Parker-Hannifin Corp (PH) — Q3 2019 Earnings Call Transcript

Thank you, Jonathan. Good morning and welcome to Parker-Hannifin's third quarter fiscal 2019 earnings release teleconference. Joining me today are Chairman and Chief Executive Officer, Tom Williams; and President and Chief Operating Officer, Lee Banks. Today's presentation slides together with the audio webcast replay will be accessible on the company's investor information website at phstock.com for one year following today's call. On slide two and three, you'll find the company's Safe Harbor Disclosure Statement, addressing forward-looking statements as well as non-GAAP financial measures. Reconciliations for any reference to non-GAAP financial measures are included in this morning's press release and are also posted on Parker's website at phstock.com. Today's agenda appears on slide number four. To begin, our Chairman and Chief Executive Officer, Tom Williams, will provide comments and highlights from the third quarter. Following Tom's comments, I'll provide a review of the company's third quarter performance together with the guidance for the full year fiscal 2019. Tom will then provide a few summary comments and we'll open the call for a question-and-answer session. Please refer now to slide number five and Tom will get us started.

Thank you, Cathy, and good morning, everybody, and thanks for your interest in Parker. We had a very strong performance in the quarter, but before I jump into the quarter, I’d like to take you back for a few seconds here to 2015. We had launched the new Win Strategy in our first generation of five-year goals. If you remember, one of our key goals at that time was to get to a 70% operating margin by FY ‘20. I kind of remember that meeting; we also got feedback that perhaps it might be too aggressive. But we are excited to tell you that we have achieved that goal basically about 18 months early, and that included doing the CLARCOR acquisition during that period of time. So, really a remarkable accomplishment, and my thanks to everybody around the world, the Parker team, for that huge accomplishment ahead of schedule. So, you might be asking how? How did we do that? I’m going to come directly from the slide that's up there, slide five, describing our business model and the competitive differentiators that we have. If you look at that, it is really a powerful lineup, and that list represents what makes us different. It strategically positions us versus our competitors and helps to answer the question of why would you invest in Parker, why would you buy from Parker, and why would you work at Parker. So, I like to show this every quarter, but I am only going to pick one bullet to go over to give you some extra color. Let's talk about the operating CapEx requirements of the company. If you go back before the Win Strategy started, we were basically a 6% CapEx to sales company, and today we are bouncing that at 1.5% to 2%. How we did that is we implemented the Parker Lean system, value stream transformations, waste reduction efforts, and by doing that we have freed up floorspace, machine, and people capacity, and that enabled us to free up basically 400 basis points of free cash flow, which you can imagine what we can do with 400 basis points of free cash flow, deploying it as effectively as we can back to our shareholders. That's been a big part of our success over the last decade or so. So let's go ahead and jump into takeaways from the quarter. Safety continues to be our top priority. We had a 20% reduction in recordable incidents. We continue on about that 20% clip, and it's really making great progress. My thanks to our team members around the world for their ownership of safety, and remember the connection between safety performance, engagement, and financial performances is a clear linkage between all those. We had a strong operational quarter reflecting the benefits of the Win Strategy, and we put up a number of quarterly records, including segment operating margins, net income, and EPS, and our confidence remains very strong for achieving record performance in FY ‘19. Again, a big thank you to all the Parker team members out there for the great progress and all the hard work. So, some highlights on the quarter. Organic growth came in approximately 2%, offset by currency and divestiture. Order rates did moderate, bumping up against some tough comparables, with growth moderating and North American distributors destocking; and of course, we will discuss that more in the Q&A portion of the call. EPS and net income were all-time records. Segment operating margins hit an all-time record at 17.1%, and adjusted total segment operating margins were 17.2%, up 90 basis points versus the prior year, and we saw improvement across all of our reporting segments. Aerospace posted an all-time record of 20.7% segment operating margin for the quarter, and a big thank you to the aerospace team for their great work. We've seen really nice returns from past investments in aerospace, which is a long-cycle business and is performing at a very high level, utilizing all of our motion control technologies in that space. Our as-reported EBITDA margin was up 150 basis points to 18.6% or 18.7% adjusted and we had very strong cash flow, with operating cash flow of 12.1% excluding discretionary pension contributions. Free cash flow conversion was 104%, so in summary, an excellent quarter with a number of records. Switching to capital deployment. Last week, we announced a 16% increase in our dividend, and we've now made dividend increases for 63 consecutive fiscal years. It's a record we're very proud of and a record we intend to keep as we go into the future. We also continued our 10b5-1 repurchase program of $50 million in Parker shares and we made an opportunistic discretionary purchase of $150 million in shares, which we initiated immediately after our second quarter blackout period finished and before the LORD acquisition process started. Of course, on Monday, we announced the agreement to acquire Lord Corporation for $3.675 billion; Lord was approximately a $1.1 billion business, 23% EBITDA, and a leader in material sciences and vibration control technologies. And if I could just remind you, because some people didn't listen in on the call on Monday, what the strategic rationale was behind that acquisition. This is a strategic portfolio transaction that significantly expands our engineered materials business. It has complementary products, markets, and geographies that are aligned to key growth trends, and it's very culturally aligned with Parker's values and has a rich history of innovation and product reliability. Strong global brands with a long-standing blue-chip customer list that is very similar to our customer list strengthen material science capabilities in electrification, light weighting, and aerospace offerings, and it's expected to be accretive to organic sales growth, EBITDA margin, cash flow, and EPS, excluding one-time costs and deal-related amortization. So moving out to the outlook, we’re maintaining EPS guidance with a midpoint of $11.32 as reported and $11.60 adjusted. Our forecasted organic growth range is in that 2% to 3% for a full fiscal year, and we're anticipating record earnings in FY ‘19 to the Win Strategy execution. We are really in a great position to perform regardless of how the macro environment turns out, and there are a number of positives that are going to serve as a tailwind to our performance as you look forward for the next several years. The first is we're still in the early days of the new Win Strategy and execution, and you can see the progress we’ve made just in the first five years of it, 15% to 17% and the CLARCOR acquisition, so lots of headroom as we continue to improve with the Win Strategy. Integration of CLARCOR is showing lots of promise, with continued upside to margins as we continue to improve on the manufacturing consolidation. The LORD Corporation brings a top-quartile performing company into the portfolio that has attractive technologies in materials science, vibration controls, and will generate that incremental organic growth margin and cash flow that I referred to earlier. So, we continue to have confidence in reaching our second set of financial targets, the ones we set for FY '23. Just to remind everybody, those targets are to grow organically 150 basis points faster than the market, to achieve segment operating margins of 19%, EBITDA margins of 20%, and continue our free cash flow conversion of greater than 100%, which would yield an EPS CAGR of 10% plus over that time period. In summary, we anticipate another record year for FY '19 and we're making progress toward that second generation of 5-year targets. With that, I'll hand it back to Cathy for more details on the quarter.

