Parker-Hannifin Corporation

Good day, ladies and gentlemen, and welcome to the Parker Hennepin's Fiscal 2019 Third Quarter Earnings Conference Call and Webcast. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session, and instructions will be given at that time. If anyone should require assistance during the program, please press star then zero on your touchtone telephone. As a reminder, today's program is being recorded. I would now like to introduce your host for today's program, Kathy Siever, Chief Financial Officer. Please go ahead.

Thank you, Jonathan. Good morning, and welcome to Parker Hannafin'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 slides 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 five, and Tom will get us started.

Thank you, Kathy, 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 a new wind strategy in our first generation of five-year goals, and if you remember, one of our key goals that we had at that time was to get to 17% operating margin by 2020. And I kind of remember that meeting. We also got feedback that perhaps it might be too aggressive. but we're excited to tell you that we've achieved that goal basically about 18 months early, and that included doing the Clark 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? It really comes directly from the slide that's up there, slide five, describing our business model and the competitive differentiators that we have. And if you look at that, it's really a powerful lineup And that list represents what makes us different. It strategically positions us versus our competitors, and it helps answer the question, why would you invest in Parker? Why would you buy from Parker? And why would you work at Parker? So I'd like to show this every quarter, but I'm only going to pick one bullet to go over to give you some extra color. And let's talk about the operating CapEx requirements of the company. If you go back before the wind strategy started, we were basically at 6%. CapEx to sales company. And today we balance in that 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 freed up floor space, 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, deploy 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 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 on safety. Remember the connection between safety performance, engagement, and financial performance is a clear linkage between all those. We have a strong operational quarter, reflecting the benefits of the wind strategy, and we've put up a number of quarterly records, segment operating margins, net income, and EPS. And our confidence remains very strong for achieving record performance in FY19. 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. Our order rates did moderate, pumping up against some tough comparables, growth moderating and North America distributors destocking. Of course, we'll discuss that more in the Q&A portion of the call. EPS and net income were all-time records. Segment operating margins was an all-time record at 17.1%. And adjusted total segment operating margins were 17.2%. up 90 basis points versus prior year, and we saw improvement across all of our reporting segments. Aerospace posted an all-time record at 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 that's performing at a very high level, and that utilizes all of our motion control technologies into 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, operating cash flow of 12.1%, excluding discretionary pension contribution. 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 10B51 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 lowered acquisition process started. And, of course, on Monday, We announced the agreement to acquire Lord Corporation for $3.675 billion and lowers approximately a $1.1 billion business, 23% EBITDA, and a leader in material science and vibration control technologies. And if I could just as a reminder, in case 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 which significantly expands our engineer 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 long-standing blue-chip customer list that is very similar to our customer list. Strengthens material science capabilities, electrification, lightweighting, and aerospace offerings. And it's expected to be accretive to organic sales growth, EBITDA margin, and cash flow and EPS, excluding one-time costs and deal-related amortization. So moving out to the outlook, We're maintaining EPS guidance midpoint of $11.32 as reported and $11.60 adjusted. Our forecasted organic growth range is in that 2% to 3% for the full fiscal year. And we're anticipating record earnings in FY19 due to the wind strategy execution. We are really in a great position to perform regardless of how the macro environment turns out. And there's a number of positives. They're going to serve as a tailwind to our performance as you look forward for the next several years. The first is we're still early days of the new wind strategy and the execution. And you can see the progress we've made just in the first five years of it, 15% to 17% and the Harker acquisition. So lots of headroom as we continue to improve with the wind strategy. Integration of Clarkor is showing lots of promise. with upside, continued upside to margins as we continue to improve on the manufacturing consolidation. And the lower corporation brings the top quartile performing company into the portfolio that has attractive technologies and material science, vibration controls, and will generate that incremental organic growth margin of 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 FY23, and those are just to remind everybody to grow organically 150 basis points faster than the market, to achieve segment operating margins of 19%, EBITDA margins of 20%, continue our free cash flow conversion of greater than 100%, and this would all yield an EPS category of 10% plus over that time period. So in sum, we anticipate another record year for FY19, and we're making progress towards that second generation of five-year targets. And with that, I'll hand it back to Kathy for more details on the quarter.

