Parker-Hannifin Corporation (PH) Q3 2019 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Parker-Hannifin’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. [Operator Instructions] I'd now like to introduce your host for today’s program Cathy Suever, Chief Financial Officer, Please go ahead.

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’d 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 years goals. If you remember, one of our key goals that we had at that time was to get to 70% [ph] operating margin by FY ‘20. And 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, and 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. And 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 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. And 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 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, deploy it as effective 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, and remember the connection between safety performance, engagement, and financial performances are a clear linkage between all those. We had strong operational quarter reflecting the benefits of the Win Strategy, and we 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 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, growth moderating and North America 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 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 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 that's performing at a very high level and it 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 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. And of course on Monday, we announced the agreement to acquire Lord Corporation for $3.675 billion and Lord was approximately $1.1 billion business, 23% EBITDA, and a leader in material sciences and vibration control technologies. And if I could just as a reminder, 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 which 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 long-standing blue-chip customer list that is very similar to our customer list, strengthens material science capabilities, electrification, light weighting, 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 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 how the macro environment turns out, and there's 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 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 CLARCOR acquisition, so lots of headroom as we continue to improve with the Win Strategy. Integration of CLARCOR is showing lots of promise, with upside -- continued upside to margins as we continue to improve on the manufacturing consolidation. And 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. 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 CAGR of 10% plus over that time period. So, in sum, we anticipate another record year for FY '19 and we're making progress toward that second generation of 5-year targets. And 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 are business realignment expenses of $0.03. This compares to fiscal 2018 adjustments of $0. 04 for business realignment expenses and the $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. 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 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 3% of currency impact and 0.5% from a prior year divestiture. Total segment of the 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 onetime 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 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 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 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 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 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 revenue synergies by fiscal '20. And 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. And 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.

Operator Instructions] Our first question comes from the line of Nathan Jones from Stifel. Your question, please.

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 where there this quarter?

Yes Nathan, its 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 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 was 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. So, 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. And then, while we were flat to prior year in volume, we were soft to the guide that we gave you. And so, those three things together, we were light by about 100 basis point 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, we of course we couldn’t foresee the Mexico labor thing when we did the guide or the mix in 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 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 4Q as well?

Yes. But that's reflected in our guide. We have that in the guide -- in our guide for Q4 is 18.1%, so still pretty nice margins for Q4 in North America, and that'll be better in prior year by 30 bps, but yet it'll still wait 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. And Cathy mentioned $75 million in additional synergies from CLARCOR this year. That would be 110 basis points by itself of margin expansions, 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, its Tom again. I think the full year is impacted by the same things that I've 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 CLARCOR, but that's how I’d characterize as 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 guidance, 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 color, 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.

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? Or what are maybe kind of some of the underlying things that is 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, noticeable inventory destocking in North America channel in Q3. And 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 in-plant automotive investment, which is -- it comes in waves depending on platforms and built schedules; continued softness in the microelectronics area; and then, softness on land-based oil and gas. And there's 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. So, I expect that to cycle its way through as time goes on. And then, just 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 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 market. So, I really put these markets in three buckets. And if I thought about distribution at a high level, it was pretty neutral for the quarter I'm not going to comment anymore and 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. 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. But 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 up 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%. So, 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 was impacted -- 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 on either one side or the other of 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, and that's really around machine tools and automotive and trucks. So, it'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. 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 4Q as well?

Yes. 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 Raso from Evercore ISI. Your question, please.

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 is the backlog 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. Just a couple of comments about really kind of how we formed our view for Q4. It was influenced by Q3's orders. So, we see a negative 6% in North America. And that kind of declined throughout the quarter. However, we saw an improvement in April to where -- and we really thought that our order entry rate at minus 6% was probably influenced by about 300 basis points by distributions destocking. 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 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 Q4. And then, Aerospace is a plus 3%, piggybacking on what Cathy talked about as far as the comparables to last year. So, it's hard, as you might imagine, to predict FY '20 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, looking at it in tables. And so, I think we need a few more months to know whether we can say that it's going to end in June. But, 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 -- the comps get a little bit better, but they're still pretty high. And so, maybe our first half is a little more challenged and the second half becomes a little more attractive when you look at some of the order entry comparables. I still feel very optimistic about the underlying growth. If I take distribution as an example and back out the destocking, our view is distribution was growing around 3%, low single digits in North America. And so, I think that's going to be there once the destocking plays through for the reasons that Lee went through. And we'll give you the visibility for sure when we get there, but I'm still optimistic. A lot of us -- this noise is going to play through. We have a couple of 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 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 hard to say. I think Q4 will still be -- we're forecasting to be soft for Q4 based on our guide. When you get to Q1, it's still a pretty good comparable, pretty tough comparable at a plus 8% for North America. So, I think you 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 that it's going to come through. The destocking will finish, the trade tensions will finish. But, 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 maybe to 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 a little weaker than people thought. And I'm not sure if there's any costs related that's going to allow you to be a little more aggressive next year. Just maybe frame that balance for us.

David's, it's Lee. I think we always try to price to win. So, 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.

I appreciate it, thank you.

All right, thank you David.

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

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? And if not, how does this reconcile, as I said, with your target of global industrial growth for plus 150 basis points? Thank you.

