Good day ladies and gentlemen and welcome to the Q3 2017 RBC Bearings Earnings Conference Call. At this time, all participants are in listen-only mode. Following the prepared remarks, we will host a question-and-answer session, and our instructions will follow at that time. As a reminder to our audience, this conference is being recorded today for replay purposes. It is now my pleasure to hand the conference over to Mike Cummings with Alpha IR. Sir, the floor is yours.

Good morning and thank you for joining us for RBC Bearings' Fiscal 2017 Third Quarter Earnings Conference Call. With me on the call today are Dr. Michael J. Hartnett, Chairman, President and Chief Executive Officer; and Daniel A. Bergeron, Vice President and Chief Financial Officer. Before beginning today's call, let me remind you that some of the statements made today will be forward-looking and are made under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those projected or implied due to a variety of factors. We refer you to RBC Bearings' recent filings with the SEC for a more detailed discussion of the risks that could impact the company's future operating results and financial condition. These factors are also described in greater detail in the press release and on the company's website. In addition, reconciliation between GAAP and non-GAAP financial information is included as part of the release and is available on the company's website. Now, I'll turn the call over to Dr. Hartnett.

Thank you, Mike, and good morning. The format this morning will be the same. As usual, I'll provide an overview and turn it over to Dan Bergeron, our CFO, to give you some of the details on the financials. Net sales for the third quarter fiscal 2017 were $146.7 million versus $144.2 million for the same period last year, a 1.7% improvement. Our aerospace and defense markets increased 1.2% on a year-over-year basis and our industrial markets were up 2.7%. Industrial distribution showed a slight contraction of 1.5% while OEM sales showed an expansion of 4.7%. For the third fiscal quarter of 2017, sales of industrial products represented 34.7% of our net sales with aerospace products at 65.3%. Adjusted gross margin for the third quarter 2017 was $55.6 million or 39.7% of net sales compared to $54.1 million or 37.5% for the same period last year. Again, mixed timing plays a dominant role here. As discussed in earlier calls, we see margins more reflective of our historical levels as we continue to integrate the Sargent businesses and both rationalize as well as tune our existing product offering and sales channels to better meet the demands of the market and advance our business. We still expect some modest headwinds due to new program start-ups. Let me back up a minute. However, incoming quarters for the products – yeah, we still expect some modest headwinds due to new program start-ups both in North America and Europe as we expand capacity to support long-term programs and should see volume increases as a result of – for new aircraft products on both continents early next year. This expansion will begin to contribute to revenues in the second quarter of fiscal 2018. I'm pleased to report that we seem to be moving through the start-up…

Okay. Thanks, Mike. SG&A for the third quarter of fiscal 2017 was $25.7 million compared to $23.9 million for the same period last year. The increase of $1.8 million was mainly due to $0.9 million in personnel-related cost, $0.4 million of incentive stock compensation, $0.2 million in professional fees and $0.3 million in other items. As a percentage of net sales, SG&A was 17.5% for the third quarter of fiscal 2017 compared to 16.5% for the same period last year. Other operating expense for the third quarter of fiscal 2017 was an expense of $6.1 million compared to expense of $2.6 million for the same period last year. For the third quarter fiscal 2017, other operating expenses were comprised mainly of $3.8 million of integration and restructuring cost and $2.3 million in amortization of intangible assets. Other operating expense for the same period last year consisted mainly of $2.5 million in amortization of intangible assets and $0.1 million of other costs. Operating income was $20.5 million for the third quarter of fiscal 2017 compared to operating income of $27.1 million for the same period in fiscal 2016. On an adjusted basis, operating income would have been $27.6 million for the third quarter fiscal 2017 compared to $27.6 million for the same period last year. Adjusted operating income as a percentage of net sales would have been 18.8% for the third quarter of fiscal 2017 compared to 19.2% for the same period last year. For the third quarter of fiscal 2017, the company report a net income of $12.8 million compared to net income of $17 million for the same period last year. On an adjusted basis, net income would have been $17.4 million for the third quarter of fiscal 2017 compared to net income of $17.3 million for the same period last year. Diluted earnings per share was $0.54 per share for the third quarter of fiscal 2017 compared to $0.73 per share for the same period last year. On an adjusted basis, diluted earnings per share for the third quarter of fiscal 2017 would have been $0.73 per share compared to an adjusted diluted EPS of $0.73 per share for the same period last year. Turning to cash flow, the company generated $36.1 million in cash from operating activities in the third quarter of fiscal 2017 compared to $21.5 million for the same period last year. Capital expenditures were $4.8 million in the third quarter of fiscal 2017, compared to $4.8 million for the same period last year. In the third quarter fiscal 2017, the company paid down $35.1 million of debt, and we purchased $1.2 million of company stock. On a nine-month basis, the company paid down $69.4 million of debt and repurchased $4.8 million of company stock. I'd now like to turn the call back to the operator for Q&A session.

