Curtiss-Wright Corporation (CW) Q3 2018 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Curtiss-Wright Third Quarter 2018 Financial Results Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions]. As a reminder, this call is being recorded. I would now like to introduce your host for today's conference, Jim Ryan, Senior Director of Investor Relations. You may begin.

Thank you, Sara. And good morning, everyone. Welcome to Curtiss-Wright's Third Quarter 2018 Earnings Conference Call. Joining me on the call today are Dave Adams, our Chairman and Chief Executive Officer; and Glenn Tynan, our Vice President and Chief Financial Officer. Our call today is being webcast, and the press release as well as a copy of today's financial presentation are available for download through the Investor Relations section of our company website at www.curtisswright.com. A replay of this call also can be found on the website. Please note today's discussion will include certain projections and statements that are forward-looking as defined in the Private Securities Litigation Reform Act of 1995. These statements are based on management's current expectations and are not guarantees of future performance. We detail those risks and uncertainties associated with our forward-looking statements in our public filings with the SEC. As a reminder, the company's financials and guidance includes an adjusted non-GAAP view that excludes first year purchase accounting costs associated with this acquisition. Reconciliations for current and prior year periods are available in the earnings release at the end of this presentation and on our website. Also please note any references to organic growth, excluding the effects of foreign currency translation, acquisitions and divestitures, unless otherwise noted. Now, I'd like to turn the call over to Dave to get things started. Dave?

Thanks, Jim. Good morning, everyone. For our agenda today, I'll begin with the key highlights for the third quarter and an update on our full year 2018 outlook. Then, I'll turn it over to Glenn to provide a more detailed review of our third quarter performance, as well as updates to our 2018 guidance. Finally, I'll return to provide some color on the AP1000 program and wrap up our prepared remarks before we move on to Q&A. We delivered yet another strong quarterly performance ahead of our expectations led by higher sales and improved profitability in the Power segment. Adjusted operating income rose 6% overall, on a 5% increase in sales, generating a 20 basis point improvement in adjusted operating margin to 16.5%. This solid performance drove adjusted diluted EPS of $1.70, up 19% year-over-year, which also included the benefit of a lower effective tax rate and continued share repurchase activity. New orders decreased slightly in the third quarter, principally due to timing, following a very strong second quarter. Year-to-date, orders were up 6%, led by solid demand in naval defense. Based on the strong operational performance thus far in 2018 and our outlook for continued momentum through the end of the year, we increased our full year outlook for operating margin, diluted EPS and free cash flow. We increased full year 2018 adjusted diluted EPS guidance by $0.10 to a new range of $6.10 to $6.25, representing year-over-year growth of 23% to 26%. We also raised our free cash flow outlook by $10 million and are now guiding to an adjusted free cash flow range of $310 million to $330 million. Now, I'd like to turn the call over to Glenn to provide a more thorough review of our third quarter performance and financial outlook for 2018. Glenn?

