Westinghouse Air Brake Technologies Corporation (WAB) Q3 2017 Earnings Report, Transcript and Summary

Good morning, and welcome to the Wabtec Corporation Third Quarter 2017 Earnings Release Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Tim Wesley, Vice President Investor Relations. Please go ahead.

Thank you, Andrew. Good morning everybody. Welcome to our 2017 third quarter earnings call. Let me introduce everybody else who is with me in the room; Ray Betler, President and CEO; Pat Dugan, our CFO; and our Corporate Controller, John Mastalerz. We will make some prepared remarks, as normal, and then we'll be happy to take your questions. Before starting the call we will make some forward looking statements, so we ask that you please review today's press release for the appropriate disclaimers. Ray, go ahead and get started.

Okay, thank you, Tim. Good morning everyone. If you exclude expenses for contract adjustments, restructuring, and integration actions, our third quarter results were in line with our expectation. During the quarter, our transit business once again grew its record backlog, winning orders around the world. Our freight revenues and backlog have remained mostly flat for the past four quarters, indicating a level of stability, and we are seeing a slight pickup in the U.S. aftermarket. Our adjusted operating margins improved sequentially, and we expect a strong finish to the year based on our existing backlog and increasing synergies. We also continue to make meaningful progress in the Faiveley integration, and just completed our first strategic planning process with Faiveley as part of Wabtec, less than one year after the integration and acquisition process. We're even more excited today about our worldwide growth opportunities and our ability to drive margin improvement through the application of lean in the Wabtec Excellence Program. During today's call, we'll cover all these details. So let's get started. Let's talk about third quarter and full-year. For the third quarter, we had adjusted EPS of $0.88 that excludes expenses of $0.04 for restructuring and integration, and $0.14 for contract adjustments. The adjustments reflect higher than expected costs on certain existing contracts based on our most recent project reviews. In these reviews, we had the benefit of using the best combined technologies, processes, and practices from the legacy Wabtec and Faiveley businesses. We believe our revised estimates reflect the reality in the current situation for these projects. We aren't discussing their specific contracts for competitive and customary reasons, but the $20 million that we booked, $15 million was in transit, $5 million was in freight. Today, we also updated our guidance for the full year. We now expect revenues of about $3.8 billion and EPS of $3.45 to $3.50 excluding expenses for restructuring, integration, and contract adjustments. Compared to our prior guidance, we've reduced revenue by about $50 million as some projects already in backlog are ramping up slower than we had expected. Our operating margin target for the fourth quarter remains at about 15%, which would demonstrate continued progress on the Faiveley integration. And based on this guidance, we're expecting the fourth quarter to be the strongest quarter of the year. Even so, we are still operating in a challenging freight environment, which means we have to continue to stay focused on controlling those things we can. That means being disciplined with it comes to costs, taking actions to right size our business, properly mobilizing for new transit projects, and continuing the effective integration process with Faiveley so we can continue to capture synergies and the growth that we expect. Positive developments, as I stated at the outset, we remain excited about our future growth opportunities and the positive developments we saw during the third quarter. Our backlog increased once again to a record $4.5 billion, which is a positive indicator for future organic growth. Our operating margin adjusted for restructuring and contract expenses was slightly higher in the first half, despite a slight mix shift toward lower margin transit revenues. We continue to make strategic progress especially with the Faiveley integration. We're on track to deliver $15 million to $20 million of synergies in 2017, and we continue to gain confidence that our long-term synergy target of at least $50 million in year-three is conservative. We're driving synergies through supply chain efficiencies, operational excellence, and cost savings, and by leveraging our engineering and administrative capabilities. Longer term synergies are focused on facilities consolidation, global and market expansion, and product portfolio rationalization along with new product development. Another positive step is an acquisition we closed just as after the quarter ended. We acquired a company called AM General Contractor. That company is a manufacturer of fire protection and extinguishing systems mainly for transit rail cars. Based in Europe, AM General has annual sales of about $25 million. AM General offers a patented infrared