Thank you, sir. Our first question will come from the line of Kristine Liwag with Bank of America. Please proceed.

Hi. Good morning, guys.

Morning.

Good morning.

I wanted to follow up a little bit more on the restructuring. Can you provide a little bit more detail on why you decided to restructure this facility now, and should we expect to see more restructuring activity in the future if we do see industrial demand pick up?

Well, with the downturn in industrial demand last year, we were in a situation where we had to sort of rationalize our production capacity and sort of reduce our overall manufacturing footprint for those products. And so the net result of that was this restructuring charge. Now, going forward, I think time will tell. I mean, we're always looking for a more efficient way of execution and a more efficient way of getting our products produced and supplied to the customer. And we're really always weighing the alternative scenarios on what we might consider as underperforming businesses or maybe interesting combinations of businesses that would be a more efficient way for us to manufacture the product. So, time will tell on that, it's kind of our job to kind of screen through those options and determine what's the best way for the company and we continue to work on that.

Great. And switching gears to aerospace, Boeing is planning to increase the 737 ramp to 47 per month from 42 in 3Q calendar 2017. Are you seeing pick-up in demand now to prepare for this increase? I mean, I know your aerospace position is largely narrowbodies, so this should be a pretty big pick-up for you.

We normally see that, Kristine, about six months ahead of their rate. So we should begin to see this this quarter. Our incoming quarter rate – order rate for the aircraft products has sort of been normal. We haven't seen that bump in demand yet. But we're contracted on all the products that we've always been contracted for on that 737. So, we should begin to see that soon.

Great. And maybe a housekeeping question for Dan. With SG&A with 17.5% as a percent of sales, is that the going run rate that you think the business would operate, 17.5%, or do you think for the full year, it's going to normalize more towards 16%, 16.5% range?

Yeah. I think by the end of the year, we're back in that 16.5% range. It's just that the third quarter is always our lowest top line volume, so – and we are investing a little more in human capital given some of the turnaround in our industrial markets which is a little bit of pressure on that line.

Great. Thank you.

Thank you. Our next question will come from the line of Steve Barger with KeyBanc Capital Markets. Please proceed.

Hi. Hey, good morning, guys.

Good morning, Steve.

You said incoming industrial orders over the past four weeks have been spectacular. What is that on a year-over-year basis? And what end markets are you seeing the most strength from?

Well, it was over the past 12 weeks, Steve. And....

Sorry. 12 weeks, right?

So, it's four weeks. I would not really mention it. But 12 weeks seems like it's worthy of mention. And the second part to your question, how strong. In some cases, it's up more than 50%. So, that strong. And what was the third part of your question?

What end markets specifically are you seeing that, in construction or mining...?

No, no. It's really – it's from oil and gas. What you're reading about is actually turning into orders for us, it's from general industrial products, it's from the bottling, the canning, the plant MROs all over the country are starting to order at accelerated rates. So, it's a big sea change in that whole business that we weren't expected but we're happy to participate in it.

Yeah. I mean, that sounds really positive. When you think about what happened to industrial markets over the past few years and how things are shaking up, what would you expect your revenue growth rates on the industrial side could be year-over-year for the next five or six quarters?