Thanks, Tom. I'd like you to now refer to Slide #7. I'll begin by addressing earnings per share for the quarter. Adjusted earnings per share for the third quarter of fiscal 2019 increased 13% compared to the prior year, reaching $3.17. Adjustments from the 2019 as-reported results include business realignment expenses of $0.03. This compares to fiscal 2018 adjustments of $0.04 for business realignment expenses and $0.06 for CLARCOR costs to achieve. On Slide 8 you'll find the significant components of the $0.37 walk from adjusted earnings per share of $2.80 for the third quarter of fiscal 2018 to $3.17 for the third quarter of this year. The most significant increase came from higher adjusted segment operating income of $0.15. The Aerospace segment generated 26% more income in 2019 with meaningful organic growth and considerably higher margins. The Diversified Industrial segment generated consistent year-over-year income with higher margins despite declining revenues. Lower corporate G&A accounted for a $0.12 increase driven by market-adjusted investments tied to deferred compensation. Lower interest expense and higher other expense lowered earnings per share by a net $0.01, and lower average shares resulted in an increase of $0.11. Slide nine shows total Parker segment sales and segment operating margin for the third quarter. Total company organic sales in the third quarter increased year-over-year by 1.8%. This was negatively offset by a 3% currency impact and 0.5% from a prior year divestiture. Total segment margin on an adjusted basis improved to 17.2% compared to 16.3% for the same quarter last year. This 90 basis point improvement reflects productivity improvements and the benefits of synergies from acquisitions combined with the positive impact from our Win Strategy initiatives. Moving to Slide 10, I'll discuss the business segments starting with Diversified Industrial North America. For the third quarter, North America organic sales were relatively flat as compared to the same quarter last year. With flat sales, operating margin for the third quarter on an adjusted basis was 16.5% of sales versus 16.4% in the prior year. A one-time labor settlement in Mexico and a less favorable mix put pressure on margins in the quarter. Despite these headwinds, North America continued to deliver improved margins, reflecting the hard work dedicated to productivity improvements as well as synergies from acquisitions and the impact of our Win Strategy initiatives. I'll continue with the Diversified Industrial International segment on Slide 11. Organic sales for the third quarter in the Industrial International segment increased by 0.7%. Currency negatively impacted the quarter by 7.5%, and a prior year divestiture accounted for a 0.7% loss of sales. With relatively flat sales, operating margin for the third quarter on an adjusted basis improved 120 basis points to 16.5% of sales. This margin performance reflects our team's continued progress in growing distribution along with improved operating cost efficiencies from realignment initiatives and the benefits of The Win Strategy. I'll now move to Slide 12 to review the Aerospace Systems Segment. Organic revenues increased an impressive 9.2% during the third quarter due to continued broad-based growth across all Aerospace markets. Operating margin for the third quarter improved an impressive 260 basis points to 20.7% of sales, reflecting the benefits of higher volume, lower development costs, and cost efficiencies from The Win Strategy initiatives. Moving to Slide 13. We show the details of order rates by segment. Total orders decreased by 4% as of the quarter end. This year-over-year decline is a consolidation of minus 6% from Diversified Industrial North America orders, minus 4% from Diversified Industrial International orders, and a positive 2% from Aerospace Systems orders. On Slide 14, we report cash flow from operating activities. We had strong cash flow this quarter. Year-to-date cash flow from operating activities was $1.093 billion. When adjusted for a $200 million discretionary pension contribution made during the first quarter, cash flow from operations was 12.1% of sales. This compares to 8.6% of sales for the same period last year. The revised full-year earnings guidance for fiscal 2019 is outlined on Slide 15. Guidance is being provided on both an as-reported and an adjusted basis. Total sales for the year is now expected to be relatively flat compared to the prior year within a range of minus 0.4% to plus 0.6%. Anticipated organic growth for the full year is forecasted in the range of 2% to 3% or 2.5% at the midpoint. The prior year divestiture negatively impacts sales by 0.4%, and currency is expected to have a negative 2.1% impact. We've calculated the impact of currencies to spot rates as of the quarter ended March 31. We have held those rates steady as we estimate the resulting year-over-year impact for the remainder of this fiscal year. You can see the forecasted as-reported and adjusted operating margins by segment. Total Parker margins are forecasted to increase approximately 100 basis points from prior year, reaching an adjusted range of 17.0% to 17.4% for the full fiscal year. The full-year effective tax rate is projected to be 23%. This anticipates the tax rate expense run rate of 23.5% for the fourth quarter. For the full year, the guidance range on an as-reported earnings per share basis is now $11.17 to $11.47, or $11.32 at the midpoint. On an adjusted earnings per share basis, the guidance range is now $11.45 to $11.75, or $11.60 at the midpoint. The adjustments to the as-reported forecast made in this guidance include business realignment expenses of approximately $16 million or $0.09 per share for the full year fiscal 2019, with the associated savings projected to be $10 million. The guidance on an adjusted basis also excludes $14 million or $0.08 per share of CLARCOR cost-to-achieve expenses. CLARCOR synergy savings are estimated to achieve a run rate of $125 million by the end of fiscal 2019, which represents an incremental $75 million of run rate savings in fiscal 2019. We remain on track to realize the forecasted $160 million run rate synergy savings and $100 million in revenue synergies by fiscal '20. Finally, guidance on an adjusted basis also excludes $0.11 per share for the second quarter tax expense related to U.S. Tax Reform. This forecast does not include any results from our announced acquisition of LORD Corporation or any other acquisitions or divestitures that might close during the remainder of fiscal 2019. In August, we will give you an update on our projections for LORD, but we will not include LORD's results in our guidance until we have closed the transaction. We ask that you continue to publish your estimates using adjusted guidance for purposes of representing a more consistent year-over-year comparison. On Slide 16, you'll find the components of our full-year guidance relative to the outperformance in the third quarter versus our initial guidance going into the quarter. Actual third-quarter earnings per share on an adjusted basis were $0.18 higher than previously guided due to $0.04 driven by excellent operating results, lower net corporate G&A interest, and other expense of $0.07, lower income tax expense of $0.06, and fewer shares outstanding contributing $0.01. For the balance of the year, we are projecting $0.16 per share lower segment operating income due to anticipated lower volume and $0.04 per share higher net corporate G&A interest and other expense. We expect these to be partially offset by $0.01 from lower taxes and $0.01 from lower shares outstanding. This concludes my prepared comments. Tom, I'll turn the call back over to you for your summary comments.