Thanks, Tom. I'd like you to now refer to slide number seven. 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 are business realignment expenses of $0.03. This compares to fiscal 2018 adjustments of $0.04 for business realignment expenses and $0.06 for Clarkor costs to achieve. On slide 8, you'll find the significant components of the 37-cent 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 15 cents. The aerospace segment generated 26% more income in 2019 with meaningful organic growth and considerably higher margins. The diversified industrial segments generated consistent year-over-year income with higher margins despite declining revenues. Lower corporate G&A accounted for a 12-cent increase driven by market-adjusted investments tied to deferred compensation. Lower interest expense and higher other expense lowered earnings per share a net one penny. And lower average shares resulted in an increase of 11 cents. Slide 9 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 3% of currency impact and 0.5% from a prior year divestiture. Total segment operating 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 impacts from our wind 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 with 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, which reflects the hard work dedicated to productivity improvements, as well as synergies from acquisitions and the impact of our wind 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 0.7% loss of sales. On 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 wind 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 margins 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 wind 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 $1,093,000,000. When adjusted for a $200,000,000 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 are 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 currency 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 a tax 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 Clarkor cost-to-achieve expenses. Clarkor synergy savings are estimated to achieve a run rate of $125 million by the end of fiscal 19, which represents an incremental $75 million of run rate savings in fiscal 19. We remain on track to realize the forecasted $160 million run rate synergy savings and 100 million revenue synergies by fiscal 20. And finally, guidance on an adjusted basis also excludes 11 cents 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 Lorde, but we will not include Lorde'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 18 cents higher than previously guided due to 4 cents driven by excellent operating results, lower net corporate G&A interest and other expense of 7 cents, lower income tax expense of 6 cents, and fewer shares outstanding contributing 1 cent. 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 to you for your summary comments.

Thanks, Kathy. So we're very pleased with the continued progress. We've got much room for improvement still with the wind strategy. And with a solid execution to date, we're projecting record earnings for fiscal 2019. And we feel like 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.

Certainly. Ladies and gentlemen, if you have a question at this time, please press star then 1 on your touchtone telephone. If your question has been answered and you'd like to remove yourself from the queue, please press the pound key. Our first question comes from the line of Nathan Jones from Stifel. Your question, please.

Morning, everyone.

Morning, Nathan.

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

Yeah, Nathan, it's Tom. So there's a couple headwinds that we ran into for the quarter that really masked some pretty good performance by North America. Specifically, Kathy 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 was about 35 companies that were impacted that were in the Maquiladora range region of the country. And that 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. So we saw the stocking of about 300 basis points of impact on the top line on distribution. So we had much less distribution volume than we had expected, and of course everybody recognizes the difference in in margins between distribution and the OEM. And then while we were flat the prior year on volume, we were soft to the guide that we gave you. And so those three things together, we were light by about 100 basis points to our guide in North America, and that's what makes up the 100 basis points. So without that, and these are some pretty unique things that happened. Of course, we couldn't foresee the Mexico labor thing when we did the guide or the mix and volume shift. So without that, I felt very good about how North America performed, minus that, and those are one-off type of things that shouldn't repeat. Other than the distribution, destocking is, from what we can tell looking at our trend lines, is going to continue in the Q4, but just not quite the same kind of destocking rate.

Okay, so the destocking distributed is going to have a somewhat negative impact on the mix there for North America in 4Q as well?

Yeah, but that's reflected in our guide. We have that in the guide. In our guide for Q4, it's 18.1%, so still pretty nice margins for Q4. In North America, it'll be better than prior year by 30%. But, yeah, it'll still wait on North America a little bit.

Got it. Then maybe if we just broaden out the North American margin discussion a for the full year, you're at 20 basis points of margin expansion at the midpoint of your guidance now. And Kathy mentioned $75 million in additional synergies from Clark Hall this year. That'd be 110 basis points by itself of margin expansion. 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.

Yeah, Nathan, it's Tom again. I think that the four years impacted by the same things that 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 as far as the productivity improvements that we needed to get from Clark were. But that's how I characterize this. A mixed headwind, a little less volume than we had expected. versus our prior guide, that would be another factor because when we did the original guides, we had quite a bit more volume associated with that. So the combination of volume, mix, the labor settlement is pretty much contained in Q3, but those are weighing down the full year number.

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

Thanks, Nathan.

