Global X U.S. Cash Flow Kings 100 ETF
Q3 2016 Earnings Call Transcript

Published: 2 Nov 2016

[Operator:]

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Q3 2016 SPX FLOW 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. [Operator Instructions]. As a reminder to our audience, this conference is being recorded for replay purposes. It is now my pleasure to hand the conference over to Mr. Ryan Taylor, Vice President of Investor Relations. Sir?

[Ryan Taylor:]

Thank you, Brian, and good morning, everyone. Thank you for joining us today. With me on the call this morning are Marc Michael, our President and CEO of SPX FLOW; and Jeremy Smeltser, our Chief Financial Officer. Our Q3 earnings release and Form 10-Q was issued earlier this morning and can be found on our Web site, spxflow.com. This call is also being webcast with a presentation located in the Investor Relations section of our Web site. I encourage you to follow along with the presentation during our prepared remarks on the call this morning. A replay of this webcast will also be available on our Web site later today. Portions of our presentation and comments are forward-looking and subject to Safe Harbor provisions. Please also note the risk factors in our most recent SEC filings. In the appendix of today's presentation, we have provided reconciliations for all non-GAAP and adjusted financial measures presented today. And with that, I’ll turn the call over to Marc.

[Marc Michael:]

Thanks, Ryan. Good morning, everyone. Thanks for joining us on the call. 2016 has been a challenging year for the FLOW industry overall and particularly challenging for companies who serve the oil and dairy markets. In light of the challenging macro environment, I’m proud of our team across the enterprise for their dedication during this cyclical downturn and I am pleased with the progress we've made to this point on our realignment program. In our first year as a standalone public company, we have done a significant amount of heavy lifting to transition our organization to a streamlined operating enterprise. I firmly believe we are establishing a strong foundation and leaner operating structure that will be well-positioned for cyclical recovery, enabled long-term success. In the third quarter, we realized $16 million of year-over-year cost savings and accelerated certain actions to further streamline our functional support. We remain on track to achieve our goal of $135 million of annualized cost savings by 2018, and we are evaluating incremental actions. Additionally, during the quarter, we refinanced $600 million of debt and amended our credit facility. As a result, we reduced our annual interest cost by about $7 million or $0.12 per share. And we don't have any significant required debt payments until 2020. Looking at our realignment program in more detail, as I mentioned, we realized $16 million of cost savings in Q3 and remain on track to achieve $60 million in savings this year and an incremental $55 million in savings in 2017. As a key part of our transition to an operating structure, we’re aligning our segment teams to focus on developing intimate customer relationships and expanding customer relevance within each end market. The key areas our end market teams are emphasizing include product management, channel development, engineering customer solutions and project execution and delivery. To enable our end market teams to concentrate solely on serving our customers and growing our business, we took significant steps late in Q3 to further streamline our functional support and drive a consistent approach across the enterprise. Our ultimate goal is to create a more customer-centric service oriented organization and deliver greater value to our customers, investors and employees. Despite those positive developments, our third quarter results were impacted by a deceleration of short cycle industrial orders at the outset of the quarter and delayed power and energy shipments. As a result, revenue was $467 million below our original guidance of $490 million to $510 million and consistent with our October 17 preannouncement. Versus the prior year, revenue declined 21% or $123 million. A majority of the year-over-year decline was concentrated in our oil and dairy related businesses reflecting the impact of low commodity prices on our customers’ investment decisions. Segment income declined $31 million versus the prior year to $48 million or 10.3% of revenue. Detrimental