Thanks, Cathy. So, we're very pleased with the continued progress. We've got much room for improvement still with the Win Strategy. And with the solid execution to date, we are projecting record earnings for fiscal 2019. We feel that we're well on our way to being a top-quartile financial performing company. Again, my thank you to the global team for all their hard work and their dedication to Parker. And with that, Jonathan, I'll hand it over to you to start the Q&A portion of the call.

Good morning, everyone.

Good morning, Nathan.

Just like to start on industrial North America on the margin profile here. I would have expected a little better number there this quarter. I mean, margins there are pretty flat, volumes pretty flat. But you should have had some improvement on getting rid of some of the duplicate costs from CLARCOR next year, some accrual of cost synergies from the CLARCOR acquisition. So, just any color you can give us on what the offsets were this quarter?

Yes, Nathan, it's Tom. So, there are a couple of headwinds that we ran into for the quarter that really masked some pretty good performance by North America. Specifically, Cathy referred to it a little bit in her comments. We had a one-time labor settlement in Mexico, which is about $5 million. This was in case people aren’t familiar with it, there were about 35 companies that were impacted; they were on the Maquiladora range region of the country, and it was a one-time labor settlement to settle a union strike that impacted all 35 companies, and that was about $5 million. The other is that we saw a marked shift versus our guide in the distribution mix. We saw destocking of about 300 basis points of impact on the topline on distribution. So, we had much less distribution volume than we had expected. And of course, everybody recognizes the difference in margins between distribution and OEM. While we were flat to prior year in volume, we were soft against the guide we had given you. These three things together made us light by about 100 basis points to our guide in North America, and that accounts for the 100 basis points. Without that, and these are pretty unique things that happened, we couldn’t foresee the Mexico labor issue when we did the guide or the mix in volume shift. So, I felt very good about how North America performed minus those one-off occurrences that shouldn’t repeat. The distribution destocking from what we can tell looking at our trend lines is going to continue into Q4, but just not quite the same kind of destocking rate.