technology solution for both rail and industrial markets. And it brings a strong aftermarket presence for both components and services. Its gross opportunities, including and expanding retrofit market for the next five years driven by European Union regulations. In addition, AM's technology offers expansion opportunities in geographical markets such as the U.K., India, and China. Now, let's turn to the strategic planning process. Also during the quarter, we completed our first strategic plan as an integrated company, now with the benefit of Faiveley's contribution from the worldwide transit presence. Lastly, we presented the plan to our Board and it was enthusiastically received. The five-year plan meets our long-term financial goals to average double-digit growth in revenues and earning through the business cycle, while improving margins. To achieve these goals, we have growth initiatives in each of our major product lines, consistent with our corporate strategic growth strategies, to continue to grow through new products and technologies, to continue to growth through market expansion, to continue to grow through aftermarket expansion, and to continue to pursue acquisitions which are strategic fit. We plan to, for example, embark on major technology initiatives to maintain our leadership position in the North America PTC market and to leverage our PTC installed base for follow on features and functionality. We plan to invest in technology to develop new generation products in all key segments to help our customers improve productivity and efficiency. And we expect to do this while improving our margins, our quality, customer satisfaction, and our safety. Five years from now, we expect to be a much stronger, more global, more balanced, and less cyclical company. We are in the early stages of planning for our next Investor Day meeting that will be held in early 2018. And we look forward to sharing some of the strategic planning objectives and information with you at that event. Now to turn to transit segment, with the acquisition of Faiveley, our transit business has transformed Wabtec into a truly global player where many other markets are larger and more stable than our traditional U.S. markets. Over time that should mean more visibility, stability, better growth opportunities both organically and through acquisitions, and improve margins as we benefit from the increased scale market share and aftermarket. During the quarter, we had organic sales growth of about 3%. We booked several significant orders and we continue to bid on others. Our backlog remains at a record high which bodes well organic growth next year. Recently, we have won orders in all major worldwide markets, in all major product categories, and with all major customers. Many of those represent repeat or option orders which demonstrates our customer satisfaction with us as a supplier. All of this demonstrates our improving market position globally. For example, we were awarded more than a 100 million of contracts by Alstom and Bombardier to supply the first 71 train sets of new generation double deck trains for regional network around Paris. Under the contracts, we will provide complete braking systems, door systems, HVAC systems, and pantographs. Deliveries are expected to start by September 2018 and to be completed by 2022. This is all part of a framework contract which means orders could go up to and into 255 trains. Other orders include brake systems for both transit in Canada, MBTA, and Indian Railways, Couplers for MBTA, and Swiss National Railways, air-conditioning for Caltrain and Deutsche Bahn in Germany and aftermarket services in U.K. And remember that these OEM orders typically lead to long term aftermarket contracts which provide high margin revenue and profitability through -- for 30 to 40 years in the aftermarket segment. On the freight rail side, we continue to face some short-term challenges. But our freight revenues and backlog have been stable for the past four quarters which is a positive indicator. In North America, freight rail traffic continues to grow although we still see a lot of rolling stock in storage. About 20% of freight cars and 15% of locomotives are still in storage. As a result of these storage figures and railroads own cost cutting efforts, we have seen only a slight pickup in the U.S. aftermarket business. Most of that pickup has been in friction products although we are beginning to gain business in other service areas. With winter coming and kicking into effect in the next few months, we could see more demand for typical repair and service work of components. The U.S. OEM market for cars and locomotives remain sluggish and will likely be flat or slowdown next year. Around the world, the freight market conditions are mixed with some areas that are sluggish and other areas that are growing. Faced with these market conditions, our freight-related business is balanced. So, we are focused on the need to reduce cost in the short-term while maintaining appropriate levels of investment for future growth. And with that, I would like to turn it over to Pat for financial discussions.