Thank you, Dave. And good morning, everyone. I will begin with a review of our third quarter end market sales. Overall, we experienced a 4% year-over-year increase in sales to our defense markets, while sales to our commercial markets increased 5%. Starting with the defense markets, in aerospace defense, our results reflect solid demand for flight test equipment, most notably on fighter jets, which was more than offset by lower sales on various UAV and helicopter programs. In ground defense, we experienced lower sales of embedded computing products on various domestic and international programs. And finally, in naval defense, which drove our overall defense market growth, our results reflect the solid contribution from our DRG acquisition, most notably for increased CVN-80 aircraft carrier and service center revenues. Moving to the commercial markets. In commercial aerospace, core sales of OEM products and services were up 7% in the quarter, but were more than offset by reduced revenues from FAA directives, which we expected as these programs continue to wind down. In the fourth quarter, we expect this end market to show positive year-over-year growth, driven by higher production revenues on narrow-body aircraft. In power generation, strong growth of 15%, principally reflects a significant increase on the China Direct AP1000 program as well as higher nuclear aftermarket sales, due primarily to the seasonally strong fall outage season. And finally, in general industrial, solid sales growth of 5% reflects increased demand across a number of energy and industrial applications, most notably for industrial valves. Next, I will discuss the key drivers of our third quarter 2018 operating performance. Please note that I will refer to adjusted results as noted on the slide, which exclude the first year purchase accounting costs for DRG. Starting with the Commercial/Industrial segment, operating income decreased 4% and operating margin was down 70 basis points to 15.2%. This performance reflects a combination of unfavorable mix and unfavorable absorption on lower sales of actuation systems, due primarily to the winding down of the FAA directives. Those impacts were partially offset by savings generated from our prior year restructuring initiatives. In the Defense segment, operating income was flat, while operating margin increased 60 basis points to a healthy 24.3%. Profitability in the quarter was favorably impacted by FX. In the Power segment, adjusted operating income increased 66%, while adjusted operating margin increased 470 basis points to 18.2%. This performance was mainly driven by higher revenues and profitability on the China Direct AP1000 contract, as we continue to produce favorable cost performance on the program. DRG also contributed to the operating income in the quarter. So in summary, overall Curtiss-Wright third quarter adjusted operating income increased 6%, driving a 20 basis point improvement in adjusted operating margin to 16.5%. Next to our 2018 end market sales guidance, where we've highlighted a few changes in blue on the slide to reflect a net $15 million decrease in the Defense segment in total Curtiss-Wright sales. As a result, we now expect overall Curtiss-Wright sales to grow between 7% and 9%, including 4% to 6% organic growth. We now expect aerospace defense sales to grow 8% to 10% and naval defense sales to grow 19% to 21%, principally due to a shift in system sales into 2019. Despite those changes, overall defense market sales are still expected to show healthy growth of 12% to 14%, 4% to 6% organically. Meanwhile, overall sales growth in the commercial markets remain unchanged at 3% to 5%. The updated 2018 sales waterfall chart is available at the end of this presentation and will be available on our website. Moving to our 2018 financial outlook. Starting with sales, the aforementioned decreases in end-market sales impacted only the Defense segment, where we now expect sales to be up 1% to 3%. Our Commercial/Industrial and Power segment sales guidance remain unchanged. Regarding our 2018 profitability, I'll begin with the Commercial/Industrial segment, where we lowered operating income guidance by $3 million, mainly due to potential risks associated with tariffs. As a result, Commercial/Industrial segment adjusted operating margin decreased 30 basis points to a new range of 14.8% to 15%, which is still expected to be up 30 to 50 basis points compared with 2017 results. Next in the Defense segment, despite a net $15 million reduction in sales, we increased our adjusted operating income guidance by $2 million due to the anticipation of favorable mix with lower margin system sales shifting into 2019, offset partially by higher sales of higher margin COGS. As a result, Defense segment adjusted operating margin increased 90 basis points to a new range of 22.4% to 22.6%, up 100 to 120 basis points compared with 2017 adjusted results. Moving to the Power segment, following the strong year-to-date performance, we increased our operating income guidance by $3 million, due to higher profitability on the China Direct AP1000 program. As a result, adjusted operating income is expected to grow 26% to 29%, while adjusted operating margin is expected to increase 80 to 100 basis points to a new range of 15.5% to 15.7%. We also increased corporate costs by $2 million to reflect our expectations for higher pension costs. Total Curtiss-Wright adjusted operating income remains unchanged, while overall adjusted operating margin guidance increased 10 basis points to a range of 15.3% to 15.5% and now reflects a 60 to 80 basis point increase compared to 2017 adjusted results. Continuing with our 2018 financial outlook, we reduced our full year effective tax rate guidance from 24% to 23% based on the year-to-date run rate, which added $3 million to our net income guidance. We also lowered our share count slightly to reflect the additional third quarter share repurchase activity. In total, these changes along with our confidence in our full year operating performance resulted in an increase to our full year 2018 adjusted diluted EPS guidance range of $6.10 to $6.25, up 23% to 26% over 2017 adjusted results. Next to free cash flow. Based on our strong operational performance and continued efforts in working capital management, we raised our full year 2018 free cash flow guidance by $10 million. 2018 adjusted free cash flow, which excludes the $50 million voluntary pension contribution made earlier this year, is now expected to range from $310 million to $330 million, with an adjusted free cash flow conversion rate of approximately 115%. Also, as we highlighted last quarter, we continued to repatriate cash from our foreign operations. During the third quarter, we repatriated $40 million, bringing our year-to-date total to $190 million. As part of our ongoing balanced capital allocation strategy, part of this cash is being used to repurchase shares under a $50 million 10b5-1 plan filed in May. In addition, we used some of the funds to prepay $50 million of our senior notes on October 15, which will have a positive impact on our interest expense going forward. And finally, on October 17, we amended and extended the terms of our $500 million revolving credit agreement. The agreement now matures in 2023, has an increased accordion feature of $200 million and reflects more favorable pricing and covenants based upon our strong balance sheet. The successful completion of this financing provides us with continued flexibility to execute on our disciplined and balanced capital allocation strategy. Now, I'd like to turn the call back over to Dave to conclude our prepared remarks. Dave?

