quarter of 2008, we expect cardiovascular product sales to be
in the range of $205 million to $220 million. Total sales of neuromodulation
products in the third quarter of 2008 were $64 million, up 25% from the third
quarter of 2007, including $1 million increase due to foreign currency
translations.

For the fourth quarter of 2008, we expect sales of neuromodulation products to
be in the range of $63 million to $68 million. The geographic breakdown of St.
Jude Medical sales in third quarter of 2008 was 54% in the United States,
versus 46% outside the United States or OUS. This compares to 57% U.S. and 43%
OUS in the third quarter of 2007.

A detailed geographic breakdown of this quarter's sales by product shows high
voltage at $248 million, U.S; $133 million, OUS; low voltage at $134 million,
U.S; $163 million, OUS; Atrial Fibrillation product sales at $64 million, US;
and $71 million, OUS; Cardiovascular product sales at $87 million, US; and
$120 million OUS; and finally Neuromodulation products at 57... $55 million,
US; and $9 million, OUS.

The gross profit margin this quarter was 74.7% representing a 110 basis points
improvement over the third quarter of 2007. For the full year 2008, we expect
gross profit margins to be in the range of 74.2% to 74.7%.

Our third-quarter SG&A expenses were 37% of net sales and for the full year
2008, we continue to forecast SG&A as a percentage of net sales to be in the
range of 36% to 36.5%.

Research and development expense in the third quarter of 2008 was 12.1% of net
sales, with expense up 12% from the third quarter of 2007. For the full year
2008, we expect R&D expense to be in the range of 12% to 12.5% of net sales as
we continue to balance delivering short term results with the right
investments in long term growth drivers.

Other expense was $5 million in the third quarter and for the fourth quarter
of 2008 we expect the other income and expense line item will be a net expense
of approximately $3 million to $6 million. Year-to-date our effective income
tax rate was 27.5% which we anticipate will approximate the effective rate for
the full year of 2008. As a reminder, this effective income tax rate
incorporates the extension of the federal research and development credit in
2008, retroactive to the beginning of the year.

Moving on to the balance sheet; at the end of September 2008, we had $579
million in cash and cash equivalents and $1.402 billion in total debt. For the
nine months ended September 27 2008, net cash provided by operating activities
was approximately $650 million, a 33% increase over the first nine months of
2007.

The outstanding debt on our balance sheet primarily represents $1.2 billion of
Senior Convertible Debentures due in December 2008 and $197 million of notes
due in Japan... issued in Japan, which are due in 2010 and bear interest at a
fixed rate of 1%.

In preparation for the December 2008 maturity of the $1.2 billion in
convertible debentures, we made $500 million borrowing last week under our
existing $1 billion bank credit facility. The cash proceeds of this borrowing
are being held on our balance sheet and will be combined with our existing
cash balances in December and used to retire the $1.2 billion in convertible
debentures.

In addition, St. Jude Medical has entered into foreign currency exchange
contracts to manage its exposure to foreign currency denominated inner company
positions and third party trade receivables. The contracts will be mark-to-
market and any resulting gains or losses are expected to be generally offset
by losses or gains on the foreign currency exposure being managed.

Next, I want to offer some comments regarding our earnings per share outlook
for the fourth quarter and the full year 2008. In preparing our EPS guidance,
we have assumed that in the fourth quarter of 2008 and for the full year of
2008 the share count used in our fully diluted EPS calculation will be about
349 million to 351 million shares.

In addition, our guidance for the fourth quarter of 2008, excludes the catch
up portion of the benefit that we will record for GAAP purposes, related to
the extension of the federal research and development credit that is
retroactive to the beginning of 2008. The company's expects consolidated EPS
for the fourth quarter to be in the range of $0.59 to $0.61, and for the full
year of 2008, we expect earnings per share to be in the range of $2.30 to
$2.32.

As in previous years, we will give guidance for 2009 during our fourth quarter
call in January. With that in mind, let me offer just a few preliminary
comments regarding our 2009 outlook. We are right now in the process of
developing our operating plan and budgets for 2009, and the visibility into a
number of variables that will influence our 2009 results will become clear as
we move closer to the start of next year.

One of these variables is the impact of foreign currency on our operations.
Another factor is the positive impact from our ongoing productivity
initiatives, which have the affect of reducing operating expense as a
percentage of net sales. Taking all of this into account, we are optimistic
that when we complete our 2009 operating plan, we will be comfortable that we
will be planning to meet or exceed current consensus expectations of $2.61 for
earning per share in 2009.

We will update everyone on our official guidance for 2009 in January, when we
report our fourth quarter results. I would now like to turn it back to Dan
Starks.

**Daniel J. Starks - Chairman, President and Chief Executive Officer**

Thank you, John. Our year-to-date 17% growth in revenue and 31% growth in
earnings per share reinforces our confidence that St. Jude Medical is in the
right markets with the right products at the right time.