Thanks, Ray, and good morning to everybody. Sales for the third quarter were $958 million, when you look at our segments transit segment sales increased 97% driven by acquisitions which contributed $290 million, we had a 3% growth in our organic sales adding about $9 million and a favorable FX impact of $5 million. This is the first time that we have seen organic sales grow in a few quarters which demonstrates that our record backlog is starting to kick-in. Freight sales decreased 6% and that increase is due to lower organic sales mainly from the freight car OE that decreased about $65 million which more than offset the increases that we received from acquisitions which contributed $41 million and a favorable FX impact of about $2 million. Freight sales now have been in the range of $340 million to $350 million for four quarters in a row and our freight backlog has also remained pretty stable during that period. So those are positive indicators. I would also like to point out that revenues from train control and signaling which are recorded in both of those segments were about $84 million in the quarter compared to $68 million in each of the first two quarters of the year and we expect a strong fourth quarter also. Operating income for the quarter on a consolidated basis was $102 million. This included the contract adjustments of $20 million which Ray has already discussed and also the restructuring expenses of $6 million. If you excluded these expenses, our operating income was $128 million or about 13.4% of sales slightly higher than our adjusted operating margin in the first half of the year so, that shows some positive benefit from our cost cutting and the integration activities. Going forward, we expect our SG&A cost to be about a $115 million to a $125 million per quarter. Our engineering expense and amortization costs were up mainly due to the Faiveley acquisition compared to a year ago and we expect similar quarterly run rates in Q4. And we have a new press release disclosure of segment operating income in this quarter so, when you look at transit and you exclude the expenses of $18 million for contract adjustments restructuring and integration or transit adjusted operating income increased 29%. The adjusted operating margin in transit was 10.7% of sales compared to an adjusted 10.4% of sales in the first half of the year. In the freight side if you exclude expenses of $7 million for contract adjustments restructuring and integration. Our freight adjusted operating income decreased 12%. The adjusted operating margin in freight was 20.2% which is also slightly higher than the adjusted 19.6% for the first half of the year. Interest expense for the quarter was $18 million. That's due to the borrowings for the Faiveley acquisition and the higher interest rates and going forward we expect our interest expense to be roughly the same, although we are focused on generating cash to reduce debt and improve our interest expense. Our other expense, we had a charge of $2.9 million in the quarter and that's mainly from non-cash foreign currency translation. This is an unexpected headwind of about $0.03 per share. Since it's mainly due to changes in currency rates over which we have no control. It's very difficult to forecast this line item. In the year ago quarter for example we had a benefit of about $1.2 million for the same reasons. Our effective tax rate for the quarter was about 16% lower than what we had expected that's because during the quarter we completed analysis of the deferred tax liabilities which resulted in a benefit of $10 million. We expected some benefit but this is slightly better than we had forecasted internally and we normally expect the effective rate to be about 27.5 that can vary due to the timing of any discrete items such as the one I just mentioned. Just to recap, some information on the earnings per share. I'll just point out that we did include a table in our press release, but I'll walk through this again on the call here. Our GAAP earnings per diluted share for the third quarter was $0.70. The contract adjustments and restructuring and integration expenses reduced EPS by a total of $0.18. So our adjusted earnings per share was $0.88. Just to reconcile this again, net income per diluted share in accordance with GAAP, about $0.70, add back our contract adjustments, $0.14, add back restructuring and integration costs, $0.04, result in a net income per diluted share excluding these items of $0.88. Just to remind you on a year-to-date view, our adjusted EPS in Q1 was $0.84, $0.80 adjusted for the second quarter. And so we're not at $2.52 adjusted for the year to date, and our annual guidance on an adjusted basis $3.45 to $3.50. So shifting to our balance sheet, the balance sheet remained strong, and provides our financial capacity and flexibility to invest in our growth opportunities. We have an investment-grade credit rating. And our goal is to maintain that rating. Our working capital at September 30th, included receivables -- trade receivables about $793 million, inventories were about $765 million, and payables were $513 million. Our cash at the end of the quarter, $228 million, which is mostly held outside the U.S.. Our debt at the end of the quarter we reduced by about 6%. So when you look at what comprises our debt we have about $1.9 billion of debt, which includes $748 million of 10-year senior notes, about $248 million of bonds, $390 million of term loan, and $475 million outstanding on our revolver. Taking this all into account, our net debt to EBITDA is about three times. So just a couple of miscellaneous items, our depreciation for the quarter, $17 million, compared to $11 million in last year's quarter, and for the full year we expect it to be about $65 million. Our amortization expense for the quarter, $8.7 million compared to $5.3 million a year ago. And for the full year we expect it to be about $36 million. And our CapEx, our capital expenditure spend for the quarter, about $22 million, compared to $13 million a year ago. And we expect to spend about $80 million for the year. Our backlog, which we included in the press release, we have a multi-year backlog at the end of the quarter at a record $4.5 billion, and our book-to-bill for the quarter was about one-to-one. Our rolling 12-month backlog, which is a subset of the multiyear backlog was a record $2.2 billion, a 5% increased compared to the end of the second quarter which is a positive sign for the next year. So with that, I'd turn it over back to Ray.