margins were 25% reflecting solid progress on our cost savings initiatives. In power and energy, shipments of lower margin backlog and low utilization rates at larger manufacturing sites impacted profitability. And in food and beverage, an elevated level of project costs in the period muted a very solid underlying margin performance. On an adjusted basis, operating income was $34 million and earnings per share was $0.34 in line with our preannouncement. Looking at backlog, total backlog was $862 million at the end of Q3, down 2% sequentially. Our industrial backlog increase 4% sequentially offset by modest declines at the other segments. Q3 orders were down 6% from Q2 due primarily to very low level of orders in oil-related markets and timing delays on the placement of a few food and beverage system orders. Looking at the order and market trends by segment; in food and beverage, orders for skidded systems, components and aftermarket parts and services were steady sequentially. On a positive note, aftermarket orders grew 4% year-over-year. We’re encouraged by the stability in the core run rate activity. However, in contrast, large orders continue to be deferred. That said, our front log of systems opportunities increased modestly for the second consecutive quarter with new projects concentrated on nutritious product categories in fresh liquid dairy, non-dairy alternatives and nutritional beverages. In the milk powder market, the global surplus of skim and whole milk powders continues to delay customer investments for new capacity. We’re seeing signs of recovery as prices for commodity milk and milk powders increased sharply off trough levels during Q3. While this is encouraging, we anticipate a slow recovery in commodity milk pricing through 2017 and expect order placement by our customers to lag commodity price recovery. Overall, for food and beverage, we are very encouraged with the stable order trends for components, aftermarket and skidded systems. In our power and energy segment, the overall environment continues to be challenging. Q3 orders declined 13% sequentially. OE orders declined nearly 20% sequentially and just over 30% year-over-year. Aftermarket orders declined 6% sequentially and 14% year-over-year. In oil markets, order activity was at the lowest levels we've experienced since the downturn and the overall environment continues to be very competitive. On a positive note in nuclear power, we continue to see customers move forward with investments. And we are well-positioned with our nuclear safety pumps and valves to support our customer needs. In Q3, we were awarded an $18 million order to provide nuclear safety pumps on a new power plant to be built in the UK. Overall, power and energy orders were quite challenging in Q3 and we do not expect any recovery in Q4. As we plan for 2017, we are evaluating additional cost actions to adjust this business to current order levels. In our industrial segment, orders were down 7% year-over-year reflecting general weakness across industrial and process markets. Sequentially, however, orders were up 3% driven by a strong finish to September which featured a handful of capital orders; highlighted by a $5 million order to provide 28 desiccant dryers for a large manufacturing plant in China. Overall, we’ve experienced choppy order trends in industrial markets this year reflective of the broader trends in the global industrial economy. Our revised full year guidance accounts for our third quarter results in the lower level of order activity. For the full year, we now expect revenue to be just over $2 billion with adjusted EPS between $1.27 and $1.47 per share and adjusted EBITDA of approximately $206 million. While we’re encouraged by the relative stability in our short cycle in aftermarket orders across food and beverage and industrial, given the ongoing order weakness in our energy product lines and the overall backlog declined this year, we anticipate organic revenue headwinds in 2017. As such, we are taking a prudent approach to planning for next year and intend to mitigate a large portion of the expected revenue headwinds for additional footprint and cost reduction actions not currently included in our global realignment program. We plan to provide details on incremental restructuring actions when we issue our 2017 guidance in February. At this time, I’ll turn the call over to Jeremy for a detailed review of our financial results and our revised 2016 guidance.