Okay. So, the destocking distributor is going to have somewhat negative impact on the mix there for North America in Q4 as well?

Yes. But that's reflected in our guide. We have that accounted for in our guide for Q4 at 18.1%. So still pretty nice margins for Q4 in North America, and that'll be better than prior year by 30 basis points, but yet it will still weigh on North America a little bit.

Got it. Then, maybe if we just broaden out that North American margin discussion for the full year, you’re at 20 basis points of margin expansion at the midpoint of your guidance now. Cathy mentioned $75 million in additional synergies from CLARCOR this year. That would be 110 basis points by itself, so maybe you can comment a little bit more on the full-year impacts and what kinds of things are the offsets there over the full year and how we should think about those going forward?

Yes Nathan, it's Tom again. I think the full year is impacted by the same things I mentioned earlier, that the distribution mix really is impacting the whole second half of the year and weighing down on that number. The labor settlement weighed down on it as well. We continue to see progress; we're probably about two-thirds of the way through on the productivity improvements we needed to get from CLARCOR. That’s how I’d characterize as a mixed headwind, a little less volume than we had expected versus our prior guide, which would be another factor because when we did the original guidance, we had quite a bit more volume associated with that. The combination of volume, mix, and the labor settlement is pretty much contained in Q3, but those are weighing down the full-year number.

Okay, thanks very much for the color. I'll pass it on.

Thanks, Nathan.

Thanks, good morning everyone.

Hi, Joe.

So, maybe just kind of following a little bit on Nathan's question and your commentary, Tom, on distribution. Is it your sense that distributors destock now because they pulled forward demand at the end of the calendar year last year? What are some of the underlying factors that are impacting the destock that you're seeing this past quarter and then into this quarter?

Joe, this is Lee. I'll answer that question. I think as long as I'm on, I'll take an opportunity just to update everybody on the markets, too, if I can. So, as Tom said, there was noticeable inventory destocking in the North American channel in Q3, and we expect that to continue. You could tell the imbalance of stock material was improving through the quarter and improved in April. But we do expect it to continue through Q4. A couple of key things differ. One, our visibility to this is kind of a 30-day lag. So, we didn't have perfect information as we went into Q3. Second, there were some noticeable slowdowns in some end markets that our North American distributors service, which caught them off-guard. Definitely, a slowdown in in-plant automotive investment, which comes in waves depending on platforms and build schedules; continued softness in the microelectronics area; and then, softness on land-based oil and gas. There are two factors taking place there. One, there's takeaway capacity, mostly in Alberta and the Permian Basin. But there's also an overbuild at some of the key land-based oil and gas OEMs. I expect that to cycle its way through as time goes on. Lastly, I would say as order entry was accelerating, which led to this inventory destocking, our team likes to use inventory as a real competitive weapon out there. So, it’s a kind of natural thing that happened, but that’s what's different than Q2. I want to take a second and update on the markets. I really put these markets in three buckets. If I thought about distribution at a high level, it was pretty neutral for the quarter. I won't comment anymore on that; I gave you the color earlier, but it varies by region. North America was neutral. On the positive side, we continue to see growth around the world. Aerospace is obviously strong. Natural resources, construction, forestry, engines, lawn and turf North America-centric, and rail is very strong. Heavy-duty truck Class 8 backlogs are very strong. There may be some softening coming in the future based on order entry there, but right now the backlogs are solid. Material handling and refrigeration end markets along with telecom and life sciences are also experiencing solid growth. A lot of positive markets still right now. I talked about distribution, which I put in that neutral category right now. On the soft side, there are some trade-related end markets that we have highlighted last quarter. General industrial, machine tools, automotive, mills and foundries are continuing to be soft. Then, oil and gas is weak based on where we play, which predominantly is on the upstream side. We have exposure to all areas, but upstream. Then, power generation and semiconductor microelectronics are also weak. Quickly on Aerospace. A great quarter. Commercial OEM is up 6% for the quarter and we're going to finish the year plus 9%. So, strong backlogs there. Military OEM, up 16% for the quarter, and we're forecasting up 13% for the year. Commercial MRO, as you would suspect, is very strong at 11% for the quarter, forecasting plus 6% for the year. Military MRO is very strong, plus 10% for the quarter, forecasting plus 2%. Year-over-year for the quarter, we’re looking at plus 9.2%. For the full year, approximately 8%. I'll just comment on Asia as a region because there are a lot of questions on that. It's clear that China has been impacted by broad trade challenges in Q3. This was compounded really by a longer Chinese New Year shutdown versus very high comps. What happened around the Chinese New Year shutdown was that a lot of OEM customers decided to shut down either one side or the other of the holiday. So, a little longer shutdown than we typically see. Microelectronics markets continue to really contract, which negatively impacted Korea, Japan, and ASEAN regions. Japan and Korea also experienced a depressed export market, a heavy percentage export to China, and that's really around machine tools, automotive, and trucks. So, that's probably more than you wanted, Joe, but now you have it.