Andrew, it's Tom. So, the goal versus the global industrial production is really over a cycle, over multiple years. And if you look at us the last really two years approximately, we were growing in that anywhere from 6% to 10% organically. And so, we were clearly growing 2x to 3x 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 2015 and 2016, but more of a steady growth. And 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, LORD coming on and the synergies we'll get there, 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 LORD and all that. We still have an opportunity to hit that, and that's the plan.

And just a 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 any. Andrew, again, it's Tom. We've got really -- we had some softness in Q4 and 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 -- that underlying margin enhancement is still there, being offset by the volume. And we still have the distribution pressure with the destocking, with that mix shift hitting us. We'll still come in Q4 at 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 FY '20 that that destocking is going to play through. It's not going to continue forever and we're going to get some upside for that as we turn the corner into FY '20.

Thank you, so much.

Thanks, Andrew.

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

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. 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.

And I was also just wondering back on kind of the whole order equation. It looks like your organic revenues have historically very, very closely tracked your orders, right, 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 kind of 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. In general, you're right that our follow-up period orders tend to generate the next quarter's sales. With the exception of the destocking, it 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 improved better to where -- what you're seeing with that 2.5% is about what we saw in April. And our sense as far as when we talk to our distributors, we'll see the rest of the quarter. in a lot of cases on those type of orders, we can cycle them all within the same period.

Okay, thank you.

Thanks, Jeff.

Thank you. Our next question comes from the line of Ann Duignan from JPMorgan. Your question, please?

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 Hannover Fair and then at the bauma Show. And at the bauma Show, if you talked to industrial customers, it's generally soft. And I would -- a lot of it seems to be trade related in some way or another. So, these would be generally machine tool companies, et cetera. If you are in a construction equipment, forestry industry, you can't build equipment fast enough. So, there's still a high demand. Distribution markets are still strong throughout EMEA. And then, there's a little bit -- it's bouncing off a low number, but there's an acceleration around the world around 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 have on there. There is definitely softness around some of the industrial markets we're there. Construction equipment, et cetera, still seems to be still 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 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. So, it's like you said. It's Texas, Oklahoma, 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?

Yes. And also, we've got distributors that do a lot around in-plant 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 if you went out and talked to a lot of our other distributors, they're very positive about business even with -- 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.

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

Thank You Ann.

Thank you. Our next question comes from the line of Nigel Coe with Wolfe Research. Your question please.

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. 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 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. I think when you look at the comparables, I think we're going to -- the next quarter, we've given what we think for this Q4. I think when you go into FY '20, clearly, the first quarter Q1 of FY '20 has a pretty tough comp. And after that, everything has become more balanced. I do think that everything we -- when we do our discussions with our distributors, once this channel destocking plays through, we feel that that underlying growth -- when we look at the trend lines on [purchases versus sales] to our 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 net 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 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 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 kind of 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. And so, that's going to naturally, over time -- 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've done a very nice job with The Win 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 Win 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 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.

Yes. We're building off of what we did with the prior quarter, which Q3 came in very nicely at 16.5%. And so, 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. 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 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 cost are basically neutral. There's some that have softened or some that have accelerated and I would just expect this to be margin neutral here in Q4.

Thank you very much. Will get back in queue.

Thank you.

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

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. So, 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 [indiscernible] etc. 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. It's -- 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.

Our next question comes from the line of Josh Pokrzywinski from Morgan Stanley.

Hi good morning.

Good morning Josh.

Just want to follow up on a couple of things and I'll beat the dead horse a little bit more here or 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 sign 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?

Yes. Josh, so 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 periods. 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 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 over correction was. And then, the other things I talked about. Just kind of a slowdown in in-plant automotive and then continued softness in microelectronics. And then, lastly, I think we've been a little smarter here. We had that last 30 days of data because we do -- our distributors do report their sales. And we would have seen that. The data would have said something different than a phone interview. So, it would have helped.

Got it. But, I guess, within that, there's something that presumably felt less bad or got better, call it, 60, 90 days ago that maybe 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. There's a very good underlying growth happening throughout the country. It's just there was just a rapid growth taking place. There was an inventory stocking taking place and probably got out ahead of what demand was.

Josh, it's Tom. I just wanted to add on maybe for everybody else to -- 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 and their sales and operating planning correcting to current 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, by 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 that was -- 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 our guidance going forward.

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. And I would say it was very much in line with the total company as far as growth, in the same kind of organic growth as the total company had. Remember, it's an industrial orientated just like LORD has. It has aerospace exposure as well. I think the difference, what LORD brings that we're excited about, is LORD is 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 if you factor in currency, they grew about 7%. So, they have the same kind of currency headwinds we have. But the automotive difference, like while we felt pressure on automotive, they do not feel the same kind of pressure because the bill of material for an AGV or an EV, if you look at the thermal management and the structural adhesives on light-weighting is about 10 times to 20 times. That's the right number, 10 times 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've 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. 14% organic growth in Q1 is -- I don't care how you slice it, that's pretty darn good.

Understood. I appreciate the color Tom.

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.

Maybe just a quick one around the North America margin outlook. Just wanted to sort of test your conviction. And 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, 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, supply chain work and our value pricing strategies. We still got upside on what we are doing from an innovation standpoint. And we're going to continue to get some tail wind as we continue to get better 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 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.

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, 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?

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 over time, temps, et cetera, ratcheting back and having the whole variable cost structure match the order entry output. And we have some -- 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.

Thank you.

Thanks 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.

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