[Jeremy Smeltser:]

Thanks, Marc. Good morning, everyone. I’ll begin with a look at Q3 earnings per share. For the third quarter, we reported a loss of $0.11 per share. This included a charge of $0.59 per share related to the debt refinancing, primarily the prepayment of the remaining interest on the retired bonds. We also recorded $0.21 of special charges related to our realignment program. These charges were partially offset by a $0.35 net tax benefit driven by the $24 million tax incentive in Poland that Marc mentioned. This incentive was previously expected to be recorded in Q4. However, we met certain investment milestones slightly ahead of schedule and as such, burned the incentive in Q3. Although there was no cash impact to the quarter, going forward we will not have to pay cash income taxes in Poland over the next 10 years up to the $24 million incentive. Excluding these items, we reported adjusted earnings per share of $0.34 in line with our revised guidance. Moving on to the segment results beginning with food and beverage, revenue was $173 million, down 16% versus the prior year. Currency with a modest benefit. Organic revenue was down 17% due primarily to lower revenue from large system projects. Segment income was $20 million or 11.3% of revenue. As compared to last year, profitability was lower due to the organic revenue declines and elevated project costs, the majority of which related to one large project. The elevated project costs had a 400 basis point impact of margins in the period. On a sequential basis, margins improved 70 points on lower revenues. This was driven by a significant improvement in production of valves at our new manufacturing facility in Poland. And as Marc mentioned, the underlying business performed quite well driven by solid execution in components and aftermarket as well as benefits from cost reduction initiatives. In our power and energy segment, revenue was $127 million, down 36% versus the prior year. Currency had a 3% impact. Organic revenue was down 33% or $64 million. OE revenue declined $46 million. This decline was split fairly evenly between lower sales of valves and pumps. Aftermarket sales declined $18 million year-over-year. Segment income was $5.5 million or 4.3% of revenue. The sharp decline in profitability was largely due to lower sales of our higher margin, aftermarket and valve product line. We also experienced low utilization rates at our larger manufacturing sites. These declines were partially offset by savings from restructuring actions. The third quarter results for power and energy were lower than we anticipated due to customer delays and execution challenges of a handful of larger orders. As we plan for 2017, we are evaluating and expect to take additional actions to reduce the cost structure in this segment to reflect the lower level of orders and revenue. In our industrial segment, Q3 revenue was $167 million, down 10% versus the prior year. Currency had a 1% impact. Organic revenue declined 9% as sales across the majority of the product line declined versus the prior year. As mentioned previously, short cycle orders decelerated at the outset of Q3 impacting our revenue conversion in the quarter and reflective of the broader slowdown in industrial demand during the quarter. Segment income was $23 million or 13.8% of revenue. We were able to offset a majority of the volume decline through restructuring savings and other cost reduction initiatives. This is reflected in the margin which was essentially flat to the prior year, despite the revenue decline. Looking now at our fourth quarter modeling targets on a consolidated basis, we’re targeting revenue between $500 million and $530 million. We expect segment income between $55 million and $67 million with margins between 11% and 12%. As compared to our prior expectations, we have reduced our fourth quarter segment income target to reflect ongoing challenges in our power and energy segment including the reduced order activity, lower aftermarket revenue and ongoing project delays and absorption challenges. Our Q4 segment income target also assumes elevated project costs in food and beverage consistent with Q3. Corporate expense is expected to be approximately $13 million and we are targeting special charges of about $15 million. On an adjusted basis, excluding special charges, we are targeting between $41 million and $53 million of operating income and earnings per share of $0.55 at the midpoint. This assumes a tax rate of 28% and 41.5 million shares outstanding. Looking at our revenue and operating income on a sequential basis, at the midpoint, Q4 revenue is expected to be $515 million, up 10% sequentially due primarily to higher shippable backlog across all three segments. About 42% of the Q3 ending backlog is expected to be converted to revenue in Q4. That represents about 70% of our Q4 revenue target consistent with our backlog conversion rates over the first three quarters this year. For food and beverage, we expect revenue to increase sequentially as we ramp up execution on the large projects we were awarded in Q1 of this year. We have a couple of larger mix orders in our industrial backlog that are planned to ship this quarter. As it relates to operating income, excluding special charges, we expect modest leverage on a sequential revenue increase and about $5 million of sequential improvement from cost savings initiatives. Looking at our full year model, our GAAP guidance includes several items unique to 2016 including the $426 million impairment charge recorded in Q2; $80 million of special charges; final pension funding for retirees and the debt refinancing charge and tax credit recorded in Q3. Excluding these items, our adjusted EPS guidance range is $1.27 to $1.47 per share and our adjusted EBITDA guidance range is $200 million to $212 million. As it relates to free cash flow, we have reduced our full year guidance to reflect lower revenue and profit expectations. In addition, the expected timing of cash collections on several large projects has shifted into 2017 due to various timing delays along with order delays and associated down payments. We now expect to generate about $70 million of adjusted free cash flow for the year, the majority of which is expected in Q4. Looking at our financial position, we ended the quarter with $228 million of cash on hand and just over $1.1 billion of total debt. Net leverage increased to 3.8 times. We had anticipated an increase in leverage as a result of discrete pre-tax cash outflows in the period, including $50 million to refinance our debt and $54 million related to the final pension funding for retired executives. In addition to these items, we invested $20 million in cash restructuring. All-in, free cash used in the third quarter was $28 million. On an adjusted basis, free cash flow was $26 million. We made good progress on our working capital initiatives during the third quarter and we expect to see continued working capital improvement during the fourth quarter. For Q4, we are targeting approximately $55 million of adjusted free cash flow. Based on our Q4 midpoint guidance, we expect net leverage at year-end to be consistent with Q3 and below our net leverage covenant of four times. Given our net leverage position, our near-term capital allocation priority is net debt reduction. Over the next few quarters, we expect EBITDA to benefit as we realize savings from our realignment program and we will continue to focus on working capital performance to drive strong cash conversion and reduce net debt. We are closely monitoring our cash position and order development. If we do experience a further weakening in our end markets, we expect to have the flexibility to increase our net leverage covenant to provide short-term relief. Looking at our new debt structure, you can see that we don't have any material required debt payments until 2020. In Q3, we completed the issuance of $600 million of senior notes but equally into two tranches; one of 5.625% due to 2024 and the other at 5.875% due in 2026. The proceeds from these offerings were used to redeem the $600 million 6.875 bond that was due to mature in 2017. As a result, we lowered our annual interest cost by $7 million and we have staggered maturities which should provide more flexibility in the future. We're very pleased with this result. That concludes my prepared remarks. And at this time, I’ll turn the call back over to Marc.