Thanks, Pat. So to summarize, we remain very confident in our worldwide growth opportunities and in our ability to perform in the future. We expect a strong finish to the year based on our existing backlog and increasing synergies. We have a record and growing backlog. We're making great progress in the Faiveley integration, and we're continuing to invest in our balanced growth strategies around the world. And with that, I'm happy to take your questions.

We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Justin Long of Stephens Inc. Please go ahead.

Thanks and good morning.

Hi, Justin.

Hi. Maybe I could start with a question on the guidance. So you talked about consolidated margin still being around 15% in the fourth quarter. Could you just break out what you're assuming for margins in both the freight and transit segments within that number? I just want to get a better sense for where you think margins will close the year for each segment as we begin to look into 2018?

Hi, Justin, right now we haven't broken it out, but I think you would end up with that was very similar, on an adjusted basis, very similar to what you've seen in Q3 and for the full year, with obviously an improving result due to the volumes that are implied in the guidance that are going to come through here in the fourth quarter.

Okay, so maybe asking it a different way; is all of that sequential improvement coming from transit margins or do you expect a pickup in freight margins as well?

Yes, I think what you're going to see is an improvement in both. It's going to be -- really you build off of what we've done so far year-to-date, what we've seen in Q3, absent the adjustment, you would end up with kind of an improvement quarter-over-quarter that would be fairly consistent with both segments.

Okay, that's helpful. And then secondly, I wanted to follow-up on cost cuts in the freight segment and the potential for additional cost cuts going forward. If we see an environment where rail volumes start to moderate a little bit and that continues into next year, the build rates for rail cars and locomotives in North America are blasted [ph] down in 2018. Do you still have opportunities to take costs out of that freight segment? And if so, is there any way you can help us think about what's left in terms of the remaining opportunity?

Yes, as a matter of fact, Justin, we have specifics plans in our synergy plan, that you know, runs over a three-year period, so some of those costs reductions and synergy plans are focused solely on freight. They include restructuring, as well as consolidation. There's a couple of businesses that we have gone through to planning, and we'll start that process next year. Some we've already started the process, headcount reduction across the board, freight and transit, as well as opportunities for rationalization of product portfolio. And we have growth opportunities, not just reduction opportunities in places where we're starting up new businesses and investing, as I mentioned, in places like Turkey, for instance, India.

Okay, great. That's helpful. And then lastly, just a quick one on the quarter, you talked a little bit more about the contract adjustment in 3Q, but could you provide a little bit more detail on why you excluded that as a one-time item versus saying it's a normal course of business headwind?

So I think it's clearly it's being driven by the continued integration of the two companies and how we look at these projects. We've had the opportunity to take the best of both of the two organizations, and see where if there's a way to deliver a project to our customers using the best of both technologies, know-how, and capabilities. And in some cases, it really forced us to look at costs that had already been incurred, and whether we needed to incur extra.

Okay.

Justin, this is Tim. I think the other thing is just the size of the adjustments. It's not unusual to have pluses and minuses. But generally when those are significant from a dollar amount those are things that we're going to mention, we're going to talk about.

And maybe I can add a little bit of color here, Justin. So since we brought the businesses together, last December, we've been going through integration of processes, so what are best practices in terms of the overall project review process, risk opportunity, evaluation, assessment, allocation, things like how we structure the projects, things like that. And then we've been going through using those best practices in all of our projects and interrogating those projects. So we have more objectivity because there're new sets of eyes from the Wabtec side, on the Faiveley projects from the Faiveley side on the Wabtec projects. And I think all of those have added value in terms of basically the scrutiny we've put on the process, which means that I think going forward we'll have a more effective, more rigorous process that we can use across a collective organization.

Okay, that's really helpful. Appreciate all the color. And I'll pass it on. Thanks.

Thank you.

The next question comes from James Rodgers of Great Lakes Review. Please go ahead.

Hi, it's Jason, at Great Lakes. Just a question on the reduction in the revenue guidance for the year based on transit, is there anything you could point to or any detail about the slower-than-anticipated ramp in the projects or is it just the typical delays that you experience?

Yes, I don't think that there's changes -- this is Pat. I don't think there's any item in particular that we would focus on. I think that as you get to the end of the year you refine your aftermarket estimates and your -- which can be more of a drop in order. And you also start getting a little bit better color on the OE side, and what the customers' expectations are in terms of deliveries and staging with their own project schedules.

And I wondered if you could quantify what the amount of synergies that you realized from Faiveley in the third quarter.