Thank you. Our next question comes from the line of Joe Ritchie from Goldman Sachs.

Thanks. Good morning, everyone. 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, you know, destock now because they pulled forward demand at the end of the calendar year last year? Or what are maybe kind of some of the underlying things that is impacting, you know, the destock that you're seeing, you know, 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, noticeable inventory stocking in North America, the channel in Q3. And, you know, we expect that. You could tell the imbalance of stock material was improving through the quarter. It's improved in April. But we do expect it to continue through Q4. A couple of key things different. One, kind of our visibility to this is kind of a 30-day lag. And 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 that I think caught them off guard. Definitely a slowdown in implant automotive investment. which is, you know, it comes in waves depending on platforms and build schedules. Continued softness in the microelectronics area. And then softness in land-based oil and gas. And there's two factors taking place there. One, you know, 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. So I expect that to cycle its way through as time goes on. And then just lastly, I would say, you know, as order entry was accelerating, you know, which led to this inventory to stocking, our team likes to, you know, use inventory as a real competitive weapon out there. So kind of a natural thing that happened, but that's what's different than Q2. I'm just going to take a second, if I can, and update on the markets. So, you know, I really put these markets in three buckets, and if I, If I thought about distribution at a high level, it was pretty neutral for the quarter. I'm not going to comment any more on it. I gave you the most colors, but it varies by region, but North America was neutral. On the positive side for us, they continue to grow around the world. Aerospace, obviously, I'll comment on that. You know, really natural resource construction, forestry, engines, lawn and turf, North America-centric, rail is very strong. Heavy-duty truck, Class 8, backlogs are very strong. There's probably some softening coming in the future based on order entry there, but right now the backlogs are very strong. Material handling and refrigeration end markets along with telecom and life sciences. So a lot of positive markets still right now. I talked about distribution, which I put in that neutral category right now. And then I'd say on the soft side, there's some trade-related end markets. We highlighted those last quarter. But general industrial machine tools, automotive mills and foundries continue to be soft. And then there's oil and gas, which is soft based on where we play, which predominantly is on the upstream side. We have exposure to all areas, but upstream. And then power gen and semiconductor microelectronics. Just quickly on aerospace, a great quarter. Commercial OEM up 6% for the quarter. We're going to finish the year plus 9%, so strong backlogs there. Military OEM up 16% for the quarter. We're forecasting a 13% for the year, so very strong there. Commercial MRO, as you would suspect, very strong at 11% for the quarter, forecasting plus 6% for the year, and military MRO a very strong plus 10% for the quarter, forecasting plus 2%. Year over year for the quarter, plus 9.2%, and then rounding for the full year, approximating 8%. I'll just comment on Asia as a region because there's 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, there was slowness in the economy. A lot of OEM customers decided to shut down either one side or the other at Chinese New Year, so a little longer shutdown than we typically see. Microelectronics markets continue to really contract with a negative impact on Korea, Japan, and ASEAN regions. And then Japan, Korea also experienced really a depressed export market, heavy percentage export to China. naturally around machine tools and automotive and trucks. So it's probably more than you wanted, Joel, but now you have it.

No, that's exactly what I wanted. Thanks, Lee. I appreciate all the color. And 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 just provide a little bit more color on what R&D was for the quarter and what we should be thinking about in terms of that for Q as well.

Yeah, Joe, I'll help you with that one. We do see a little bit of the comps for the fourth quarter. We had significant military MRO last year fourth quarter. So the comps for 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 did 4.3% development costs in Q3. With the push of some of those into the fourth quarter, and we expected fourth quarter to be high, right now we're forecasting fourth quarter 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.

Thank you. Our next question comes from the line of David Rasso from Evercore ISI. Your question, please.

Hi, good morning. I was just curious, with the order rates that you're seeing, and if you can clarify, where do you think the distribution de-stocking ends? Is it done in your mind by June 30th? 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, you know, are we thinking of the year as a year that can, you know, return to growth, not just earnings I'm talking about, of course, but revenues, just seeing where the order book is trending now, inventory levels, just trying to get some perspective. And, you know, maybe if you could help us with where is the backlog today versus a year ago, or how are you thinking about fiscal 4Q? Where does the backlog end the fiscal year, year over year?