[Marc Michael:]

Thanks, Jeremy. In summary, I'm proud of our team across the enterprise for their dedication during this cyclical downturn and I’m pleased with the progress we've made on our realignment program. That said, we have room for continued operational improvement and I expect us to execute at a much higher level going forward. I’m confident we will achieve our current savings target of $135 million and we are evaluating and intend to implement additional footprint and cost actions in our 2017 plan. I am encouraged with our relative stability in our food and beverage and industrial segments and see opportunities for us to grow the high value product lines in aftermarket sales within those segments. Power and energy continues to be a significant headwind and the weaker orders in that segment were the primary cause of our 2016 guidance reduction. Even in a challenging macro environment, I am fully committed to improving our profitability and creating shareholder value. Given a sequential decline in orders in the second half of 2016, we are planning for a lower level of revenue in 2017 and 2018. As we plan for 2017, we are evaluating additional actions to adjust our cost structure to a lower level of revenue. The 2018 framework outlined on this slide illustrates the performance I believe our business should achieve on $1.9 billion to $2 billion of revenue. By executing our realignment program, adjusting our cost structure and improving our operation performance, all of which are in our control, I’m confident we can increase our annual EBITDA and generate a significant increase in free cash flow by 2018. I’m committed to creating value for our shareholders and I appreciate your support and commitment as we transition to an operating company and work toward creating a better future at SPX FLOW for all our stakeholders. That concludes our prepared remarks. Thank you for joining us on the call this morning. And at this time, we’ll be happy to take your questions.

[Operator:]

Thank you. [Operator Instructions]. Our first question comes from the line of Mike Halloran with Robert W. Baird. Your questions please.

[Mike Halloran:]

Good morning, guys.

[Marc Michael:]

Good morning, Mike.

[Mike Halloran:]

Hi. So let’s talk about that framework going into 2018 and how do you bridge it from your '16 guidance? Because I look at things, you’ve got some revenue pressure which just seems appropriate versus what you’re seeing. In that 2018 guide, you obviously have another incremental 65 million that are going to roll through on your announced cost savings. That’s $1.10 or so if I did the math right. Backing some of that volume deleverage off, there’s obviously a gap between that $2.50 and $2.90 range versus where you’re ending up here. So maybe help bridge that gap. Is it simply we’ve got further cost savings where you announced that we feel comfortable can get us in there or are there other moving pieces that I’m missing?

[Jeremy Smeltser:]