Thanks, Glenn. Before my closing remarks, I wanted to provide a few updates on the AP1000 program. Westinghouse and its partners in China recently announced that both for Sanmen Unit 1 and Haiyang Unit 1 AP1000 nuclear reactors have successfully achieved commercial operation and are producing power. This is an exciting milestone for the world's first Generation III+ reactor. Naturally, we've been getting questions from the investment community about the timing of the next order for Curtiss-Wright RCPs. While it's a great sign that the first Chinese AP1000 reactors are now in commercial operation, we don't believe it's prudent at this time to speculate about the exact timing of our next order. We can, however, acknowledge that China's demand for significant growth in new nuclear power plants and AP1000 in particular remains solid, while India and other countries have also expressed interest in this reactor design. With regards to our current China Direct AP1000 contract in February, we'll provide updated revenue, free cash flow projections for the remainder of this contract along with the typical release of our 2019 financial guidance. In summary, from an enterprise perspective, we look forward to a solid finish and another strong annual performance in 2018. We expect synchronized sales growth in all end markets, generating 4% to 6% organic growth and 7% to 9% overall growth. We are driving solid operating margin expansion with expectations for 60 to 80 basis points of improvement over 2017 led by improved top-line growth and our ongoing margin improvement initiatives. We remain focused on maintaining top quartile financial metrics and still have additional runway on this journey, which will be further influenced by continued organic growth across our markets. We also expect to deliver strong double-digit growth in adjusted diluted earnings per share and generate more than $310 million in adjusted free cash flow, with a conversion rate of 115%. And we have a strong and healthy balance sheet. As we conclude this year and look ahead to 2019, we will continue to deliver on our long-term strategy and generate solid financial results for our shareholders. At this time, I'd like to open up today's conference call for questions.

[Operator Instructions]. Our first question comes from the line of Kristine Liwag with Bank of America. Your line is now open.

Dave, can you provide more color on how you're thinking about the Department of Energy export licenses for the AP1000. Proverbially, the cat's out of the bag, since you've already done or completed -- you've completed a technology transfer with China a decade ago. So why is this even an issue?

Yes. It's a question that's been bowling around for a little while now, certainly in light of the new policies that seem to be coming out more recently. We're in good shape certainly on the current order we have with China Direct. They're in continued conversation on the future and what sort of process will go through, but it looks very positive for us. And as you indicated, this technology transfer happened long time ago, and most of our -- all of our constituents that are part and participant in that process of giving the approvals have been involved and have been having dialog over it to that point that it was given, and they are fine with it. Our Nuclear Navy customers are fine with it. So we don't anticipate that it's going to be the upcoming problem. If anything, it might be a little bit of a speed bump from a time lag, from that kind of a perspective, but so far so good. And like I said, with China Direct order that's in place today, that's in place, it's moving along, and we don't anticipate any kind of a problem there.

And since you already have the technology as IP out of the country, is there flexibility for you to build a manufacturing plant in China if need be?