I would like to spend the next few minutes reviewing the reasons for this
confidence, starting with discussion of the Cardiac Rhythm Management or CRM
market. Despite its many challenges, the CRM market continues to provide an
unusually strong growth opportunity for St. Jude Medical. It sometimes is
overlooked, that the CRM market itself has grown almost $1 billion in the last
four quarters and will total approximately $11 billion this year.

We expect the global CRM market to continue to grow at mid to high single
digit rate. Keep in mind that we have only two major competitors in this $11
billion space and the 2008 will be the fifth year in a row in which we have
gained total CRM market share.

We expect to continue to gain share in the CRM market in 2009 and beyond for
all of the reasons we have indicated previously. These reasons are important
enough that I would like reiterate several of them briefly. First, as result
of our leadership continuity, our sustained execution of a consistent
strategic plan over the last 10 years and our consistent expansion of
investment in R&D, our product line is stronger and more competitive than it
has ever been relative to the competition. We have been averaging over 20 new
CRM products per year. We have the only seven French high-voltage leads on the
market.

We have the only full featured local language programmers on the market in
Japan and in China. We have the only technology available to optimize B to B
and A to B timing in an ICD within minutes during an office follow-up visit
without the need for a separate echocardiography procedure. During the fourth
quarter, we are just starting to roll out our Merlin@home wireless remote
patient care system in United States and in Europe. This technology puts us in
the wireless remote follow up space for the first time and is a particularly
important addition to our product line when combined with capabilities of our
electronic medical records program and with upcoming devices such as our Atlas
[ph] ICD.

We are beginning a limited launch during the fourth quarter in Europe of our
Atlas [ph] ICD product line which includes one of the most meaningful new
technologies any company has brought to the ICD market in some time.

As Eric Fain mentioned, at our Annual Investors conference earlier this year,
the Atlas [ph] ICD contains a patented algorithm that initially will be used
to trend myocardium ischemia events by detecting ST segment shifts. This
technology ultimately has the potential to predict an imminent myocardium
infarction and notify the patient to get to an emergency room for intervention
before the onset of symptoms or cardiac damage.

We are fully focused on leveraging our Merlin Wireless Remote Patient Care
System, our 7 French high-voltage leads and our patented ischemia detection
technology, not only to gain CRM market share but also to increase both the
cost effectiveness of an ICD propellers and the value of an ICD for referring
physicians and for patients.

The product line advantages, I have mentioned briefly are only the tip of the
iceberg. I appreciate that every company talks about how good its products are
but the proof is in market share changes.

St. Jude Medical is the only CRM Company that has gained CRM market share
every year the last five years in a row. We expect to be in an even stronger
position with respect to our product line compared with our competitors moving
forward than we have been doing the last five years.

Second, moving past product based reasons for our optimism that we are well
positioned to continue gaining CRM market share, I would like to move on to
the topic of our people.

Historically, St. Jude Medical has gained CRM market share, even though we've
had a disadvantage with respect to field coverage. Using the U.S market as an
example, we previously have talked about our addition of approximately 450
field sales and support people over a four quarter period, at the same time
that the competition conducted layoffs and suffered significant involuntary
loss of experienced talent.

Similar dynamics with respect to people played out in other geographies as
well. What once was a disadvantage for St. Jude Medical with respect to people
and coverage has turned into an advantage. Again, I appreciate that every
company has [ph] some advantage with respect to service and coverage, and that
it can be difficult to sort through competing claims. The proof is in trends
relating to customer contract, numbers of centers implanting each company's
devices and ultimately market share.

Although we do not disclose full details about the first two metrics for
competitive reasons, we have provided enough visibility about these metrics to
help everyone understand the many reasons that we have gained CRM market share
every year the last five years in a row, and the basis for our confidence that
we will continue to gain CRM market share going forward.

Our third category of reasons, for our optimism that we will continue to gain
CRM market share, in addition to the strength of our products and of our
people is the impact of our additional programs. For example, we have strong
customer and product line synergy between our Atrial Fibrillation or AF
program, and our CRM business. We are leaders in developing additional heart
failure diagnostics, such as our six vector impedance based pulmonary edema
diagnostic technology and our direct left atrial pressure sensing technology
to go along with the potentially break through ischemia detection technology
we already have discussed.

All of this is surrounded by our commitment to connect patient data and our
devices directly to every major electronic medical record system. There is
plenty more to say about the value of our competitive position in the CRM
market, but I would like to move on to talk about Atrial Fibrillation or AF.

The AF market is the second major example where St. Jude Medical is in the
right market with the right products at the right time. This market already is
a $1.5 billion market even though it is less than 10% penetrated. The broad AF
market is continuing to grow at a strong double digit rate and is on track to
become a $3 billion to $4 billion market over the next five to seven years.

St Jude Medical's AF program is well positioned to benefit from the growth of
the AF market as evidenced by our 33% increase in revenue from AF products
during the first three quarters of 2008. Just as with the CRM space, we have
leadership with products, people and programs.