No. That's exactly what I wanted. Thanks, Lee. I appreciate all the color. If I could just maybe follow on. Obviously, commercial aero, the MRO piece of the business sounds like it was a little bit better than we anticipated for the quarter. I know that you guys were originally talking about some headwinds in the second half of the year for the Aero business, both from an aftermarket standpoint, but also because R&D was stepping up. So, if you could maybe provide a little bit more color on what R&D was for the quarter and what we should expect in terms of that for Q4 as well?

Yes. Joe, I'll help you with that one. We do see a little bit of headwind in the fourth quarter; we had significant military MRO last year in the fourth quarter. So, the comps for the fourth quarter are higher than usual, and so, that's part of the headwind in terms of volume or growth that we were talking about, and we still see that as a headwind. The development costs for the quarter were lower than we expected. Some of the costs got pushed into the fourth quarter. We saw 4.3% development costs in Q3, with some of those costs pushed into Q4. Right now, we're forecasting fourth quarter development cost to be 7.5% to 8% for the quarter. That'll get us to a total year development cost of somewhere between 5.5% and 6%.

Great, thank you very much.

Thank you, Joe.

Hi, good morning.

Good morning, David.

I was just curious, with the order rates that you're seeing, and if you can clarify, where do you think the distribution destocking ends? Is it done in your mind by June 30? Just curious, big picture, Tom, just how you're thinking about looking into fiscal '20 with the order rates. Maybe you can help us a little bit to kind of baseline. Are we thinking of the year as a year that can return to growth? Not just earnings I'm talking about, of course, but revenue. Just seeing where the order book is trending now, inventory levels, just trying to get some perspective. And maybe if you could help us with where the backlog is today versus a year ago or how you're thinking about fiscal 4Q. Where does the backlog end the fiscal year year-over-year?

So, David, it's Tom. I wanted to share some insights on how we formed our perspective for Q4, which was shaped by the Q3 orders. We observed a 6% decline in North America that continued throughout the quarter. However, there was an improvement in April; we believe that the order entry rate at minus 6% was likely affected by about 300 basis points due to distributors reducing their inventory. Analyzing the sales into and out of distribution, we noticed a 300 basis points difference there. Therefore, we anticipate about a 2.5% softness in North America for Q4, which is slightly better than the order entry, reflecting the improved order entry we observed in April. International sales remained relatively stable throughout the quarter and in April, so we’re maintaining an international forecast of minus 4% for Q4. Aerospace is projected to increase by 3%, building on what Cathy mentioned regarding last year’s comparables. Predicting fiscal year 2020 is challenging, and I won’t venture to do that without having an additional three months of data. We believe that destocking will persist through the quarter, and we have improved our ability to analyze these trends using tables. We need a few more months to determine if this will conclude in June. Nonetheless, the gap between purchases and sales at our distributors is closing, which is a positive trend. It's uncertain if this will fully manifest within the quarter. When comparing to last year, the comparisons are gradually improving, yet they remain relatively high. Thus, the first half may pose more challenges, but the second half could appear more promising based on order entry trends. I remain very optimistic about the underlying growth. For instance, if we exclude the effect of destocking, we believe distribution was growing around 3%, low single digits in North America. That should remain once the destocking phase concludes as Lee discussed. We will certainly provide more clarity when we reach that point, but I’m still hopeful. There are some challenges we face initially this year, but those should benefit us in the second half.

And given your April comments and maybe just what you're seeing and what you're hearing from customers, would it be fair to say as a bit of a baseline, given a little bit easier comp and your commentary about April, you would not expect further order deterioration year-over-year in North America and international?

Well, you still get tough comps.

On a year-over-year declines you would use this base case?

It's difficult to predict. We anticipate that Q4 will remain soft as per our guidance. Q1 will still reflect a difficult comparison at a plus 8% for North America. I believe we need a bit more time for things to stabilize. However, eventually, we will rise above that. I remain optimistic about the underlying growth that will emerge. The destocking phase will conclude, and the trade tensions will come to an end. For us, the impact of trade tensions has been minimal in terms of costs but has had more of an effect on demand. A clearer growth path for the company should become evident.

In closing, I have one last question. Some of the order growth rates appear to be slightly lower than expected. As you consider 2020, how do you plan to balance price adjustments and any cost relief you may have experienced that could enable a more aggressive sales strategy? I’m trying to understand how you will manage the trade-off between maintaining your margins and addressing the current order softness, along with whether there are associated costs that could promote a more assertive approach next year. Please provide some insights on this balance.