I guess, I suppose it would be feasible. It's not something that would likely ever occur. As you know, the Chinese are working on a prototype, and they will want to build in country. And frankly, the best thing for us all is for them to be highly successful in the AP1000 plant and all associated manufactured, all it does is it spurs on the interest in furthering the interest of the AP1000 nuclear power plant as being something extremely viable. So it's probably something we could do, but it's not very likely.

Great, thanks for the color on that. And switching gears to Defense. Can you provide more color on what's driving that weakness on Defense? When we see the Defense contractors report earnings so far, it looks like procurement are largely up. So why is your embedded computing business down for helicopters, UAVs and ground programs? Are there specific programs that are driving this decline? Is this a market share issue or a timing issue?

Well, it's -- I'll start, at least. It is a timing issue, if you realize in the defense markets in the first half, we were up organically 10%. So we did expect a little bit slower rate in the second half of the year. Last quarter, we talked about some timing issues, particularly with Q3 in the Defense segment in the embedded group with some revenue recognition coming earlier than expected as well as some favorable contract adjustments in the Navy. So that's having -- it's a timing impact as well. In the Power segment, they're down a little bit in Q3 due to timing on the submarine revenues, which as you know have fluctuates. Q4 is typically our largest quarter, we are expecting solid sequential ramp in Q4. And for the year, we expect a healthy 12% to 14% growth, 4% to 6 % organically. So I would look at the third quarter as a timing issue for sure in Defense …

Great. Thank you for the color.

Thank you. Our next question comes from the line of Nathan Jones with Stifel. Your line is now open.

Just a question first on the C&I margins down 70 basis points year-over-year, and I think in the press release, you guys called out lower profitability for sensors and controls products. Is there a price cost issue there? I think we've heard about some of those kinds of products potentially having some limited availability out there at the moment, has that pushed prices up you've not been able to pass it through yet? Any color you can give on that side of the business.

I mean we were -- sensor, I think we were down, I think what you're referring to, we said in the quarter, because we had some impact from unfavorable mix with higher actuation, which is lower margin and lower sensors which are higher margin. Other than that, that again is a timing issue with us. It fluctuates from quarter-to-quarter. It's like task and thesis I think. They tend to fluctuate from quarter-to-quarter, but they do have an impact on the margin, and I think that's what you're referring to.

Okay. So it's a mix issue, not a profitability issue on the individual products.

Correct.

Okay. So that makes sense. Can you maybe comment a little more broadly on the overall order rates? I mean you had orders in the quarter down 1%, despite adding Dresser-Rand in. Can you talk about where the timing issues were on the order rates, maybe any color you can give on what kind of expectation you have for orders over the -- in next quarter, in next 12 months. Anything you can help us out with there?

Sure. I mean, orders in generally for us is always a timing issue. It's -- we were lumpy, especially with big contracts in Commercial, Power and Defense. But I'll look at this way, orders were up 6% and as Dave said, year-to-date, our backlog is up 4% from 12/31/17. If you remember, we had very strong orders in Q2, we had $150 million in incremental defense orders in Q2, that will add to some timing in Q3 as well. I will say in the third quarter, we did get a large order for DRG for the balance of their CVN-80 contract, but we are expecting a sequential increase in orders in Q4 and expect to be at 1.0 book-to-bill for the year. So you'll see big orders, fairly steep orders increase in Q4. It's timing.

So is it fair to say then that the timing is not really that things got pushed out of 3Q to a latter date. It was that they were potentially recognized earlier in the year and maybe left a little bit of a gap here in the third quarter?

Correct. I mean, the third -- the second quarter was huge. I mean, again, we had $150 million of incremental defense orders in Q2 alone and that happens, the defense business orders, especially are lumpy and when they come, they are big and they cause lumpiness from quarter-to-quarter. That's all it was.

Got it. Certainly better to be telling people that you got orders early rather than that they shifted to their right.

Correct.

So thanks very much for the color.

Thank you. Our next question comes from the line of Sam Pearlstein with Wells Fargo. Your line is now open.