Starting on the product side, our EnSite mapping and navigation technology,
supported by our full pipeline of next-generation enhancements has given us
clear leadership in a key segment of the market. We have a strong number two
position in the conventional EP workstation space and are in the process of
integrating this technology into our EnSite platform.

We invented the concept of guiding sheaths for ablation procedures and have
clear leadership position both in guiding sheaths and in diagnostic EP
catheters. We are just beginning to launch our next-generation low profile
high intensity focused ultrasound or HIFU ablation technology for echocardio
use to leverage the favorable clinical data now published from multiple
clinical trials using St. Jude Medical's Epicor Surgical Ablation system.

We are just beginning to launch our confirmed AF implantable loop recorder in
Europe to help physicians confirm definitively whether AF has been eliminated
by an ablation procedure as part of the decision, whether to terminate
prominent post [ph] procedure

We have an expanding line of additional ablation technologies and more, in our
AF product development pipeline that we will disclose in the future, when the
time is right.

With respect to people and programs focused on AF, we began our AF program in
1993, with our collaboration with Dr. John Schwartz [ph] in the first catheter
managed [ph] ablation procedures for patients who suffered from chronic end
stage atrial fibrillation. This evolved into the formation of our AF division
in 2004, under the leadership of Jane Song and her management team.

Today, we have a 15 year head start and the broadest and deepest program in
one of the best growth opportunities in medical devices. We welcome the entry
of other companies into the AF space, to help develop the market.

The neuromodulation market is a third example where St. Jude Medical is well-
positioned, and yet another one of the best growth opportunities in medical
devices. This market also already totals at least $1.5 billion, is less than
10% penetrated, is growing at a strong double-digit rate, and is on track to
be become a $3 billion to $4 billion market over the next five to seven years.

We reported 25% growth of neuromodulation revenue this quarter, even though
we're just beginning to roll out our Eon Mini product line. We face only two
competitors in spinal cord stimulation. We have a strong patent portfolio
covering multiple neuromodulation segments. We're making steady progress, and
our efforts to expand our business into Parkinson's disease, essential tremor,
depression and migraine as well as other potential neuromodulation indications
longer term.

We are capturing synergies between our CRM business and our neuromodulation
business, based on the low-voltage simulation technology vendors,
international infrastructure and other characteristics that are similar to
both the... both businesses.

Our structural heart and vascular closure businesses complete our growth
platforms. For now, we will conservatively describe these platforms as
addressing additional markets already totaling $2 billion and continuing to
grow at an average compound rate of about 5%. At our next Annual Investors
conference in February 2009, we will update you on the upside we see for these
businesses as well as our program to more fully leverage our current products.

Some of our initiatives already are visible. For example, our recent
acquisition of CryoGen operations from Datascope for eventual use in our
Angio-Seal product line.

Looking at all these markets together, CRM, AF, neuromodulation, structural
heart and vascular closure, a number of takeaways become clear. First, St.
Jude Medical today, competes in multiple large and growing markets. These
markets total approximately $16 billion and are growing at an average rate of
about 7% to 8%.

The average growth rate of the markets in which we compete will accelerate as
AF, neuromodulation and other new growth drivers become a larger percent of
our total business. Second, we have customer synergy, technology synergy or
both across all of our growth platforms. This aspect of our competitive
strategy is sometimes under appreciated.

Third, we have a number one or number two market shares in each one of our
major growth platforms. This combined with the synergy we enjoy across all our
growth platforms positions St. Jude Medical to gain unusual leverage from each
growth drivers.

It is no coincidence that we usually gain market share in multiple growth
programs at the same time. For example, we gained market shares simultaneously
in all or most of our major businesses on a year-over-year basis in 2006, 2007
and year-to-date in 2008.

The fourth point that deserves emphasis is that in each instance where our
growth programs have become mature, we are focused on optimizing our cost
structure and on strengthening our cash flow.

I already mentioned our acquisition of CryoGen operations to support our
Angio-Seal product line long term. We are making good progress following
through on our commitment to expand manufacturing operations in cost advantage
locations. For example, we recently opened a new manufacturing facility in
South Carolina and another such facility under construction in South Carolina.

We are expanding our investment in manufacturing operations in Brazil. We
recently received FDA approval to begin manufacturing pace makers at our new
150,000 square foot facility in Puerto Rico. In the future, we will open
additional manufacturing facilities in other cost advantaged locations as part
of our global business expansion and global business presence.

Our SAP Enterprise software installation already is approximately 50%
complete, increasing our spending short term but creating the infrastructure
we can leverage for significant productivity gains longer term. We are
pursuing a full menu of other structured continuous improvement programs as
well.

As a back drop to all of our internal programs to grow our sales and to
improve our productivity, our cash flow and balance sheet give us the
flexibility to support our growth from time to time as appropriate with the
combination of stock buybacks and sensible acquisitions.

During the third-quarter for example, we completed our acquisition of EP
MedSystems and our acquisition of Datascope's CryoGen operations and other
vascular sealing assets to support our growth longer term.