I think our challenge, Steve, is going to be to put the capacity back because we didn't liquidate and we have a substantial manufacturing footprint there. And the – all the cost associated with the normal operating environment is human cost. So we have to – we're going to be capacity constrained if these rates continue. And we're talking about the effects of that right now, and the constraint will be a human constraint.

So, I guess in that context, I didn't understand your answer to the first question on the call. The heart of the industrial downturn was last year. Orders for the past 12 weeks, per your comments, are really strong. In the press release you said you want to position for a period of increasing industrial demand. So, why consolidate the facility now and write down inventory and fixed assets?

Well, two reasons. Number one, you don't turn that planning on or off like a switch. I mean, it takes you months to figure out what your manufacturing footprint should look like and what your strategies should be and what product lines you feel are marginal in terms of margin performance and where the outlook is dim. And that one of those product lines was on tapered roller bearings for truck axles. So we decided to exit that particular part of our business. And that was....

Was that....

That was only worth a few million dollars a year to us at the most.

Was that the only product line that you exited?

I'm running through the list. But, yeah, that's the....

That's the majority of it.

That's the majority of it.

Okay. And that was legacy ROLL, right, not Sargent?

Right. Right.

So, I think I know how you'll answer this, but just looking at the year-to-date numbers, revenue is up almost 5%, incremental operating contribution margin is less than 1%, so really flat EBIT on up revenue. Has anything fundamentally changed in the price cost structure here that's limiting incremental margin? Are you at the limit in terms of managing costs in the footprint versus current volume levels?

Yeah. I think what's affecting that is the – we are at a severely reduced level of industrial demand for a couple of our plants. And so the overhead absorption equation and all the rest of that doesn't balance very well, and it dilutes your margin. So then you have the choice to make, and you just tough it out and wait for the cycle to turn. Already it reduced the footprint, and we sort of cut the baby in half there.

Because you're doing some restructuring, but it does feel like the cycle is turning? Is that....

Well, yeah, the cycle has turned for our most profitable products, and we left behind the ones that were not promising.

Understood. All right. I'll get back in the line. Thank you.

Yeah.

Thank you. Our next question will come from the line of Walter Liptak with Seaport Global. Please proceed.

Hi. Thanks. Good morning, guys.

Good morning, Walter.

Just to follow on with that conversation, I was wondering, how much costs are coming out permanently as a result of this – part of that charge was inventory, the fine, but how much – is there planned overhead and kind of other permanent costs that are around now?

Have to dig for that number, Walter, just....

Sorry about that.

So, Walter, the total charge was $7.1 million. Of that, it's $3.2 million mainly of components in inventory that we decided not to finish into finished goods. And there's $2.4 million of fixed assets that were written down to disposal value. And we had an operating lease where we took a $1.2 million exit obligation reserve against that lease, and then we had a small amount of intangible assets associated to it which was about $0.3 million.

Okay. Great. Okay. And I'm not sure if you answered this one yet, but is there more restructuring that you have to look at, or do you have the right size for your manufacturing footprint now?

Yeah. I think Kristine asked that question already and I think the answer we gave her, Walter, was time will tell, and....

Okay, sorry. Yes. Okay, great. As you're thinking about the increased content in some of the narrowbodies and the growth rates, you called out double-digit growth. And I wonder if you could provide a little bit more description. Are you talking about double-digit annual growth, and what's the market opportunity you see over the next three years?

Well, we said low double-digit growth, and we did mean annual on that. Is there any other way to describe that?

No. I just want to make sure that you weren't saying double-digit over the next three years, so annual rate?

No, it's low double-digit. And the question is – well, I mean we have new content on some of the older ships, and we have, that are – because of contract rollovers that favored us versus others. And so that's pleasing and then that we have new content on new ships that are being built and so some portion of the growth is coming from those aspects and other parts of the growth are coming from increased rates on the narrowbodies. I think Boeing is still talking about 60 ships a month. And as was discussed earlier, they're moving to 47 this year, so we have increased rates there, and we do have new products that are being – have either been qualified or are being qualified, and that will accrue to the revenues also.