Yes, I think at the end it's about $6 million or $7 million is kind of what we're focusing on. That's also a little bit blurry because you get between restructuring, and synergies, and kind of the normal adjustment of costs related to volume changes. But I think that if you kind of focused on that number you would see that the -- I think that's probably a pretty good estimate of where we're at.

And James, what we can say is if there's no risk of us missing the synergy target for the end of the year.

Sounds good. Wondered if you could talk about October results, so far they're tracking in line with your guidance.

Yes, I don't think we're going to give that kind of guidance here on this call. October is still an ongoing month. And so it's probably more information what we'd normally give.

All right. Just final question, notice the receivables growth year-over-year in the quarter was about twice that of sales. I wonder if you could address that?

Yes, I mean, we definitely have -- when you look at working capital, we have been working very hard to reduce it. The overall working capital is up. There's a couple of reasons. Some of it relates to the acquisition, but our sales have started to ramp up here in the third quarter. But the think that I've been focusing on is our DSOs from Q2 are down, actually improved about 6% from the June numbers. And then so we're doing -- I think, doing a better job of collecting our receivables. And the trick now is just to continue to make that improvement going forward into the fourth quarter.

Okay, thank you.

And the customer…

Yes. I mean, that's the -- when you look at trade unbilled you're balancing that against your customer deposit, so that's offset a lot of things.

The next question comes from Allison Poliniak of Wells Fargo. Please go ahead.

Hi, guys, good morning.

Good morning, Allison.

Can we just go back to Justin's questions again because I just want to make sure I'm thinking about this right, the way you talked about the contract adjustments and sort of the changes that you're making, that should be less impactful -- I know they have been on a regular basis, but they should be less impactful going forward because you have a better understanding on that side?

Yes, so just think about the situation. So we historically have done our -- obviously have different project processes in terms of the way we set up our projects, the way we administer our projects, the way we implement and execute our projects, and the way we evaluate and report our projects. So part of the integration process, as we've talked, is to assess and focus best practices and come to integrated uniform process in the future. And that's what we've been doing over the course of the last year. And it's something that goes on every month. It's really continuous because we have project reviews on a regular basis. You know, we're a big project portfolio, and so we're vetting all these projects, we're challenging every assumption that's made. We're challenging risk and trying to identify opportunities. And we're also applying corrective actions and solution where they're needed from the best sources we have. And so, to give you an example, we have, let's say, a product deficiency. Okay, how do we solve that issue? Do we pull from the portfolio with part of legacy Faiveley or part of legacy Wabtec? If it was a Wabtec product and Faiveley has a better product in their portfolio now we can leverage that as a better potential solution. So, all those things are going on in this project assessment and project review process. We'll get to a point going into next year now where we have done that work across our total project portfolio. We'll get to a point where we have only one way of bidding and structuring projects at the front end, which is really the key to success starting a project off properly. We'll get to a point where we have a common way of establishing contingency, things like warrantied accounts. So there's a lot of details behind it, Allison. But that's what we've been focused on. And I think the process is working well. And I think we're going to have a more stable environment in the future. That doesn't mean we're not going to have issues. You got a lot of big portfolio, lot of moving parts, lot of risk that has to be managed. But I feel a lot better about our ability to manage our projects in the future.

Now that's very helpful. And I just want to go back to a comment that you made, Ray, on synergies in Faiveley. You talked about it, potentially the year three being likely a conservative number. What are you seeing, is it more revenue synergies coming through potentially that you didn't think about? Are you seeing more stuff on the cost side? Can you maybe clarify that statement a little bit?

I think it's pretty much across the board. We've told you we took a conservative approach, so [indiscernible] $150 million. We took a conservative approach. We wanted to hit a target that we felt we could hit. And then challenge ourselves internally to do better. So you'll get an understanding at the end of the year when we really made up this year, and you will be able to take off from that. But we felt pretty good about our ability to exceed our synergy targets.

Great. Thanks so much.

Thank you.

The next question comes from Saree Boroditsky of Deutsche Bank. Please go ahead.

Thank you. Good morning.

Good morning.

Could you provide more color on what you're seeing freight aftermarket and potentially the breakout of aftermarket builds for the quarter, and just how you are thinking about aftermarket dement into next year?