David, it's Lee. I think we always try to price to win. We target where we want to go. We're very cognizant of the balance between input costs and what's going on, and we always strive to be margin neutral. I expect it to be a lower inflation environment next year than what we've been experiencing.

I appreciate it, thank you.

All right, thank you, David.

Yes, good morning.

Good morning, Andrew.

Just again, I'm sure I'll ask another question on destocking. Just thinking about where the industrial cycle is. Your goal of 150 basis points outgrowth, should we expect a snapback in growth rates once destocking is over? If not, how does this reconcile with your target of global industrial growth for plus 150 basis points? Thank you.

Andrew, it's Tom. The goal versus the global industrial production is really over a cycle, over multiple years. If you look at us over the last two years, we were growing in that anywhere from 6% to 10% organically. We were clearly growing 2x to 3x the global industrial production index. Right now, we'd be a hair below that with the global industrial production index in that 1.5% to 2% range. I would expect, once the destocking plays through and the China demand stabilizes post trade concerns, that you would see us not a snapback. I would not characterize it as a snapback. I would characterize it as slower, moderate growth. Not the 6% to 10% that we were living in when we snapped out of the industrial recession of 2015 and 2016, but more of a steady growth. With all the things we have, extra tailwinds that we have to drive earnings growth, between the Win Strategy naturally, between efficiencies and the plant closures, and LORD coming on with the synergies, we have a lot of EPS growth that we can do over the next several years in a moderate-growth world. I feel very strongly that that 19% target is still functional, even with the extra amortization we're going to take on with LORD and all that, and we still have an opportunity to hit that, and that's the plan.

And just a follow-up on the adjustment to fourth quarter guidance on segment operating income. You identified a number of one-time items in North American performance. Frankly, if you pull that out, we thought incrementals were solid. So, wondering why so conservative on Q4. Why don't you think you could get more offsets on top line through execution to fourth quarter? Did I just miss something in your commentary? If I did, I apologize.

No, you didn't miss anything, Andrew. It's Tom again. We are experiencing some softness in Q4, and there is a notable decremental effect, which is less than a 10% decrease. The underlying margin improvement is still present, but it's being impacted by volume. We're also facing distribution challenges due to destocking and a shift in product mix. Despite that, we expect to achieve an 18.1% operating margin in Q4, which are strong numbers. However, it's important to note that this situation is part of an appealing narrative as we move into FY '20, and we anticipate that the destocking won't last indefinitely, providing us with some positive momentum as we head into the new fiscal year.

Thank you so much.

Thanks, Andrew.

Yes, thank you. Good morning, everyone. First, I was just wondering if Cathy perhaps could explain a little bit more what exactly that adjustment was in corporate and what we should expect going forward.

Sure, Jeff. We carried some investments to support a deferred comp plan and the accounting rules require us to mark-to-market that balance. In the third quarter, we saw a nice gain in the market share of those investments. Now, that compares to the second quarter where we had a significant loss. So, it's a mark-to-market investment fluctuation that we're seeing come through our corporate G&A line.

And I was also just wondering back on the whole order equation. It looks like your organic revenues have historically very, very closely tracked your orders, with maybe a quarter delay. You don't seem to be signaling a revenue contraction in North America that would be commensurate with the order decline that we just saw and perhaps continues based on your commentary. Am I missing something there? Or is there just something in the way this destock is playing through that's coloring your view? Any additional color there would be helpful.

No, Jeff, it's Tom. You're not missing anything. Generally, our follow-up period orders tend to generate the next quarter's sales. Except for the destocking, which was more pronounced in Q3, we are optimistic, which is why our guidance for North America is not as soft. April orders showed a significant improvement over March. They’re still dealing with destocking, but there's improvement, with April seeing about a 2.5% increase. From our discussions with distributors, it seems that many of those types of orders can be cycled within the same period.

Okay, thank you.

Thanks, Jeff.

Hi good morning, everyone.

Good morning, Ann.

Maybe switching gears a little bit. Could you give us a little bit of color around Rest of World markets? I know you talked about Asia, but could you talk a little bit in more depth about Europe and what you're seeing there by end market or by country?

Yes. Ann, it's Lee. I spent quite a bit of time at the Hannover Fair and then at the Bauma Show. At the Bauma Show, industrial customers are generally soft. A lot of it seems to be trade related in some way or another, so these would be generally machine tool companies. If you are in construction equipment, forestry industry, you can't build equipment fast enough. So, there's still high demand. Distribution markets are still strong throughout EMEA. So, there's a little bit of acceleration occurring around the world in offshore oil and gas, slowly but surely. So, that's positive, and we're seeing some of that in the North Sea. I would say, in Asia, I’m not sure I can really add anything more than what I've mentioned there. There is definitely softness around some of the industrial markets there. Construction equipment, et cetera, still seems to be pretty good, and distribution as a whole held in there in the Asia Pacific region.

Okay, thank you. I appreciate the color. And then, just maybe one follow-up on North America distribution. Do you know how much of your North American distribution is leveraged to oil and gas? Or even by region, distributors in Texas, or any metric that you can use to give us some sense of the size of that business?