Okay. Great. Okay. And the discussion so far today, we haven't talked too much about gross margin leverage. And I wonder what you're thinking about for gross margins. Your March fiscal year is just about done, what are you thinking about for 2018 and where you might be able to get gross margins, especially in the light of some of the industrial recovery and industrial restructuring?

Yeah. I think there's no question that our gross margins will be expanding for numerous reasons. Number one, with the industrial volume coming back, just the whole overhead absorption equation accrues substantially to our benefit on those plants. And secondly, with the acquisition of Sargent, there's certain contracts that they had which were not beneficial to their interest. And as we renegotiate those contracts or in some cases exit the business because the products really don't fit the plant, there'll be a normal margin expansion just as a result of that. And finally, there's some products that we're looking at that we manufacture at classic RBC where it would be more beneficial to use the plant capacity to support internal demand and improve margins internally than it would be to produce those products which we think are just really more commodities and sold externally. They're not strategically important to us in any way. So, we've got people working on all aspects of that plumbing.

Okay. Great. Care to take a guess at the number of basis points you might get as the gross margin leverage comes through?

Well, every time I answer a question like that, Dan gives me this look. So I'll let him answer.

I think this year, Walter, we'll probably end up pretty close or exceed the number last year. I think we ended last year at 37.8%, so I think we're right on target to at least hit that this year or exceed it. We had a good third quarter, 37.9% on an adjusted basis if you take out that inventory write-off that we had. But I think we'll give more clarity to it on the fourth quarter call when we finally have all of our fiscal 2018 plans in line, but I think we're going to try to get back to our internal target goal of adding 1% a year for the next few years, so. But I think we'll be able to give you a little more color on that on our fourth quarter call when we chat in May.

Okay. That sounds great. Okay. Thanks, guys.

Thank you. Our next question will come from the line of Larry Pfeffer with Avondale. Please proceed.

Good morning, guys.

Good morning, Larry.

Good morning, Larry.

So, just on the cash flow and cap allocation standpoint, and obviously you've talked about some costs associated with ramp-up on new products. Where do you think we should look at for CapEx and debt paydown in fiscal 2018?

Right now – for the last two years, our CapEx has been very tame. We've done a good job controlling the cost there and the demand from the plants has been pretty good. So I think next year, we'll probably be in the same range we are this year, around $5 million a quarter. From a debt standpoint, when we did the Sargent acquisition a little under two years ago, we borrowed $425 million, and now we're down to gross debt of $299.7 million. If you back out the $39.5 million of cash we have, our net debt is $260 million. So that puts our adjusted leverage at about 1.6 times from basically close to 3 times when we did the deal. So, I think we're feeling good on where we are from that standpoint. Our availability under the revolving credit facility is $238 million of capacity, and we're out working hard trying to find a few other companies to add to our portfolio. And we'll continue that, as we always have, to push hard to find some new acquisitions to add in over the next 12 months.

And are you thinking more on the industrial side of the business or aerospace or just wherever you could find something that would fit?

Wherever we find an attractive asset, we like both markets equally. And so if it's a good industrial asset, we will definitely take a hard run at it as if it was an aerospace asset.

Multiples, any different than they've been over the last few quarters?

I think, like for us, we do look a lot of private deals, and there the multiples are a little more attractive than transactions that are coming through investment bank and auction-type transactions, so. But I think they are a little better than what we were seeing maybe 24 months ago, but not by a lot.

Okay. Fair enough. Thanks, guys.

Thank you. We have follow-up questions from the line of Steve Barger with KeyBanc Capital Markets. Please proceed.

Hey. Thanks. Dan, you made the comment that full-year gross margin could come in at 37.8%. I know it's a target, but that implies around 39% in 4Q, pretty sizeable step-up year-over-year. What kind of revenue would you assume that would take to hit that?

Well, Mike gave...

About 4Q top line.

Yeah. Mike gave that as opening statement, what our Q4 range was.

Yeah. I think I said $158 million to $162 million. Yeah.

Okay. So is that really – you're assuming that that big step-up in gross margin is coming from the absorption stemming from the industrial products that we talked about earlier?