So there are a few things, Mike, that weren’t in the previous bridge. So one, the elevated level of EAC costs in the food and beverage segment in the second half of this year is something that we would expect to dissipate as we go forward. As I said, it’s primarily related to one large project. That project is still profitable, however, it’s coming in less profitable than we expected. Typically for us compared to our asphalt margins in the project business, we would assume a couple million dollars a quarter of hedge, execution risk. So it’s around 100 basis points in this quarter and in the fourth quarter were more around 400 basis points. And that’s just something that we don’t typically see over the last couple of years. And so we assume our execution will improve there. And then I think the other big item that people need to wrap their heads around is really the transition costs this year and next year into the Poland facility. So for this year, what we’ve experienced is some level of duplicative costs in Germany and in Denmark for the activities that are moving to Poland. And for the year, I estimate that at about $15 million to $20 million in total. So we’re making good progress and you can see that in the food and beverage margins. I mentioned earlier, sequentially Q2 to Q3, our productivity and throughput increased dramatically in valves and now we’re going through that process for heat exchangers and we’re starting it for homogenizers. And so over '16 and '17 we’re seeing it drag down by the transition costs, but as we shut the lights out on those factors we’re exiting, those transition costs will go away. And then I’ll let Marc talk about incremental realignment activities.

[Marc Michael:]

Yes. So there’s two other things I would mention. Again, the incremental realignment activity is going to be an important assessment we’re making as we go through the 2017 planning process, which we’ve already ticked off. And as we pull that together and finalize it over the next few weeks, we are expecting we’ll have additional savings opportunities that would flex the lower run rate of the business. So that’s an additional area. And then I’d also mention there’s a lot of continuous improvement activity which is not really – I wouldn’t consider as bridge item but we do expect to improve upon as we look at our factory ops. So our cost to quality, our controllable cost per hour, overall throughput we’ll expect that also to contribute as David Kowalski and his team continue to make improvements in our operations in 2017 and into 2018. So I think the key message here is that there is a significant amount that is in our control; things that Jeremy mentioned, the ongoing realignment, the improvement in our operations. All these are really important to us. And the final thing I would mentioned too is we looked at the performance of the business and you see somewhat in the underlying margin profiles in industrial and if you take out the challenge we had on the one project in food and beverage, the underlying margin profiles are holding up pretty well in the lower environment. And so we’re going to continue to work on the high margin product lines and the aftermarket business. So there’s still again a lot that we have in our control as we work through 2017 into 2018, and that’s a pretty long period that we have to continue to improve the business overall. So we feel still really confident that we can achieve the numbers that we’ve indicated here on this financial framework analysis.

[Mike Halloran:]

Yes, it makes a lot of sense. And then on the revenue side bridging into next year, obviously this 2018 framework comprise that you guys are thinking further revenue pressure in the next year, which makes a lot of sense. Maybe help understand some of the puts and takes. You’re starting to see a little bit more improvement in the dairy pricing. When does that roll through? Industrial orders picked up a little bit towards the end. What kind of momentum does that give you into next year? And then some thoughts on the power and energy side too.

[Marc Michael:]

So I’ll start and then Jeremy can add any additional points. So I’ll take you through a walk on each segment of this. So starting with power and energy, again, the tougher part of this right now is especially oil and gas. In oil and gas, we did see another lag down in Q3 both in OE and the MRO business associated with some of our quick return business. So Q3 was really a new trough point for us, as we mentioned in the prepared remarks. Conversely, we do see some positive things happening in our P&E group. The conventional power orders continue to be steady and we received this nuclear order. And we’ve been talking about the possibility for nuclear orders since the outset of the year and some of those are starting to come through now. So when we look at P&E, oil and gas is still the challenging part and that’s – as mentioned that was the big part of what impacted 2016. And we’re taking a prudent approach there that as we look into 2017, we don’t expect that to really improve or get better. We’re not counting on large projects to come back in. In food and beverage, again really consistent for us. If we look back over the past six or seven quarters, our run rate business has been very steady. So our aftermarket business, our components business has been very steady and has been progressively improving. There’s just really an absence of these large projects. And so that’s been kind of the key point. And we haven’t planned the business around having these large projects as we’ve talked about throughout the year too. So in food and beverage, again, really good smaller systems orders that are easier to execute on, typically better margin profiles, very steady aftermarket and component business. And we’ve seen that really again going on now for six or seven quarters. So we’re really pleased with the performance in food and beverage overall. We’ll clean up some of the project-related issues and we’re in a good spot there as we look into 2017. And then in industrial, as we’ve also talked about throughout the year, there’s been limited large orders. And when there are large capital orders and these are kind of the $10 million type orders in industrial, it’s been very competitive and we haven’t really secured a lot of large orders. Now we did have this one nice $5 million order in the quarter for desiccant dryers with a customer in China. But for the most part, there hasn’t been a lot of large orders. The run rate business overall we saw a step down happening in the run rate business starting in April and that kind of continued through August. But what was encouraging is we saw run rate business in industrial towards the second half of September start to pick up, and that’s kind of continued through October. But it’s getting it back to levels that we saw in Q1. So it seems to be stabilizing in industrial even though it still may continue to be a little bit choppy as we move through the next several quarters in the overall macro environment we’re faced with in our industrial product lines. And then aftermarket has been pretty consistent there too. So as we look into 2017 and we think about how we’re planning for 2017 just as we looked at this year, we’re not counting on large projects across the board. So large capital projects in both P&E, F&B and industrial. Those aren’t a part of how we’re planning the business. We’re planning it more on the run rate portion of our business and that’s how we’re aligning the cost structure. And as we look into '17, that’s where we kind of see the revenue profile starting to shape up.