Nothing I can repeat right now. That might be something we could take offline. But the exposure tends to be around those distributors that are in that area of trade. It's like you said, it's Texas, Oklahoma, around the Gulf down there, that’s where it is. But it’s something we can look at.

Okay. And the destocking was broad-based in the oil and gas sector or regions?

Yes. We have distributors focused on in-plant automotive primarily in the Midwest and the southern regions, and their level of investment and activity has significantly decreased. Additionally, we have distributors on the West Coast and some on the East Coast involved in the microelectronics sector, which also appears to be experiencing a downturn. However, many of our other distributors remain optimistic about business, even in the oil and gas sector. The current slowdown is simply a reduction from the previously high level of activity that contributed to this destocking.

Thank you. I appreciate it. I'll get back in line.

Thank You Ann.

So, no points here for originality. I want to go back to the order numbers. And fully understand the comments about the destocking in the MRO channel. But I'm wondering if we're still restocking through calendar 2018. Therefore, even if we do get to a point where the destocking stops, are we then comping against restocking activity and therefore still have challenging comps through the back half of the year? The second part of my question is really the same; normally, it takes four to six quarters for negative order comps to cycle through back to positive. Is there any reason to assume that this cycle is going to be different and we can get back to positive comps earlier than four quarters?

Nigel, it's Tom. When you look at the comparables, I think we have provided our outlook for Q4. As we enter FY '20, the first quarter presents a tough comparison, but subsequent quarters will be more balanced. I believe that once the channel destocking concludes, the underlying growth will become clearer. When we analyze the trend lines regarding purchases versus sales to our distributors, we see a difference of about 300 basis points. North America appeared essentially flat, which suggests that without the destocking, North America would have experienced a growth of around 3%. When this situation resolves, I anticipate that this is approximately where we will end up, but it remains uncertain how long that will take. We noticed the gap beginning to close, which was encouraging in April, but we won't have clarity until it fully resolves. I am working on improving our internal graphical displays, which help us better track the trends, although there is a 30-day lag in the visibility we receive from our distributors. As a result, we may not always have complete information for our quarterly updates. By August, we should have a clearer understanding of our status regarding the destocking.

Thanks, Tom. I appreciate that. And then, obviously, with FY '20 in mind, just wondering, with Aerospace margins performing so well, are we at a level where we can still grow from here into FY '20 and beyond? Just curious how your view is on the next two or three years on Aero margins? Can they go into the low 20s?

Nigel, it's Tom again. I feel very strongly that they can. We're going to get to an equilibrium, which we're approaching that this year on R&D. If you look at this year, our mix of OEM to MRO actually got a little bit disadvantaged to us versus FY '18 that we have with a less MRO mix versus OEM. Over a multi-year period, that MRO mix is going to come up again. Our team has done a very nice job of entering into service productivity, and they've done a nice job with The Win Strategy. Of course, they're getting some leverage with a lower R&D. So, while the R&D may reach equilibrium, that entry into service productivity, The Win Strategy things and continued volume are going to continue to provide margin expansion opportunities with Aerospace. Your approximation of where we can head is spot on and that's what we're going to try to do.

Thanks, Tom. Appreciate it.

Thank you, Nigel.

Hi. This is actually Themis on for Jamie. Just a question on international margins where I think you raised your margin assumptions despite a weaker top-line forecast. So, can you help us better understand what drove that?

You're talking about for Q4?

Yes.

We're building off of what we did with the prior quarter, which Q3 came in very nicely at 16.5%. Our Q4 guide is 16.6%. So, that's in line with what we did with the prior quarter. That's building on prior-period restructuring that we've done, which continues to give us leverage. The Win Strategy. We feel good that, even with the softness in the top line, we have enough momentum with what we're doing from an earnings standpoint to keep those margins about where we were in Q3.

Got it. Thank you. And then, maybe real quick, could you provide some more color around your price cost assumptions for Q4?

Yes, I would say commodities and input costs are basically neutral. Some have softened or some have accelerated. I just expect this to be margin neutral here in Q4.

Thank you very much. I will get back in queue.

Thank you.

It's Joe Grabowski on for Mig this morning. Most of my questions have been answered. I guess I'll just throw one out there. You mentioned a slowdown in in-plant automotive and you talked about that business kind of comes in waves depending on platforms. But we have seen a slowdown in auto builds around the world. So, maybe a little bit more color on that dynamic and where you see it kind of over the next several quarters.

Yes. The way I look at our automotive exposure is basically in-plant and then MRO activity. The big dollar amounts are when they're tooling up for a new platform, new transmission line, etc. A lot of our distribution base gets involved with those types of investments and their machine-tool customers. That's where the slowdown is. These slowdowns tend to happen between model builds. It's nothing that's systemic long term, but it's just a slowdown right now at that level.

That's helpful. Like I said, most of my other questions have been answered. So thank you.

Okay. Thank you for calling.