So, David, it's Tom. Just a couple comments about really kind of how we formed our view for Q4. It was influenced by Q3's order. So you see a negative six in North America, and that kind of declined throughout the quarter. However, we saw an improvement in April to where, and we really felt that our order entry rate at minus six was probably influenced by about 300 basis points by distributions to stocking. We look at the sales into distribution and the sales out of distribution. That was about a 300 basis points delta there. Hence, we forecast for Q4 about a 2.5% softness in North America. So that's a little better than the order entry, picking up on a little better April order entry that we saw. International stayed pretty consistent through the quarter as well as April. Hence, we kept international at minus 4% for And then aerospace is a plus three, piggybacking on what Kathy talked about as far as the comparables to last year. So it's hard, as you might imagine, to predict FY20, and I'm not going to do that because it would really help us to have another three months under our belt. I think you can project, which is what we have in the guide here, that the destocking will continue through the quarter. And I think we've got a better way of graphing that now to see these trends a little bit easier than looking at it. and tables. And so I think we need a few more months to know whether we can save that it's going to end in June. But it's clearly that gap between purchases and sales at our distributors is narrowing. So the trend looks good. Whether it will get done in the complete quarter, we don't know. I think when you look at the comparables to last year, we continue to get a little bit better, but they're still pretty high. And so, you know, maybe our first half is a little more challenging. The second half becomes a little more attractive when you look at some of the over-entry comparables. I still feel very optimistic about the underlying growth. If I take distribution as an example and back out the stocking, you know, our view is distribution was growing around 3%, you know, low single digits in North America. And so I think that's going to be there once the VSOCing plays through for the reasons that Lee went through. And, you know, we'll give you the visibility for sure when we get there. But I'm still optimistic. A lot of this noise is going to play through. We have a couple tough comps in the beginning of the year, but that should help us in the second half.

And given your April comments and maybe just, you know, what you're saying and what you're hearing from customers, would it be fair to say that 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 got tough comps. You would use this base case?

It's hard to say. I mean, I think Q4 will still be more forecasting to be saw for Q4 based on our guide. When you get to Q1, you know, it's still a pretty good comparable, pretty tough comparable at a plus eight for North America. So I think we still need a little bit more time for that to play through. But at some point, we're going to pick our head above that. And there's still that underlying growth that I'm optimistic is going to come through. The stocking will finish. The trade tensions will finish, which for us, the trade tensions has been negligible cost impact, but it's been more demand impact. And I think more of a true growth trajectory will be seen for the company.

And last question, just I think maybe some of these order growth rates were a little bit weaker than some people thought. Is there anything when you look at 2020, how you think about toggling between price, any cost, maybe relief that you've seen that allows you to maybe be a little more aggressive on sales, just trying to think of the toggle between Obviously, you're dedicated to your margins, but also maybe the orders here were a little weaker than people thought. And I'm not sure if there's any cost relief that's going to allow you to be a little more aggressive next year or just maybe frame that balance for us.

David, it's Lee. I mean, I think we always try to price the win. So, I mean, 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. So I expect it to be a lower inflation environment going next year than what we've been experiencing.

All right. I appreciate it. Thank you.

Thank you, David.

Thank you. Our next question comes from the line of Andrew Obin from Bank of America, Maryland. Your question, please.

Yes. Good morning.

Morning, Andrew.

Just to, you know, I'm sure I'll ask another question on G-stocking. Just thinking about where the industrial cycle is, your goal of 150 basis point outgrowth, should we expect a snapback in growth rates once G-stocking is over? And if not, you know, how does this reconcile, as I said, with your target of global industrial growth for a plus 150 basis points? Thank you.

Andrews, Tom. So the goal versus the global industrial production is really over a cycle, over multiple years. And if you look at us as a last really two years approximately, we were growing in that anywhere from 6% to 10% organically. And so we were clearly growing. growing 2x to 3x times global industrial production index. Right now, we'd be a hair below that with 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 in not a snapback. I would not characterize it as a snapback. I would characterize it as a slower, moderate growth world Not the 6 to 10 that we were living in when we snapped out of the industrial recession of 15 and 16, but more of a steady growth. And with all the things we have, extra tailwinds that we have to drive earnings growth between the wind strategy, naturally, between efficiencies and the plant closures, more coming on. And the synergies will get there. And we have a lot of EPS growth that we can do over the next several years in a moderate growth world. So I feel very strongly that that 19% target is still the target, even with the extra amortization we're going to take on with Lorde and all that. We still have an opportunity to hit that, and that's the plan.