[Mike Halloran:]

That’s very helpful. I appreciate it.

[Marc Michael:]

You bet.

[Operator:]

Thank you. Our next question comes from the line of Shannon O’Callaghan with UBS. Your questions please.

[Shannon O’Callaghan:]

Good morning, guys.

[Marc Michael:]

Good morning.

[Shannon O’Callaghan:]

Hi. Marc, on the food and beverage elevated project costs, that’s an area I know you put a lot of work into. Can you explain sort of what’s going on there? And do you view that as kind of the step back to the efforts you’ve been putting in place and a little bit on your confidence as getting past those and ensuring they don’t happen again?

[Marc Michael:]

To you point, Shannon, a lot of work went into John Watkins and his team in the project execution part of the whites organization. Put a lot of effort over the last couple of years into the processes that we have in place and the organization, and I’m still really confident in that. This is one project where there were some delays on site. We’ve been working closely with our customer on how those delays were impacting our performance and our progression overall. But we’ve got to keep progressing the project. And we always make that commitment to our customers and we continue to work with them as we’re doing the execution. And that won’t change as we go through Q4 and into Q1 on this particular project. And we’re staying close to the customer. And again, some of the site slowdown is impacting us. We’re talking to them about the schedule. We’re talking to them about the cost overruns. But we’re at a point where we have to take those charges and continue progressing the project and we’ll continue to work with them. So I’m still really confident in all the work that’s gone into what John Watkins and his team have done in the project execution part of food and beverage. And they’ll overcome this one too and we’ve got a good team and a good process in place for the normal run rate of our business.

[Shannon O’Callaghan:]

Okay, thanks. And then on the power and energy, MRO of aftermarket business being weak. What are you hearing from customers on that part of the business? Is that kind of taking another write down? And 4Q would typically be a strong quarter for that part of the business. Is that not going to happen in the fourth quarter? And just generally what are you hearing about that type of thinking?

[Marc Michael:]

It still is challenging. They’re still really controlling the budget pretty tightly. We’ll have to watch it closely. The start of October of Q4 doesn’t indicate that there’s an uptick that would happen and we’re planning more for a flat scenario, as we move from out of Q3 into Q4. And we’ll watch it closely. But customers, for the most part I would describe it, are still managing those budgets exiting the year very tightly and making sure that they’re conserving their expense budgets to maintain cash as they exit 2016. So that’s how we plan going into Q4 that we don’t expect to see any significant uptick in the seasonality aspects of Q4.

[Shannon O’Callaghan:]

Okay. Thanks, guys.

[Marc Michael:]

Thanks, Shannon.

[Operator:]

Thank you. Our next question comes from the line of Nathan Jones with Stifel. Your questions please.

[Nathan Jones:]

Good morning, everyone.

[Marc Michael:]

Good morning, Nathan.

[Nathan Jones:]

I’d just like to follow up again on this food and beverage project. I think Jeremy said it was 400 basis points of margin to the overall segment in the quarter, which is $7 million. You’re talking about another $7 million in the fourth quarter. I think Marc you just said maybe some of that increased cost then also carries over into the first quarter of next year. So we’re talking about $0.25 of earnings here. Can you give us a little bit more detail on what exactly the root causes of the problem here are and what kind of measures have you’ve taken to ensure this doesn’t happen again? We’re talking about large projects that were ordered earlier in the year ramping up in the fourth quarter. Just maybe help us get a little bit more comfortable that we’re not going to see repeat of this on other large projects?