Hi, good morning.

Good morning, Josh.

I’d like to follow up on a few points and reiterate some aspects of North America distribution. Last quarter, Lee, you mentioned that we were nearing the end of the destocking phase. You had some experience with this then. Can you explain how the distributor stocking levels have fluctuated? What worsened, what improved, and what worsened again that contributed to our early assessment that the situation was balanced last quarter before shifting again?

Yes, Josh, so it was a lot of phone calls last quarter. I’m always in touch with our distribution base just getting a level of what's happening. One, it's the holiday periods. Sometimes people aren't as focused on what's happening day to day, but the one thing that got worse during the quarter was really those factors; there was a significant slowdown in land-based oil and gas. Again, it was all the way from Alberta down to the Permian Basin. There were some key OEM customers that our distributors took care of, and there was an overbuild of equipment that will work its way through. So, that slowed down and that wasn't on the radar screen when we were checking last time. I think that was what the over-correction was. The other things I've talked about included a slowdown in in-plant automotive and continued softness in microelectronics, and lastly, I think we've been a little smarter here. We had that last 30 days of data because our distributors report their sales. We can see the patterns better now than just relying on phone interviews. It would have provided a better picture.

Got it. But within that, there's something that presumably felt less bad or got better, call it, 60, 90 days ago that maybe changed your mind since then? Was there something that actually did get better, or was it just the end of destocking that didn't happen?

I think so; the destocking is the headline number. If you called out to any of our distributors, they would feel like these are good times. There's a good underlying growth happening throughout the country. It's just there was a rapid growth taking place, then an inventory stocking taking place. They probably got out ahead of what demand actually was.

Josh, it's Tom. I just wanted to add on maybe for everybody else. Lee touched on this early on. Our distributors view inventory as a strategic advantage and they see it as a market share opportunity. Remember how rapidly the inflection was when we went from '16 into '17, and we're all growing at 8%, 10%. Our distributors hustled to build those inventory positions they wanted to have. I think that correction and their sales and operating planning correcting to the current demand didn't happen quick enough on their end. I think that combined with our inability to see the visibility we would have liked meant we didn't quite get there.

Got it. That's helpful. And then, just a follow-up, obviously, with the announcement earlier this week, engineered materials becomes a much bigger piece of the portfolio on a pro forma basis. How did your engineered materials business perform this quarter?

Josh, it's Tom. It continues to be one of our higher margin businesses. I would say it was very much in line with total company growth; it matched the total company's organic growth. Remember, it's an industrial-oriented business, just like LORD's. It has aerospace exposure as well. The difference, what LORD will bring, that we're excited about, is LORD will be a content shift for us on automotive. First of all, remember that LORD is 70% not automotive. It has a fantastic aerospace portfolio and a great industrial portfolio. LORD grew 14% organically in Q1, and factoring in currency, they grew about 7%. They have the same kind of currency headwinds we have. But their automotive business is not subject to the same kind of pressure we feel because the bill of material for an AGV or EV incorporates about 10 times to 20 times what we see with a combustion engine machine. That's why we're attracted to them, plus the fact that they’ve got this great aerospace portfolio that’s growing just like ours and the job they are doing in industrial. So, just look at their growth rate. 14% organic growth in Q1 is pretty impressive.

Understood. I appreciate the color, Tom.

Jonathan, we have time for one more question, please.

Maybe just a quick one around the North America margin outlook. Just wanted to sort of test your conviction. If we see in fiscal '20 another year of low single-digit, but positive sales growth in Industrial North America, how confident are you that margins can expand from that, what, 16.8% level at the midpoint for this year?

Julian, it's Tom. I'm still comfortable that we can expand those margins. Absolutely. We've got tailwinds on just The Win Strategy in general and all things we're doing related to simplification, lean operations, supply chain work, and our value pricing strategies. We still have upside on what we're doing from an innovation standpoint, and we're going to continue to see some tailwind as we continue to improve in the plans on the plant consolidations. The good thing is that we're seeing the progress. It was masked a little bit in Q3 because of the one-offs we talked about earlier. Still, I feel good about that trajectory. You can expect normal types of incrementals from volume gain for North America going into next year.

And then, my second one, I think, Tom, on the last call, you talked about this still being a great industrial environment. Clearly, the destocking has dented things a little bit. I wonder if, in that light, there were maybe any extra cost measures being taken with the temporary workforce, for example, or those sorts of levers that you're pulling as an organization as you navigate this softer top line patch?

Yes, Julian. Absolutely. We’re pretty good at that. That's our pedigree, our track record. We'll make all those variable cost adjustments whether it's overtime, temporaries, etc., ratcheting back, and having the whole variable cost structure match the order entry output. You can utilize attrition; there are a lot of things we can do to help you get there, and we track that religiously. So, I expect that would not be a problem for us.

Thank you.

Thank you, Julian. This concludes our Q&A for today and our earnings call. Thank you for joining us. Rob and I will be available to take your calls if you have any further questions. Thanks, everyone. Have a great day.