All of these factors taken together are the drivers behind our 17% growth in
revenue and our 31% growth in earnings per share a year-to-date. The same
factors leave St. Jude Medical well positioned to continue delivering an
average growth and earnings per share of at least 15% going forward.

I'm referring to all of these factors when I indicate that our results this
year rein enforce our confidence that we are in the right markets with the
right products at the right time.

I would now like to turn it back to Regine to moderate questions and ask every
one please to limit your self to two questions, so that we can reach as many
people on the line as possible.

Regine would you go ahead please","

Question And Answer

**Operator**

[Operator Instructions]. Our first question is coming from Bob Hopkins with
Banc of America.

**Robert Hopkins - Banc of America**

Hi, thank you and good morning. My two questions I would like to refer them to
John. Just to clarify some of the comments that were made. John, in terms of
the hedging that you are putting in place, sounds like that's mostly related
to transactional situations and not translational. Is that correct?

**John C. Heinmiller - Executive Vice President and Chief Financial Officer**

That's right; we're putting in place contracts that are typical, those used by
other companies in our peer group. We are really only aware of one other
situation that's out there where people have attempted to hedge their
translational exposures. But these are contracts now will give us added
flexibility as we move forward managing that area.

**Robert Hopkins - Banc of America**

Okay. And so than, roughly when I look at... so looking forward over that 12
months given where exchange rates are, for 2009 looks like you might have
somewhere in a neighborhood of a $100 million top line headwind, and than
maybe a $40 to $50 million operating income headwind as a result. Is that
roughly a ball park of where you think you'll be in terms of a translational
headwind?

**John C. Heinmiller - Executive Vice President and Chief Financial Officer**

Yes, I think that... as we indicated, we aren't going to give guidance for
2009 officially until we get out to our January call. We are certainly mindful
of the currency environment and what changes are taking place and then we'll
factor that as well as all the other variables that we keep our eye on during
this time of the year as we formulate our 2009 operating plan.

And then... the bottom line comment was that we expect to be comfortable with
our $2.61 consensus EPS that's is out there.

**Daniel J. Starks - Chairman, President and Chief Executive Officer**

And, Bob, this is Dan. Let me say a little bit more on the topic of FX impact
on bottom line. I think that's a dynamic; that really is very widely
misunderstood as it relates to St. Jude Medical. I think the help [ph] just
clarified for everybody's thinking going forward. If you look at the third
quarter results here for 2008 you'll notice that the... our revenue was
negatively impacted by $10 million due to actual versus assumed FX rates.

It did have an impact on our bottom-line? As you look forward to our fourth
quarter of 2008, we've indicated that the negative currency impact is about
$30 million versus our prior expectations but again that $30 million didn't
trickle [ph] to the bottom line guidance in anyway that your question kind of
a was working to get at.

There are so moving parts in the business that theron [ph] on currency and the
bottom line that we just consider to be one factor among many that we manage
and net out when we offer our guidance and when we think about what's levels
of the investment to make where in the business. If you thought about FX and
the bottom line, it's... you think that we manufacture products in Swedish
Kroner, we manufacture products in Brazilian Real, we manufacture in Canadian
dollars, we manufacture in U.S. dollars.

Once we manufacture in one of those currencies, the inventory is then
transferred to some location that may very well be in another currency. So
there is a currency transaction inside the company at the point of
manufacturing transfer to inventory. That inventory maybe further transferred
in our global distribution that may involve another currency translation at
another timeframe, at another rate of the... then the... that product though,
when it's sold we can mark the currency impact precisely with the way that we
recognize sales. But the payment then is going to come at a different time.
And, it's going to come at a... at likely a different currency translation
again.

So, there is just so many moving parts in there. We... our experience has been
that as long as we're... we stay on top of the business in the way that we
have, those... all of those different currency translations really net out.
They run through our other income and expense line. And as you see, there
hasn't been a lot of volatility in our other income spend and expense line,
which really just goes to show how minimal that impact is on the bottom-line.

So, it would inappropriate to take a percentage or significant percentage like
a 40% and work it drop it to the bottom-line and refer to that as a headwind,
it really isn't.

**Robert Hopkins - Banc of America**

But just to simplify then, because obviously it will be a headwind for next
year. From a translational perspective, so... are you saying my math isn't
right. The 40 to 50% roughly ballpark won't fall through and be a headwind for
next year on a translational basis.

**Daniel J. Starks - Chairman, President and Chief Executive Officer**

Yes, what I'm saying is that if you put aside the math, and the kind of
theoretical if all else was equal and this was the only thing happening, that
you'll... that's not the circumstances that we have. My point is that rather
than the theoretical discussion, my point is that in the real world of all of
the different currency translations that take place from the point of
manufacture to the point of earnings. I am just saying that there is lot more
transactions taking place like that and the simple rule of thumb is not the
best one.

**Robert Hopkins - Banc of America**

Okay. And then to just my second question and just to again clarify for John
on the convertible debt. Could you just give us a sense to the incremental
cost of refinancing that as we... once that transaction has taken place?