Glenn, I wanted to just go back on something you had said before. You talked about some of the timing in terms of the defense, and just looking at defense, aerospace and Navy, you did reduce the sales, you mentioned some of the system sales in the Navy getting shifted to next year. But really I guess, I'm just trying to think about in general, what's gotten pushed out versus it's not going to happen, where the customers not going to buy?

No, it's pushed out. It's orders we expected to hit in the fourth quarter, that pushed into 2019 and the customers drives that schedule. That's all it is.

And is that the same for the aerospace piece as well as the Navy?

Yes.

Okay. And then I know you were just talking about the order activity and what the strong prospects for the fourth quarter, but just trying to think about across the board. Are you starting to see any slowing order activity in any of the end markets or anything that would cause you some concern in terms of a change in the sales outlook as we go forward, not just in '18 but beyond, as those orders would get filled?

No, nothing in particular. No, Sam. No.

All right. And then last -- go ahead.

No, again, it's timing. It's not -- so it's not a trend here. It's the way our orders fluctuate.

Okay. And then just looking at the income statement, it shows G&A expenses up 14% year-over-year. Is there something unusual as to why there was such a big jump there this quarter?

Yes. Good question. There's two things. While part of it's DRG. DRG is most of it. And the other is, in the third quarter, we had a pension true-up. There are pension plans of $3 million or $3 million or $4 million, whatever it is. It's somewhere in that area, and those hit in the quarter and year-to-date.

And does that moving out -- does that new pension level continue into the fourth quarter or is that a one-time true-up?

It's a one-time true-up.

Okay. Thank you.

Thank you. Our next question comes from the line of Myles Walton with UBS. Your line is now open.

Hey. I was hoping you can go back to your comment -- at the tail end of your comments. I think you said in January you provide an update on the AP1000 revenue cash flow outlook going forward on the China contract. Does that imply that there has been a change from what you guys were looking for previously, aside from just the shifting out of revenues that you've done through the course of 2018 or what kind of update is there? What I was looking for, I guess, into next year is maybe a headwind of $25 million on cash flow from advance burn and a little bit of revenue growth. Is that different today?

It has moved around. As we mentioned last quarter, again, we're not ready to go into the details yet, but we're going to provide you what the remaining timing of the revenues are and same with the cash flows. When the -- cash flows have gone up, profitability has gone up on the contracts, so the cash flow. So we wanted to take an opportunity to just do a reset. We're just not ready to do that right now.

But it sounds like this is an asymmetric reset to the upside or --

I'm not going to speculate on that right now. We'll tell you in February.

Okay, all right. The other question I had for you was the margin performance, obviously, continues to tick up through the course of the year. How much of this mid-15% adjusted margin run rate kind of is a good planning rate as we proceed into next year? Is there any headwinds or tailwinds you'd like to reset us on?

I don't really -- no, I don't have one right now that I -- it is -- I think that's a good way to start the year for sure.

Okay, all right. And then the last one for me is on the aerospace -- Commercial aerospace piece. What kind of trends are you seeing there? I know in the quarter -- and I'd like to over read into a quarter, but obviously, in the quarter on your end market, the walk you had, commercial aero's down, I guess 3% or so. What -- and I guess, flat for year-to-date. What kind of underlying trends in that bucket of commercial aerospace are you seeing as it relates to large aircrafts, business jets, any color you can provide.

Well, the core revenues before these FAA directives, I think we said were up 7% on higher production rates. On most of the narrow bodies, up 7% in the quarter, we expect them the core revenues to be up 10% for the year, but we've been impacted by these FAA directives on the 767 and the 737, which are winding down, and we shouldn't probably have to talk about them much. So I think you'll see -- I think we did say on the script, you're going to see positive year-over-year growth in the commercial aerospace market in the fourth quarter and that can be seen as a trend for us.

Okay, okay. All right, great. I think I'll leave it there. Thanks.

Thank you. Our next question comes from the line of George Godfrey with CL King. Your line is now open.