And just to follow up on sort of adjustment to fourth quarter guidance on segment operating income, you identified a number of one-time items in North American performance. And frankly, if you pull that out, we thought incrementals were very solid. So just 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? And if I did, apologize.

No, no, you didn't miss it, Andrew, against Tom. We've got, you know, really, we have some softness in Q4. We have a very attractive decremental that's in there. It's only like minus, it's less than minus 10% decremental. So we are, you know, that underlying margin enhancement is still there being offset by the volume. and we still have the distribution pressure with the destocking, with that next shift hitting us. We'll still come in Q4 at an 18.1% operating margin for Q4, so it's very nice numbers, but I think that is part of the story that's attractive going into FY20, is that destocking is gonna play through, it's not gonna continue forever, and we're gonna get some upside for that as we turn a corner into FY20.

Thank you so much.

Thanks, Andrew.

Thank you. Our next question comes from the line. Jeff Sprague from Vertical Research. Your question, please.

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

Sure, Jeff. We carry some investments to support a deferred comp plan, and the accounting rules require us to mark to market that balance. And in the third quarter, we saw a nice gain in the market share of those investments. Now that compares to 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.

Then I was also just wondering back on kind of the whole order equation. You know, it looks like your organic revenues, you know, have historically very, very closely tracked your orders, right, with maybe a quarter delay. You don't seem to be signaling, you know, a revenue contraction in North America that would be commensurate with the order decline, you know, that we just saw and perhaps continues based on your commentary. Am I missing something there, or is there something in kind of the way this D-stock 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. In general, you're right that our follow-up period orders tend to generate the next quarter's sales, with the exception of the D-stocking was more pronounced in Q3. And what's giving us... optimism, which is why we have the guidance not quite as soft in North America, is that April orders improved quite a bit from March. They're still not out of the woods. We still have the destocking, but it improved better to where what you're seeing with that 2.5% is about what we saw in April in our sense as far as when we talk to our distributors, what we'll see the rest of the quarter. In a lot of cases on those type of orders, We can't cycle them all within the same period.

Okay, thank you.

Thanks, Jeff.

Thank you. Our next question comes from the line up. And Dignan from JPMorgan. Your question, please.

Hi, good morning, everyone. Good morning, Ann. Good morning. Morning. Maybe switching gears a little bit, could you give us a little bit of color around the rest of world markets?

I mean, 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?

Yeah, Anne, it's Lee. You know, I spent quite a bit of time at Hanover Fair and then at the Bama show. And You know, at the Bama show, if you talk to industrial customers, it's generally soft. And a lot of it seems to be trade-related in some way or another. So these would be German machine tool companies, et cetera. If you're in the construction equipment, forestry industry, you can't build equipment fast enough. So there's still high demand. Distribution markets are still strong throughout EMEA. And then there's a little bit – You know, it's bouncing off a low number, but there's an acceleration around the world around offshore oil and gas, slowly but surely. So, I mean, 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 have on there. There's definitely softness around some of the industrial markets were there. Construction equipment, et cetera, still seems to be pretty good. and distribution as a whole kind of held in there in Asia Pacific.

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

Nothing I can repeat right now. It might be something we could take offline. But, you know, the exposure tends to be about those distributors that are in that area of trade. So, I mean, it's like you said, it's Texas, Oklahoma, and around the Gulf down there is 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?

Yeah, and also we've got distributors that do a lot around implant automotive, which is kind of spread all the way from the Midwest down through the South. That amount of investment and activity has slowed down quite a bit. And then we've got distributors on the West Coast, mostly, some on the East Coast, involved with the microelectronics industry, and that's been pretty soft, as you know. But, you know, if you went out and talked to a lot of our other distributors, I mean, they're very positive about business, even in the oil and gas area. It's just a slowdown from the high level of activity that there was, which has led to this destocking.

Okay, thank you. I appreciate it. I'll get back to you in nine. Thank you. Thank you, Ann.

Thank you. Our next question comes from the line of from Wolf Research. Your question, please. Thanks. Good morning.