**John C. Heinmiller - Executive Vice President and Chief Financial Officer**

I think that the interest rate on the convert versus the interest rate on the
borrowings that we'll do is an incremental number that is easily factored into
our other income and expense category. So as I mentioned on the call, we did
pre fund the debt portion that we now need to pay that debt in December. We
have a five year bank credit facility that runs through 2011. That we're using
part of the capacity that we have under that and that now is on our books at
that higher interest rate and it really barely moved the guidance for other
income and expense for the quarter by a digit.

So, where we can accommodate that and have that factored into our guidance
already here in the fourth quarter and it's just not that significant.

**Robert Hopkins - Banc of America**

Can you give us the incremental just the rates on the convert versus the 500
million of borrowing?

**John C. Heinmiller - Executive Vice President and Chief Financial Officer**

Well, the $500 million borrowing will have an interest rate of about 4.5%, and
the convert had an interest rate of 1.2% and all that information is publicly
available if you want too make that calculation, it's the difference of those
two. And then the interest income that we can earn on the $500 million
borrowing is certainly higher than the 1.2%.

So we have to factor all that in. And we done that in providing our guidance
and it's a if you want to get real precise and make those kind of calculations
we can. But I'm telling you it's factored into the... to the other income and
expense guidance where we expect in the fourth quarter to have quarterly other
expense of $3 million to $6 million.

**Robert Hopkins - Banc of America**

Okay. Great, very helpful, thank for the details.

**Operator**

Our next question comes from Mike Weinstein with JPMorgan.

**Michael Weinstein - JPMorgan**

Good morning. Thanks for taking the questions. Dan, you talked on the call and
certainly you've talked consistently over last several years about delivering
a minimum of 15% EPS growth. Is... based on what you can see today is there
any reason why that you think you would not be able to do that in 2009?

**Daniel J. Starks - Chairman, President and Chief Executive Officer**

No. As a... and I'm hoping that the model that I gave really flushed that out
and supported that. We will have a very strong confidence. I mean here we are
where year-to-date we've reported EPS of 31% and we've got a number of
fundamental dynamics that has been benefiting the business during this year in
prior years and will continue to benefit the business going forward. We have
some dynamics that really will continue to strengthen our relative to prior
period. So we like where we're positioned and looking forward to 2009 with a
lot of confidence.

**Michael Weinstein - JPMorgan**

Thanks for that. The commentary you gave during the... your prepare remarks
about the 261 consensus. That would be up 13% and of course... you basically
trying to say that at this point we look very achievable to you guys?

**Daniel J. Starks - Chairman, President and Chief Executive Officer**

Yes, now keep in mind that we're just not giving our guidance yet for 2009. So
don't get too close to a number and we've said that we're optimistic that
we're well positioned to meet or exceed that number. So to take the whole
thing into account and then we need to finish preparing the operating plan,
finish making our investments decisions and then we'll again look forward to
providing a good update next quarter.

**Michael Weinstein - JPMorgan**

Okay. Let me switch gears, John on the OpEx hedging that you did. Can you give
a sense of how much you did and kind of what was your timing and how far out
you went?

**John C. Heinmiller - Executive Vice President and Chief Financial Officer**

Well that again, we put in contracts to manage the currency exchange exposures
that we have in our inter company accounts and in trade receivables that are
in foreign denominations where... and the timing of those is matched to those
balances that we're hedging and then we mark-to-market the contracts that we
have. So we are nicely positioned now and it just really enhances the
flexibility that we have with our cash balances and the other movements that
we are managing.

**Michael Weinstein - JPMorgan**

Then just to be clear, relative to 2009 have you done everything that you
think that you need to do it or want to do at this point?

**John C. Heinmiller - Executive Vice President and Chief Financial Officer**

Yes, I think we have everything, we have the mechanisms in place we have
everything in place but we want now and then we will just continue to extend
the program as we need during 2009.

**Michael Weinstein - JPMorgan**

Okay. Perfect, I let some others jump in queue here. Thanks.

**Operator**

Our next question comes from the line of Rick Wise with Leerink Swann.

**Fredrick Wise - Leerink Swann Llc**

Good morning, everybody. Turning to the ICD market a couple of things, may be
you could just talk generally whether you are seeing or concerned Dan about
the economic impact on procedures for ICDs or may be anywhere else at St.
Jude, but more specifically Boston has launched new products recently. Our
doctor check suggests that they're being... they're getting favorably
received. Can you talk about the impact of that launch as well, if any?

**Daniel J. Starks - Chairman, President and Chief Executive Officer**

Sure, sure. The... one of the favorable dynamics for our business is that we
think that we will have very little impact from the negative impact from the
general economy on our market conditions on the growth rates that we assume in
our multi-year planning. And generally our devices are... even though we're as
part of our devices as we are, and think they're wonderful, we... are
realistic that very few people actually seek them out, if they don't
absolutely have to have them. And so, we expect very little impact.