Thank you for taking my question. Glenn, I heard everything you said on the orders, and I just want to push like just a little bit more here. If I look at my book-to-bill ratios over the last five years, this quarter at 0.86 looks to be one of the lowest in that five-year period. And if I look at the booking, I haven't seen the Q3, because I don't think the 10-Q is out by segment, it looks like Power and Defense orders last quarter were really strong, but Commercial/Industrial were down 4%. So if we go on a segment-by-segment basis, the Power probably is continuing to be strong, but could there be some weakness in addition to the timing that perhaps may be is temporary because the backlog of being down sequentially, and, again, that book-to-bill being below 0.9 and I recognized below 1 is normal for Q3, but it just seems like it's a little bit weaker. So I'm just trying to get a sense of the magnitude of perhaps business activity versus timing of orders? Thanks.

Yes, sure. I mean, at Commercial/Industrial, orders were down 4% year-over-year, that's mostly in the defense, in the valves business in that segment. And the Defense segment was down 14%, and that's what I was talking about with the orders in the second quarter being extremely high, and we do have a big ramp overall. I don't have it by segment right now in orders in the fourth quarter. Power was up 28%. Those are the numbers for the quarter. I'm sorry. George, go ahead.

I was going to say, so, if we sit here today at the end of Q3 '18 as we look into the rate of business momentum going into '19, you feel it's the same today as it was a year ago at this time going into '18.

Again, things have shifted around, but I feel good -- like I said, we have a good fourth quarter coming up, we are going to be back to 1x book-to-bill. So I think that's a little momentum going into next year, but it's quarter-to-quarter, and I keep pounding the same drum, and sorry, if I'm repeating this up, but our orders are lumpy. We get $150 million incremental orders one quarter. We get a $450 million commercial power entry on the last day of the year. I mean, those things happen. But we kind of look at the whole year and I don't see any trends in orders that see anything different than what we're seeing now for the year going forward.

Okay. And then -- and my last question, if I look at the free cash flow targets for this year and it looks like working capital with the pension contribution will be roughly $45 or $50 million drag. You've done a great job at bringing down the working capital to improve free cash flow. Now going forward, you think working capital is more of a neutral as opposed to necessarily a positive or negative. And I'll leave it there. Thanks.

I'd hate to say, neutral. I mean, it's like anywhere else, even our journey to top quartile on operating margin. You can always be doing 100 basis points every year, although, take it back -- we get close to it every year, but it's the same thing like you're saying with working capital. We've been hammering and blocking and tackling. I'm not ready to say it's neutral yet, but we intend to remain in the top quartile. So we're not going to let it go up. I still think there is always little pits of opportunity for improvement, but it won't be big massive changes. But I'm not ready to say neutral yet. We're still working on it.

Understood. Thank you for taking my questions.

[Operator Instructions]. Our next question comes from the line of Michael Ciarmoli with SunTrust. Your line is now open.

Much better results than we've seen from the giants. So that's good. Just to stay on, back to Defense, and you keep talking about timing. I mean, I know you guys raised the Defense forecast toward the end of July, and then lowered here. Is it simply something one definitive order, something changed on that Navy side that pushed out is the biggest driver, because it sounds like you knew there were definitely timing issues in Defense back when we spoke last quarter. So something cropped up here incrementally new?

Well, last quarter, we increased, because year-to-date we had a very strong first half, there a couple of one timers -- not one-timer but timing issues with the second half of the year and some things that led to increase our guidance. This is new news for us, this quarter is the close we get to year end and we're hearing from customers of our -- some of our systems products or some of our customers for our system product telling us we're not -- the orders are going into '19, that we did -- that's new news. We didn't know that in the second quarter.

Okay.

Yes.

Yes. Perfect. And what was the Defense segment book-to-bill in the quarter.

Defense was 0.83.

0.83. Okay. And then the last one I had just on within the Commercial segment, on the general and industrial side, we've seen some pretty good momentum there and I think revenues have been growing almost on a sequential basis since late 2015 and they were down 6% sequentially 2Q to 3Q. Any -- you called out some of the, I guess the mix out there, but anything you're seeing from a demand environment in the different end markets or geographies within that general industrial segment, that's kind of giving your reason for pause or you think the growth trends are still firmly on track there?