You know, it feels like it's only been a couple of days since we last spoken.

How true.

So, no point to your virginality. 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 saw restocking through you know, calendar 18. And 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? And then the second part of my question, it's really the same question, is normally it takes, you know, four to six quarters for negative order comps to cycle through back to positive. Is there any reason to assume that this cycle could be different and we could get back to positive comps earlier than four quarters?

Nigel, it's Tom. I think, you know, when you look at the comparables, you know, I think we're going to, you know, the next quarter we'll be giving you what we think for this Q4. I think when you go into FY20, clearly the first quarter, Q1 FY20, has a pretty tough comp. And after that, I think things become more balanced. I do think that, you know, everything, when we do our discussions with our distributors, once this channel opens, the stocking plays through, we feel that that underlying growth, you know, when we look at the trend lines on purchases versus sales for distributors, that delta was about 300 basis points. So North America came in basically flat. So that means if you take out the destocking, North America would have grown around 300 basis points, a positive 3%. So whenever that plays through, I think that's approximately where we're going to end up. The question is, how long does it take to play through? We don't have that complete answer yet. We saw that difference start to neck down, which was a positive in April. But until it finishes, we're not going to know. I think we're doing a better job of graphically displaying that internally so we can see the trends better. But it does lag 30 days as far as when our distributors give us that visibility. So we don't always have perfect information when we give you a quarterly update. So when we give you August, we'll have a better view on exactly where we are with the destocking.

Thanks, Tom. I appreciate that. And then, obviously, with FY20 in mind, just wondering, you know, with aerospace margins, you know, performance so well. Are we at a level where we can still grow from here into FY20 and beyond? Just as curious, you know, how your view is kind of the next two or three years on error 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 FY18 that, you know, we have a little less MRO mix versus OEM. And so that's going to naturally over time, you know, it's not going to happen instantaneously, but over a multi-year period of time, that MRO mix is going to come up. We continue, part of what's driving these great margins is the team has done a very nice job of entering into service productivity. They're doing a very nice job with the wind strategy. And, of course, they're getting a little bit of leverage with a lower R&D. So while the R&D may be reaching equilibrium, that entry into service productivity, the wind strategy things, and continued volume is going to continue to give us margin expansion opportunities with aerospace. So I think 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.

Thank you. Our next question comes from the line of Jamie Cook from Credit Suisse. Your question, please.

Hi, this is actually for Jamie. Just a question on international margins where I think you raised your margin assumption despite the weaker top line forecasts. So can you help us better understand what drove that?

You're talking about for Q4?

Yes.

Yeah, we're building off of what we did with the prior quarter. which Q3 came in very nicely at 16 1⁄2, and so our Q4 guide is 16.6, so that's in line with what we did with the prior corridor, and it's building on prior period restructuring that we've done, which continues to give us leverage, the wind strategy. And so 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 at Q3.

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

Yeah, I would say, you know, I would say commodities and input costs are basically neutral. There are some that have softened. There are some that have accelerated. And I would just expect this to be margin neutral here in Q4.

Thank you very much. We'll get back in queue. Thank you.

Thank you. Our next question comes from the line of Mig Dobre from RW Baird. Your question, please.

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

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, engine line, et cetera. A lot of our distribution base gets involved with those types of investments and their machine tool customers. So 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 a slowdown right now at that level.

Got it. Okay. That's helpful. Like I said, most of my other questions have been answered, so thank you.

Okay. Thank you for calling.

Thank you. Our next question comes from the line of Josh Pakasiewinski from Morgan Stanley. Your question, please.

Hi. Good morning, guys. Morning, Josh. Just want to follow up on a couple things, and I'll beat the dead horse a little bit more here on North America distribution. I think last quarter, Lee, you mentioned that we were kind of at the end of destocking. You had lived through a little bit then. I guess that sine wave in distributor stocking levels, what got worse, what got better, and then I guess what got worse again that kind of led to the early call on that being balanced as of last quarter and then coming back in again?