People need to have their food. They need to have a place they're going to
sleep in, they need to keep their health at a functioning level. And our
devices really are all devices that there are on key health concern. So, we
expect very minimal impact from the broader and economic dynamics, and think
that we're in a good defensive position that way.

With respect of the ICD market and competitive conditions, I won't comment
specifically on any one competitor. I'll say generally that this is a
competitive market, that we think that all of the competitors in the space are
tough. Everybody has products that are usable. And in this kind of very tough
competitive environment, we've been the only company to gain share every year
in a row for the last five years.

So... and we're going to gain it again this year. And we fully expect to gain
market share again next year-end and continuing beyond next year. So we like
our position. It is based on so many fundamental dynamics that are unaffected
by kind of bells and whistles of other companies competitive developments. And
I think when you think about something like the impact of our ischemia
detection technology on the one hand, and kind of say now, compared to that
dynamic, we are talking about one device being 4 millimeters thinner than
another device, and even though it's 4 millimeters thinner than another
device, it actually has a 20% larger surface area.

Those are... that really falls into the bells and whistles. I'm sure both
comments are correct. But it's really not clinically material. It's not a
driver of physician choice. It may be something that physicians refer to if
they are making a choice for another reason. It's an easy thing to reference
but there is really no fundamental change in the competitive dynamics of those
kinds of product comparison.

I think things like ischemia detection and quick out [ph] the B to B, A to B
timing optimization and having the only 7 French high-voltage leads in the
market. Those are the kinds of things that really drive physician choice.
Those are lined up in favor of our continued gain of market share.

**Fredrick Wise - Leerink Swann Llc**

Okay. And turning to your comments on productivity initiatives, your hired
[ph] SAP... the SAP install being 50% done. Remind us when it is done, maybe
you John, you could flesh out what impact it's going to have? And I assume,
once it's done, we're going to see positive... their implications for
operating margins and balance sheet management and cash areas as well?

**John C. Heinmiller - Executive Vice President and Chief Financial Officer**

Yes, you're right. You're absolutely right, Rick. That said that the double
edge of the sword of offering examples to be just kind of create [ph] and to
add flavor and help people see that we are not just using buzz words. The
downside of it is then I hate to see the example of highlighted kind of more
that it ought to be.

When we think about productivity gains for example, we are not banking on a
particular enterprise software implementation, yes, we are doing it, yes it
does have an impact and it... but it's one of so many different factors that
are all happening at the same time. If you think about the beneficial impact
of our Unity platform on gross margin and the beneficial impact of the
consolidated platform, nature of our Unity platform on the cost effectiveness
of product development and having the developed feature sets only once for the
high and low voltage applications rather than having to develop them twice.

There is so many additional dynamics that we are balancing and then at the
same time that you take, a single one of those dynamics and look at it little
bit closer you have to take it in the context of, okay, now what else are we
doing at the same time as an additional expansion of investment, where... like
here in the third quarter just finished we bought EP MedSystems, we made a
modest acquisition of Datascope CryoGen and other vascular closure assets.
Those things you see reflected in the SG&A as a percent being little bit
higher on a sequential quarter basis compared to Q2.

So there is just so many moving parts that it's even though every one
industriously works to get as close to each one as they can, it's just not
realistic to map them all out unless you are inside our business, going
through our operating plan and its stick [ph] books of doing all those net
outfits that each of you want to do so. The best I can really offer is to say
that our guidance has been pretty good

We've met or exceeded our guidance every single quarter for ten years, except
one. And so, that's the best I can offer you. So, we'll continue to work to
make all those calculations in the same way that we've done it for the last
ten years, continue to provide them going forward.

**Fredrick Wise - Leerink Swann Llc**

Thanks so much, Dan,

**Daniel J. Starks - Chairman, President and Chief Executive Officer**

You are welcome.

**Operator**

Our next question comes from Tao Levy with Deutsche Bank.

**Tao Levy - Deutsche Bank**

Hi, good morning.

**Daniel J. Starks - Chairman, President and Chief Executive Officer**

Good morning.

**Tao Levy - Deutsche Bank**

I was wondering if you could comment on ICD placing. What you're seeing out
there and are hospitals becoming a little more aggressive in trying to get
prices down and negotiating things down, just given their current environment.

And then my second question is that is on A-Fib, one of your competitors is
seeking to get approval for specific A-Fib indication for their catheter. I
was wondering, where you guys stood on getting a label for A-Fib for your
ablation catheters. And in the interim, is that going to be an issue for you
guys, if again the other company can get that approval, and your catheters
don't have one.

**Daniel J. Starks - Chairman, President and Chief Executive Officer**

Tao on the topic of ICD pricing, we have not seen any major changes in pricing
dynamics for ICDs or for... really for other parts of our business. And that
means that pricing pressure is always there, and always strong, and always one
of the dynamics that we stay on top of.