So up till now we've been -- we mentioned that basically it was all friction, and it's pretty much majority dominated by friction, break pads, and things like that in the aftermarket, but are starting to see some component repair opportunity. We're seeing some compressor business. We're seeing some work out of our service shop. We're seeing some electronic repair, so some of the components are starting to flow. There's other areas that because there's less rolling stock in use because of cars in storage, things like freight rails, and things like that have been lower than we would have hoped at this point just based on install base. So, the components are starting to flow, other services or starting to flow, and this is what we can or have been just going to end of year. It's going to increase, I think going into next year, but I would tell you that the recovery, I'll reiterate again, it's not been robust, it's been FS a little bit up and down. So, I don't want to call it "Sluggish," but at the same time it's not robust. So, we expect continual gradual improvement going into next year.

That's helpful. Thank you. And then, is there any additional color you can provide on some of the new PTC technologies that you referenced earlier in the call? And do you expect to see higher engineering cost as rose out to some of these investments?

I appreciate you asking about PTC, because it's starting to progress, now we're getting closer and closer to a year from now basically everything costs to be in operation. So, we had the nice news from one of our customers that the first full production inoperability operation is completed in that railroaders experience, and 100% performance at many of their subdivisions and throughout their entire network over 95% inoperability and success with the network. So, the feedback we're getting on PTC implementation, commissioning, and now actual operation is very, very positive. There is Class 1 railroads, especially the Western railroads are pushing hard that are logging two million miles a week under PTC operation. One of the railroads has 81 of 90 total subdivisions up and running. So, with that, first of all you saw our PTC numbers are up in third quarter, which is a very [technical difficulty] We have as you know, all the install base on the onboard computer. We've already started to develop enhancements centered around that computer, but we will continue to develop our product roadmap that we presented to our Board, which is going to be a phased approach toward autonomous operations should the railroads ultimately adopt the type of approach.

Great, thank you. Have a nice day.

Thank you.

The next question comes from Matt Brooklier of Buckingham Research Group. Please go ahead.

Hey, thanks, and good morning. So just a follow-up on PTC, I know you gave the total signaling in PTC revenue for the quarter, would you mind breaking out what PTC was on the standalone basis and then how that broke up for the freight and railroad operations?

Yes, go ahead.

So, total PTC spent for the third quarter was about $47 million and signaling is about $37 million.

And we don't break that down by freight or transit, but we've been saying roughly three quarters is freight.

Okay. And then going back to your original commentary…

Matt, we lost you.

Sorry, please continue.

Yes, we lost it. Go ahead repeat your question please.

Yes, can you hear me now?

Yes.

Yes.

Okay, sorry. The guidance that you gave for the year, I think you said the combined businesses of signaling in PTC expectations for that to be down about 4%, what are your updated thoughts on where that could fall?

That's still in the guidance.

Okay, unchanged. And then just turning back to the aftermarket type your business it sounds like that's picking up some momentum, which is good to hear. It sounds like the friction product is the bigger contributor, but it still sounds like maybe potentially it's lagging your expectations as we entered the year. I think you talked to earlier that potentially that was a function of just more equipment in stores than we probably anticipated into some recovery on the Class 1 rail side of things, I'm just trying to get a sense for if there's any other headwinds for your aftermarket business that's resulting maybe in a more sluggish recovery within that particular part of your business, or is it just a function of this of so much equipment in storage at this point in time? Thanks.

Yes, Matt. We took the guidance out for the increase aftermarket last quarter as you know, and it's pretty [technical difficulty] we expect the recovery to be pretty much flat to slightly up as the year continues and grown into next year, which is basically what we have in the guidance today. So I think it's picking up well as anticipated, we're going to continue to take initiative and be proactive about trying to get business in the aftermarket trying to both the opportunities across the Board in PTC areas well as in typical freight mechanical areas, but I think it's pretty much what we did expected and we're happy to see the component and service business that we have experienced over this quarter.

Okay, good to hear. And then final question; what's the tax rate that's baked into your fourth quarter implied guidance range?

I know it's that kind of normalized 27.5%. So, that would give us kind of an overall for the year in the 25 range, because of the discrete item it came through in Q3. So, 2017, Q4, yes right.

2017, Q4, okay, I appreciate the time.

Thanks, Matt.

The next question comes from Scott Group of Wolfe Research. Please go ahead.

Good morning guys. This is Ivan Yi on for Scott.

Hi, how you doing?