Yeah, Josh. You know, it was a lot of phone calls last quarter. I'm always in touch with our distribution base, just kind of getting a level of what's happening. One, it's the holiday period, so 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 things. It was around a significant slowdown around land-based oil and gas. And again, it was all the way from, you know, Alberta all the way down through the Permian Basin. And then with some of the key OEM customers that our distributors really take care of, there was an overbuild of equipment, which will work its way through. So that slowed down. And that wasn't so much on the radar screen when we were checking last time. So I think that's what the overcorrection was. And then the other things I talked about, just kind of a slowdown in implant and automotive, and then continued softness and microelectronics. And then lastly, I think we would have been a little smarter had we had that last 30 days of data. Because we do, our distributors do report their sales. And, you know, we would have seen that the data would have said something different than the phone interviews. So it would have helped.

Got it. But I guess within that, there's something that presumably felt less bad or got better, you know, call it 60, 90 days ago that, maybe you changed your mind on since then, but 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, but I think if you were to call out to any of our distributors, they would feel like these are good times. I mean, there's a very good underlying growth happening throughout the country. It's just, you know, there was just a rapid increase There was rapid growth taking place. There was an inventory stocking taking place and probably got out ahead of what demand was. Go ahead.

Josh, it's Tom. I just wanted to add on maybe for everybody else too. You know, our distributors, Lee touched on this early on, our distributors view inventory as a strategic advantage and they view it as a market share opportunity. So remember how rapidly the inflection was when we go from 16 into 17 and we're all growing at 8, 10%. So our distributors were really hustling to build those kind of inventory positions that they wanted to have. I think that correction in their sales and operating plan and correcting to current and demand probably didn't happen quick enough on their end. We had not the same kind of visibility that we would like to have because it lags by 30 days. And I think our technology, how we looked at it, But the fact that we are now trending this, it's easier to see trends versus it is to just look at raw data. I think you have all that phenomena, the rapid inflection, maybe an opportunity for distributors to take share and maybe being a little more aggressive on that. And now it's playing through. So I think we'll never have perfect visibility, but I think the data analytics we now have will give us a little better color when we give you a guidance going forward.

Got it. That's helpful. And then just to 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?

Justice, Tom, it continues to be one of our higher margin businesses, and I would say it was very much in line with with the total company as far as growth, you know, and the same kind of organic growth as the total company had. Remember, it's an industrial-orientated. It has, just like Lorde has, it has aerospace exposure as well. I think the difference of what Lorde brings that we're excited about is Lorde is a content shift for us on automotive. First, we'll remember that Lorde is 70% not automotive. It has a fantastic aerospace portfolio and a great industrial portfolio. Lord grew 14% organically in Q1. And if you factor in currency, they grew about 7%. So they have the same kind of currency headlines we have. But the automotive difference, like while we felt pressure on automotive, They did not feel the same kind of pressure because the bill of material for an HEV or an EV, if you look at the thermal management and the structural adhesives on light weighting, is about 10 to 20 times, that's the right number, 10 to 20 times their bill of material on a combustion engine machine. That's why they have the opportunity to not be impacted by automotive and why we were so attracted to them, plus the fact that they got this great aerospace portfolio that's growing just like ours and the job they're doing on industrial. So just look at their growth rate. You know, 14% organic growth in Q1 is, I don't care how you slice it, that's pretty darn good.

Understood. Appreciate the call, Tom.

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

Certainly. Then our final question for today comes from the line of Julian Mitchell from Barclays. Your question, please.

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

Julian and Tom, I'm still comfortable that we can expand those margins, absolutely. We've got tailwinds on just the wind strategy in general and all the things we're doing related to simplification, lean, supply chain work, and our value pricing strategies. We've still got upside on what we're doing from an innovation standpoint. And we're going to continue to get some tailwind as we continue to get better in the plants on the plant consolidations. The good thing is that we're seeing the progress. It was masked a little bit in Q3 because of those one-offs that we talked about earlier. But we still feel good about that trajectory. So I think you would expect normal type of incrementals coming on volume gain for North America going into next year.

Thanks. 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 and wondered in that light if 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 go through this softer top-line patch.

Yeah, Joanne, absolutely. I mean, we're pretty good at that. I mean, that's in our our pedigree, our track record, we'll make all those variable cost adjustments, whether it's overtime, temps, et cetera, you know, ratcheting back and having the whole variable cost structure match the order entry output. And we have some, you know, you can utilize attrition. There's a lot of things you can do to help you get there, and we track that religiously. So I would expect that that would not be a problem for us.

Great. Thank you.

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

Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.