So, we see continued price pressure on ICDs just as always. And... but really,
nothing unusual. On the topic of just atrial fibrillation labeling and spaces
generally that... with one of the points to keep in mind is key to our growth
profile and our product segment that we label as AF products, is that the
actual ablation catheter itself is a very small part of the product portfolio.
And it's a small part of our total product bundle and of our total revenues.
So what we are really focused on is the procedures that take place in the EP
lab, and Electro-Physiology lab.

And yes, the most intellectually interesting is atrial fibrillation ablation
procedure, but it's that full range of procedures that we brand our AF
business. And it's that all it's that full range of products used in that full
range of procedures that we bring into each case, including in the cases that
physicians, where physicians are working to cure AF. So the AF ablation
catheter itself is really... has not been that big a part of the total revenue
opportunity.

And I think it would be a misplaced focus to look at specific labeling on one
catheter in particular, understanding that physicians choose among our full
range of catheters for different parts of their procedure and for different
procedures and different physician preferences and there is no one size fits
all.

I expect that dynamic to continue going forward.

**Tao Levy - Deutsche Bank**

And are you seeking that label expansion, if so what's the timing on that?

**Daniel J. Starks - Chairman, President and Chief Executive Officer**

Yes, sure we are. We have got number, both on surgical approach and on the
catheter approach. We have trials underway and... but I think it's probably
not the most important factor to focus on.

**Tao Levy - Deutsche Bank**

Right, okay, thanks.

**Operator**

Your next question comes from David Lewis with Morgan Stanley.

**David Lewis - Morgan Stanley**

Hi, good morning.

**Daniel J. Starks - Chairman, President and Chief Executive Officer**

Good morning.

**David Lewis - Morgan Stanley**

John, Just a local question here on guidance I appreciate your trying to
provide the visibility here heading into '09. Dan talked about a series of
broad operational leverage dynamics, it's just specifically we think about
Unity, we have a lot of middle income statement type leverage. When you think
about leverage for next year, what percent do you think comes from gross
margin expansion versus broader operating corporate leverage?

**John C. Heinmiller - Executive Vice President and Chief Financial Officer**

Again I think that... as we mentioned, we are right in the midst of a process
where we prepare down to that level of the details and here we have a good
sense of where we are headed and the best way we wanted to just provide the
outlook for that is just by expressing the confidence. In that we'll be able
to meet or exceed that current consensus expectation of $2.61 and we really
aren't going to get into any more detail on 2009 at this point. We'll provide
that kind of detail in January, when we give the guidance.

**David Lewis - Morgan Stanley**

Got it. It sounds like that will [ph] beat this FX force here but in terms of
most of trends [ph] you are making sound more transaction versus translation
but did you put most of these forward contracts in place after the recent
movement of the dollar or prior to?

**John C. Heinmiller - Executive Vice President and Chief Financial Officer**

Well, I think that... I mean the important thing that they are in place. I
don't want to get into the details of exactly what day did we effect to put
them in place, we're happy that and confident that they will achieve the kind
of hedge outcome that we're looking forward because we're obviously very
familiar with the transaction and the timing of the transactions that we're
hedging.

**David Lewis - Morgan Stanley**

Okay. Then last question, Dan you talked a lot about your AF franchise and how
long the company's been in that business. We've seen your competitors move
into that business and certainly a validation of the St. Jude strategy, the
competitors seems to be focusing on energy source as a mode of
differentiation. Can you talk about the role of energy source and whether you
think you may have to make a move with a similar energy source in the next
several years?

**Daniel J. Starks - Chairman, President and Chief Executive Officer**

Well, first just on kind of assumption about competitors focusing on energy
source. I really don't see it that way. The way I see it is... I see it as
competitors with fragmented, incomplete programs working to grab at something.
And I really don't think that's our principle focus on energy source. And I
think that again as a person thinks about the revenue opportunity, he thinks
about the procedure impact. It's really is not being driven by energy source.
I think the question of ultimate energy... I think the question of how will
energy sources shake out five years down the road? What's the procedure going
to look like? What's the catheter delivery process going to look like? What's
the mapping technology going to look like? Just all of that is fluid.

And we could offer kind of proprietary insights on it. But I won't. And I
think as you talk to physicians in the field about it, you'll get a wide
variety of comments. And so, you get champions of different energy sources.
But I think, I'm not going to offer our own proprietary insights into what...
where we see the market going, and how we see the technology developing in a
way that is not highly visible to the competition.

**David Lewis - Morgan Stanley**

That's really helpful answer. John, just one last question, given your
confidence in sort of '09 outlook and leveraging the business, could you
comment at all on the buyback plans here at these share prices?

**Daniel J. Starks - Chairman, President and Chief Executive Officer**

Yes. Why worry John, let me try to... we're of course not going to comment.
But other than what we said in our prepared remarks to say that we have the
flexibility to do it. We've done it in the past. We consider it to be a tool
in our tool kit going forward. And from time to time as appropriate, we will
undoubtedly make announcements to that effect. But we would never comment
other than to make an announcement and we are not making any announcement
today.