Yeah. And plus we're just having quarter-over-quarter improvement in our gross margin. So if you would look at Q1, we were at 37.3%; Q2 we are at 36.9%, Q3 we are at 37.9% on adjusted basis. So, I think we're pretty much right in target to be in the neighborhood.

Yeah. And I think we've got a couple of other things. We've got some – the mix, mix can change your gross margins a lot quarter-to-quarter and the fourth quarter mix looks pretty good and the other thing is it will have a full absorption in our industrial plans and that's meaningful.

Yeah. Just holistically for the business, when you think about capacity utilization in the plants, absorption product margin, would you rather have a 5% increase in industrial or aerospace in FY 2018? What would deliver more absolute operating income?

It depends upon the market sector that it came from. Industrial, if it came from certain market sectors, would be the winner and aerospace if they came from certain market sectors would be the loser. So, it really depends upon the customer and what aspect of the market they're servicing.

On the industrial side, would that be oil and gas which would be the winner?

No. Oil and gas is not much of a winner. Industrial distribution is a winner.

Got it. And which would be the adverse mix on aerospace?

The adverse mix on aerospace would be a contractual obligation that we would have acquired in the Sargent for one of the big engine producers.

Is that a fairly sizeable business and when can you reprice that?

We're working on that now and more to come.

So, I guess with respect to Sargent in general, we're almost two years into the acquisition. Can you talk about more broadly how those assets have performed relative to expectations, whether it's revenue growth or your ability to leverage product in the aftermarket, free cash flow relative to ROLL classic?

Yeah. I think I'm balanced. It performed very well. There's good solid management base, good solid management teams, strength in lots of positions and good execution and very, very attentive in our strategy sessions on how to improve the business. I mean, I just couldn't be more pleased. I mean, to some extent that I wish the RBC classic guys would take a lesson. Not all of them, but some of them. Some of them need remedial work. So, I'm very pleased with their execution and the outlook for most of their business.

Did you – so from a free cash flow standpoint when you think about those products, is that better right now than legacy ROLL or is that – is the aerospace side of legacy still giving more on a free cash flow basis relative to revenue or fixed assets?

Yeah. We just don't have it broken down that way, Steve, because their businesses flow over both our major market segments, both over aerospace, commercial, over defense and over industrial with the submarine businesses in. But the cash generation is where our expectations were and I think if you will go back all the way to the press release we did and the conference call Mike and I had when we closed the deal that we felt we could pay down $100 million in debt and I think we're pretty close on that target of doing that. So, I think from that standpoint it's met our expectation.

Okay. And did you give a free cash flow number out for the quarter? I'm sorry if I missed it.

Yeah. He did. I think it was $35 million.

I gave you the – if you go to the press release to the last page, I don't want to give you any non-GAAP information, right. So, our cash from operations is $36.1 million and our CapEx was $4.8 million.

I got it. Yeah. Okay. Great. And then just one last one for me. Would you have any – if there was a border adjustment tax, would you have an issue around that or what percentage of products is made in a country other than where it's sold?

Well, I mean, I think all the details around that, Steve, are very vague and what exactly will happen, I don't think anybody knows, not even the administration right now. But I'll just give you some statistics around our business and you make your own determination. We have 33 manufacturing facilities, 27 in the United States, 2 in Europe, 3 in Mexico and 1 in Canada. Approximately 13% of our sales are generated by our international facilities. That means that they're selling within their own territories. Approximately 15% to 20% of our domestic sales are direct export sales and we have a large percentage of indirect domestic export sales who are large domestic OEMs both in the industrial and the aerospace space where our product ends up in their final assembly and then exported to a foreign customer. So, from our initial look and analysis, we are definitely a net exporter. I'm not sure what that means either way. And I'm sure we'll all learn a lot more once there's more definitive information coming out of the current administration.

All right. Thanks. That's really good detail. Appreciate it.

Thank you. We have a follow-up question from the line of Walter Liptak with Seaport Global. Please proceed.