Great. First on CSX, they announced some changes in their locomotive contracts, what is your revenue exposure to CSX and how do you expect that to change if they're focused on cost reductions going forward?

Yes, we don't give revenue by customer. So, we can't discuss that. I mean, we give that disclosure in the 10-K, I think that's once a year when we do our…

That's major customers and you got to be an excess of 10% themselves. I don't think they're in that number, so…

Great. And secondly, in terms of M&A, there seems to be a lot going on right now in the rail space with Siemens, Alstom and potentially GE locomotive, how can Wab participate in this activity? And what are the opportunities and risks for Wab in a more consolidated rail industry? Thank you.

So I think we are well-positioned in the transit side where Siemens also moving to good relationship with both, and on a consolidated basis that obviously represents more standardization for us, small platforms with higher volume. So that's all good, that's all positive. And I think as far as the GE situation, obviously at the corporate level, they are going through in respective assessment trying to showed out what and who they want to be in the future, and if we read the same reports as everybody, if the transportation business falls out of GE, then we still will serve them as a major customer to important customer, buyers, and we have a great relationship with them as we do all the other locomotive builders.

Great, thank you. And last one, could you give any early indication for expectation for PTC in '18?

Right now we're just starting our budgeting process, and so it would be premature for us to get any kind of guidance in any of the elements of our business.

Great, thanks for your time.

Thank you.

The next question comes from Mike Baudendistel of Stifel. Please go ahead.

Thank you. Just want to ask you a question on the comment previewing your Analyst Day where you say five-year plan to grow double-digit earnings through the business cycle. Can you -- how much of that is due to acquisitions? Or maybe asked another way, can you grow it double digit throughout the business cycle just organically?

Yes, Mike. First of all, our guidance that we -- well, let me go back, the strategic planning process which we just presented last week to the Board was really an exciting opportunity. It was an opportunity for us to focusing on all of worldwide product line areas as well as in our functional areas which are mainly focused on efficiency and operational excellence. So we had the chance to look at both revenue growth and cost reduction, operational efficiency improvement, and we are really encouraged by the strategic planning process. In terms of growth itself, what we presented to Board was not based on acquisitions; it was based on organic development only. We supplement that historically if you look at what we have achieved, it ends up being about 50% organic and 50% acquisition, but our strategic plan is focused 100% on organic growth.

Great. That's helpful. And then also just wanted to ask you on the aftermarket, I mean, is there any way to put numbers? You say it was up slightly. Can you put any numbers around that? I mean is it up 1% while rail traffic is up 4 to 5%? And historically, does it typically catch up to the rail traffic growth? And over what period of time does it do that? And does it ever just exceed the trail traffic as sort of a catch-up -- sort of a makeup period for aftermarket?

Mike, this is Tim. Let me give you some of the numbers, then I'll let Ray address the rest of the question. So if you compare first quarter of this year to first quarter last year, it was down a bit. Second quarter, it was pretty much flat with the year ago quarter. And then, we saw some growth here in the third quarter versus the third quarter a year ago. So again down year ago in the first quarter, flat in the second, and growth in the third. If you look at the last two quarters and you kind of combine those, it's up modestly.

Yes, so we've always lagged -- our recovery will always lag traffic and recovery in the freight market, but we will catch up. And the one thing that could make a significant difference which we've talked about in the past is the overhaul orders. There is overhaul orders that were suspended going into this recession. And when they come back and it will come back that will be a big improvement in the aftermarket business. So there were a couple locomotive overhaul orders. We are starting to see some big opportunities in those areas. We have reviewed that and recently a couple opportunities that are in the pipeline. And if our customers actually through, they will start to see some -- more significant growth.

Great. That makes sense. Thank you.

Thank you.

The next question comes from Steve Barger of KeyBanc. Please go ahead.

Hi, good morning guys.

Hi, Steve.

Question on cash flow, I know it's been limited this year with restructuring and integration, working cap. Can we expect a step-up in operating and free cash flow next year? And can you just remind us on priorities for cash?