**David Lewis - Morgan Stanley**

Great. Thank you very much.

**Operator**

Your next question comes from the Larry Biegelsen with Wachovia.

**Unidentified Analyst**

Thanks. Good morning, it's Steve Bishop [ph] for Larry. One quick question
within the ICD space, can you give us your latest thoughts on the importance
of MRI compatibility? What's the timing for your efforts in that space? What
do you think MRI compatibility can mean for a company that has an advantage in
that area? And if possible, could you make comments specifically to the high
and low parasites?

**Daniel J. Starks - Chairman, President and Chief Executive Officer**

No. We won't say that much about it, Steve. We... just for again for
competitive and proprietary reason that... I think that over time, I think
that everybody in the space will have MRI compatible technology.

When we think of MRI compatibility, we don't think of a device that you can't
MRI. So we wouldn't think of a device placed in the trunk... in the... with
those sub clavian position we wouldn't think of it being MRI compatible if you
can't MRI the trunk with it. But we are actually very excited about our own
MRI program. We deliberately have not commented on it and I am not going to do
so today.

There will be a point here in the future when we will offer more details. But
for now we are just keeping it under wraps, other than to say that we like our
position. And long term, I think that... everybody will offer MRI compatible
systems. We may very well be the first to have a true MRI compatible system
but other than that kind of good tourist [ph] comment I won't offer any
specifics.

**Unidentified Analyst**

Okay. And then, one more also with in the ICD space. Appreciating that you are
not altering your view on the longer term growth opportunity in CRM, can you
look back at 3Q, and the quarter that you just completed. And then with the
first half of the year as a backdrop, high single-digit ex-currency growth
outside the U.S., low single-digit growth in the U.S., any deviation from
those trends in the market at large.

**Daniel J. Starks - Chairman, President and Chief Executive Officer**

Well... we will... we did not see any meaningful change in growth dynamics
during the third quarter. We will need to see the other companies' numbers
here in the third quarter to really update our market model. But generally
speaking, there we saw just continued steady growth right along the... with...
that conformed with the expectations we set previously

**Unidentified Analyst**

Okay. Thank you very much.

**Daniel J. Starks - Chairman, President and Chief Executive Officer**

You're welcome. We got time for just one more question, Regine. Is there
another question on the line?

**Operator**

Yes sir, your last question comes from Vivian Cervantes with Rodman & Renshaw.

**Vivian Cervantes - Rodman & Renshaw Llc.**

Hi, good morning. Thank you for sneaking in this last question. Coming from
TCT, and some of the news still that's coming into the world of PFOs, there
seems to be some noise that maybe there is some development in there, vis-à-
vis a tough enrollment environment, some competitors have completed
enrollment, others are saying they're close to completing. And again at TCT,
there is some buzz of activity. Just wanted to get your thoughts on that
market, and the... your client's opinion [ph]?

**Daniel J. Starks - Chairman, President and Chief Executive Officer**

Well, yes they on the PFO closure, if we segment the PFO space into stroke
application and migraine application, I'm... I believe that you are exactly
right that there is at least one trial that is well along and under stroke
application and maybe I'm not sure if the enrollment's been completed or not.
But on the PFO for migraines, so our Escape trial was a... it was evaluating
PFO Closure for migraine patients. We've actually closed that trial due to the
difficulty of enrollment over the course of about three years or so we
enrolled... really we're able to enroll only 50 some patients, and when you
ask then what do we think about the space? We think that the space is... it
continues to be a promising space.

The... with respect to PFO Closure from migraine, I know there was some
encouraging data at TCT on that from a center and that's not surprising to us.
The space remains of interest, the challenge is that the clinical practice
doesn't correspond to the regulatory requirements for enrollment criteria. And
so we spent three years working to bridge the gap between clinical practice
and inclusion criteria and working to find a happy medium ground that would
facilitate the reasonable enrollment of patients and we just weren't able to
get there.

So for now, we've suspended our pursuit of PFO Closure... indication for...
migraine indication for PFO Closure here in the United States. We continue to
provide the product in Europe and continue to see some growth in that product
program in Europe. But for St. Jude Medical's purposes in the near term, it's
not something that we referred to for sometime as a one of our growth drivers
and it will be appropriate to take it off the list of our growth drivers that
we are particularly excited about.

**Vivian Cervantes - Rodman & Renshaw Llc.**

Great, thank you. I appreciate the color.

**Daniel J. Starks - Chairman, President and Chief Executive Officer**

You're welcome. And then I apologize if we have exhausted our time for those
of you who are still in the queue. But thank you for joining us. And Regine,
I'll turn it back to you for your closing comments.

**Operator**

Today's call is being recorded and will be available for replay beginning at
12 o'clock PM Eastern Standard Time. The dial-in numbers are 800-642-1687 for
the U.S. and 706-645-9291 for international and enter pin number 67122966.
Thank you. This does conclude today's teleconference. Please disconnect your
lines at this time.

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