No. It's more typical, what goes on in that industry, which is cyclical. I mean, from a timing standpoint, we did have a stronger than expected first half at 10% growth, and we did expect based on that the second half, slower growth. I think it's around 7% in the second half. I mean on highway Class 8 industry dropped their forecast slightly in the middle of the year. It's typically slower in the industrial segment in Europe in second half, there are summer holidays, they do year-end management. So that it's a cyclical thing. And the --and we are seeing -- have seen a little bit of delays due to some of these electronic component shortages, so that's kind of a newer trend. But at the end of day, we still expect 8% to 10% growth in this market year-over-year. So it's the cyclicality. We went through this -- we go through this almost every year with the second half of the year.

Got it. Helpful. Thank you, guys.

Thank you. Our next question comes from the line of Walter Liptak, Seaport Global. Your line is now open.

Hi. Okay. So I feel like I'm in a beat a dead horse on a couple of things. But here we go. In the Power segment, can you talk to us a little bit about the strong earnings this quarter. And just help me understand, just the details behind the timing of the earnings? And what earnings will look like for the fourth quarter?

Sure. But so sales are up, but remember, part of it is DRG so in the third -- so they have a little bit lower incremental margin. So in the quarter, we'd have $8 million roughly on incremental margin on the higher sales. They did have improved profitability on the China Direct AP1000 contract, there is a contract margin adjustment in Q3. They had favorable mix with higher margin aftermarket services, again, with the aftermarket going through their fall outage season. And Q4 is a little bit different. We have sequentially a couple of things, headwinds hitting us in Q4 in this Power segment, we expect to make additional investments of about $3 million in IT security for our DRG acquisition, and we do have $1 million of incremental R&D, which would bring the margin for the year back down in line with our guidance. So we did have a couple -- the contract adjustment was a news, I'll pick. I told, I said when we first started this contract, we put out guidance with initial guidance of 23 plus. I think you guys have figured out, it's obviously we're plus more than 23%. That margin was based on estimated costs up or down, if the cost go down, it's favorable, and we've been favorably performing from a cost standpoint. And it also include the risk reserves, and if we mitigate risks that would increase the profitability, that's a little bit of what you've seen in the third quarter. So things are going very well on that contract. But the fourth quarter, we do have a couple of things, that brings to back down in line with the guidance.

Okay, got it. And just to clarify, so with the contract adjustment, it sounds like it's all positive, it's not like you make an adjustment for this quarter but for next quarter, you don't get that same adjustment.

Right. It's not …

Or there's a negative related to that contract adjustment for the fourth quarter.

No, it's not a negative, but it doesn't repeat. Well, it may, but it would be for something different. This particular adjustment doesn't repeat.

All right. Let's hope. Okay. And then just to go back into industrial and maybe to try and ask a couple of more specific questions, you called -- in industrial valves, I think you called out something, where you saw some softening. I wonder about oil and gas-related midstream, downstream, how that's going, how pricing is looking?

I thought the valves were up in the quarter. So it's not softening, that's a slow, slow comeback. I mean, it's coming back. The orders are slowly increasing, but no, we said they were up in the quarter in the industrial valves.

Okay, good. I misunderstood. Okay. And how -- and are you getting pricing?

I'm sure, there is still some -- pricing issue is still there. But it's -- we haven't -- it was probably a year ago, we heard the pricing screams, but haven't really heard much about that lately, saying the truth. I think that's …

Okay. And no one has asked about surface treatment, which I know you guys still talk about that much. But how's that trending? I think it's very general industrial house price cost and surface treatment?

Well, surface treatment is in terms of 2018 are up 4% to 6%, similar to our organic -- overall organic growth.

Okay. And the price cost is fine I guess?

Yes.

Okay. All right. Thank you.

Thank you. There are no further questions at this time. I would now like to turn the call back to Dave Adams, Chairman and Chief Executive Officer, for any further remarks.

Thanks everyone for joining us today. We look forward to speaking with you again during our fourth quarter 2018 earnings call. Have a great day.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. You may all disconnect. Everyone, have a great day.