Yes, so I mean when you look at our -- if we go back and at the second quarter and then when the third quarter comes out, some of our biggest use of cash is in areas like accounts payable and inventory and AR are up slightly, but they are very much starting to improve in terms of sales turns and day sales outstanding and inventory turns. The AP has been affected by the paying the deal cost that were approved at the beginning of the year. And right now we were managing all those things. Our unbilled are not growing in the excess of the deposits we are receiving on our customers and our projects. So I think that that's -- those are all kind of positive trends even though the results haven't been what we are expecting so far. And we are looking to improve that going into the fourth quarter, but our goal always will be and going forward is that our cash from operations exceeds our net income and we expect that to come back to be consistent next year. And then for the priorities, I mean our priorities in cash always will remain at we are going to invest in the business. Our R&D programs, our acquisition programs, and then de-levering in the business when we can and being opportunistic in terms of any kind of stock buybacks.

Got it. Thanks. And Ray, just to I guess wrap up the question on organic growth in North American freight, if current transits continue, you would expect organic growth in freight in 2018?

Yes, slight organic growth although we haven't modeled it yet.

Understood, okay.

Well, Steve, we're just -- we're just starting to run our budget round, so we just came up the strap plan. So we are literally next week starting the budget. So we'll get into the details of those discussions. And based on what we are seeing, I'd say, we are going to see some pickup in aftermarket and freight. But we haven't detailed it yet, that's all.

So, no structure or competitive changes that you see? You think this is more timing as you said relative to as traffic picks up and you kind of lag that recovery?

Yes, that's right.

Okay, thanks.

Thank you.

The next question comes from Jay Van Sciver of Hedgeye. Please go ahead.

Hi, thank you for taking my question. The adjusted EPS for…

Hi, Jay.

…3Q exclude the expenses for contract adjustments, but they don't exclude of benefit of about $0.10 related to the adjustments for foreign deferred tax liabilities. I am reading that correctly? And what's the rationale for that different presentation of those accounting adjustments?

Well, I think we talked about the contract adjustments that it was size and scale and the result of continuing integration of the businesses, you know, look at some of those projects and how we could perform better for our customers. But in terms of taxes, I mean we have those adjustments every quarter. It's part of our normal projects and the street items where we look at how we do the accounting for our income taxes and the opportunities to improve the tax rate. And so it -- just like in other quarters it flows through in our results. And they were not specific to the acquisitions. So in our eyes this was not an item that you would -- we would add back or remove from the adjusted EPS. That's the right way to say. And we talked about in my earlier comments is that internally we knew that there was an opportunity and we had included that in our results going into the second half of the year here. It just happened that we did a little bit better job and we got a little bit larger benefit -- slightly larger benefit.

Just a follow-up, you do add back a $0.001 penny for the EPS on the tax on the opening balance sheet adjustments. How is that different from say different tax adjustment?

Well, so again -- as I said, I mean the ones we just reported in the third quarter are the kind of the normal specific tax projects and efforts that we go through to minimize the -- our cost. The one that we added back earlier was very specific to the transaction and even more so it's specific to adjusting some of the normal adjustments to goodwill that come through. And then of course the tax that's related to those changes. So it seemed like a pretty bright line of what is acquisition related and should be added back and what is kind of normal operations, and we do not include it in our adjusted EPS.

Okay, but your normal operations with other tax rate typically of around 27.5% going forward is your expectation?

Yes, that's our estimate right now. It's based on the mix of business and what jurisdiction whether it's kind of foreign or U.S. and then of course the statutory rates are in those numbers or in those countries. So that's our estimate right now and that would be kind of a more normal run rate. And we of course -- once we go through our forecast and our budgets for next year, we'll redo the blended effective tax rate and we'll have changed guidance in future periods.

Great. And can you just comment if -- on how I guess acquisition capacity you have at the moment if Siemens and Alstom merger, would have an interest in the signaling divestitures that might come out of that?

Sure. Yes, I mean we have an interest in a strong pipeline for acquisitions. We obviously are focused on a investment grade credit rating. And so, we are constantly keeping everybody updated on what does -- what our balance sheet -- where we expect our balance sheet to be and where our ratios and leverage calculations would be. But ultimately, we have a strong capacity. And we can look at all kinds of different opportunities in terms of changing our capital structure to facilitate any kind of acquisition. And -- but we will do it in a thoughtful way that make sure that we don't jeopardize our credit ratings.

Great. Thank you.

Thank you.

[Operator Instructions] This concludes our question-and-answer session. I would like to turn the conference back over to Tim Wesley for any closing remarks.

Okay, thanks everybody. We appreciate you being on the call this morning. And we look forward to seeing you maybe at a couple of conferences come up or we will talk to you again in a few months. Have a great day. Bye.

Thank you.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.