Hi. Thanks for taking the follow-up. In the opening remarks you called out infrastructure expecting to pick-up and I wondered if you care to comment on just the – your expectations for sort of the government plans to improve infrastructure overheads based on private infrastructure, you've already told us of other source of spending. And maybe your view on this industrial recovery that we may be in, is there enough there for this to be something that maybe we can be talking about it a couple of years from now?

Well, typically, we've run – we have a small infrastructure business in California that runs up about 1% of our sales, and it's a pretty Steady Eddie and it produces parts for bridges and highways and buildings and dams and weir gates and that sort of thing. And the business is very profitable and very predictable. So every – we also bid projects here, there and everywhere and through our agents in various parts of the world that are under construction. And so, we recently received a contract for a project which is a large one in Asia which we'll begin shipping those products mid next year. So we haven't seen any impact on infrastructure from the new administration. So, we hear a lot of talk about strengthening the budget for infrastructure and repair. We haven't seen anything from that. I suspect that if that budget is strengthened, we will be a beneficiary of it. But we expect to see our expansion independent of the new administration.

Okay. Great. Okay. So all the comments were exclusive of any Trump bump.

Right.

I guess. Okay. And then just – this cycle has been kind of a prolonged slowdown for the last couple of years. I wonder if you think that we could get a recovery for a couple of years and maybe how much your industrial businesses are down from the peak to where they are troughing now?

Yeah. That's probably a number, I'm really going to be guessing at. But I suspect – yeah, I suspect our industrial businesses, both mining, oil and gas and sort of the general industrial nature of the business probably is down 40% from the peak, maybe even more because the mining peak was very peaky. So, I don't have those comparisons, peak to trough. But I think 40% is probably a modest guess. We are seeing demand right now in excess of that 40%. Not so much from the mining sector, a little bit from the oil and gas, but really from the general industrial sector. So, where this thing equilibrates, Walter, I would just be guessing. I'm happy to – I do think if we end up with a 4% GDP expansion that we're going to be probably living at heights that we hadn't seen in 10 years. If we see a 3% GDP expansion, we're probably going to go back to 80% of our peak.

Okay. Well, thank you for your comments.

Yes.

Thank you. Our next question will come from the line of Joe Murvar with Loomis, Sayles. Please proceed.

Thank you for taking my question. Two numbers kind of jumped off the press release to me. The first one was cash flow from operations of $36 million. I need a lot of help understanding why this number was so large. I think the last couple of years, Q3 has seen a modest increase in working capital. And then secondarily, any commentary from management regarding the future cash generation profile of the company? Year-to-date, it's been running about $75 million, which is pretty impressive.

Yeah. Joe, I think for us in Q3, it was a combination of three different things. There's less investment in working capital than we normally would see. There's timing on payments, especially with our bigger government contracts, where we might have incurred the expense somewhere. We're finally getting the payments in on those contracts. And a little bit on the tax side, on payments there mainly due to the amount of the restructuring we did and the impact it had on that. But the cash flows have just been strong. We've been trying to keep good control on our capital allocation. And I think fourth quarter will be a good quarter. It won't be the same as Q3, but it will be on our nine-month run rate.

Okay. Great. And then just – and you addressed this a little bit, Dan, but like net debt dropped $37 million sequentially. So for modeling future changes in net debt, can we use a sort of shortcut of cash flow from operations, subtract out CapEx like you talked about before, get a free cash flow number and just assume it will go toward debt pay-down?

Yes. I mean, if we don't have a deal happening that we can finance, all of our excess cash will continue to go to pay down debt, and then once in a while we step in to buy back some of our stock when the opportunity presents itself, so.

All right. Thank you.

Thank you. There are no further questions. So now, I'd like to hand the conference back over to Dr. Michael Hartnett, Chief Executive Officer, for closing comments or remarks. Sir?

Okay. Well, I thank everyone for participating in the call today and their interest in RBC Bearings, and we will talk again after our fourth quarter. Thank you. Good day.

Ladies and gentlemen, thank you for your participation on today's conference. This does conclude the program, and you may all disconnect. Everybody, have a wonderful day.