[Marc Michael:]

Yes, Nathan, and just to level set on this project; this project has actually been in execution and was taken into the backlog sooner than earlier this year. It was during 2015, may have been late 2014. And it’s a project that – a larger project in nature. And again, the run rate business that we have in the business is pretty consistent. That’s not where we’re seeing challenges. That’s the business that we’ve been taking in through the last several quarters and even as we’ve described it, the run rate parts of the business and the liquid part has been stable for us for the most part and has been consistent with our expectations. So this particular project is pretty unique and again is still profitable, but it’s not progressing at a pace that was expected. So we’ve got higher costs that are happening on site, as our subcontractors are working to complete and execute to the customer’s schedule. But again, it has been delayed. So the delays are causing the cost overruns on site and it’s holistic. It’s not just our part of the project overall. There’s delays on progressing the project and that’s where we continue to work with the customer to access how we can work with them to get a relief on the schedule that’s more consistent with what real timing is. So these charges are associated with those one project and primarily associated again with delays. And the additional subcontract cost is associated with making sure we continue to progress. Because we still commit to the customers and this is with every project. But when we run into challenges, we have to work closely with them to evaluate how to overcome them.

[Jeremy Smeltser:]

I would just add, Nathan, the reason we have confidence that this isn’t systemic as this is a unique project. And your math is right. Remember that I said earlier that we typically budget for a couple million dollars or cost overruns to our as-sold margins in any given quarter. So it’s not quite as dramatic as thinking about 7 million times two or something for next year. And a little more specificity on what Marc is saying is as there are slight delays by our customers and/or their utility contractors typically or construction companies that are building the actual structures, what we have to do is look at the schedule to complete. If that schedule extends out, that means more hours for our people and our subcontractors and we automatically put that into the estimate to complete, as well as if there are milestone timing that would require additional costs or revenue reduction on our part. We have to book those in an accounting perspective. However, the actual outcome is still to be determined. As we progress through this with the customer, we continue to negotiate for the change orders to offset those particularly in areas where it’s not related at all to our execution. And so we’re recording things now that aren’t necessarily cash and frankly maybe reversed at some point in the future as we get relief of items that can’t be attributed to our actions.

[Nathan Jones:]

Okay, that’s helpful. And then my follow up is on bridge to 2018. If you take out that 15 million to 20 million transition costs and say $15 million on this project execution, there actually is no gap between 2016 and 2018. Do you view that 2018 bridge is conservative not only including any future cost out actions or maybe pricing deteriorating and you’re going to offset that with further actions? Or just how are you viewing that bridge to 2018 in that context?

[Marc Michael:]

It’s a great point, Nathan. What we’ve really done in there is we do think that there’ll be additional cost actions but I’d also tell you based on our execution this year that there’s no short-term incentive compensation in our P&L for the whole company. And so you’d have to assume with that level of improvement that there would be some level of bonus across the company. And so that basically is an offset mathematically to the additional realignment savings. And again without having specificity on exactly what actions we’re going to decide to take incremental in 2017, I think it just makes sense to kind of let those neutralize each other for now.

[Nathan Jones:]

Okay, that’s fair. Thanks very much for the help.

[Marc Michael:]

You bet.

[Operator:]

Thank you. Our next question comes from the line of Julian Mitchell with Credit Suisse. Your questions please.

[Ronald Weiss:]

Hi, guys. Ronnie on for Julian.

[Marc Michael:]

Hi, Ronnie.

[Ronald Weiss:]

Good morning. I was wondering if you guys could frame how much of the revenue disappointment this year you categorize as kind of delays of existing orders versus new orders just not being placed at all versus your initial expectations, and if that kind of materially deferred between the segments?

[Jeremy Smeltser:]

Yes, I think – the way I would think about this is starting with industrial, the easiest story to talk about is orders are remarkably consistent across the year and the backlog in fact is basically exactly where it was at December 31 here at the end of Q3; and so very steady there. In food and beverage, as you’ll recall, we had in the press release in Q1 where we had three orders that were $55 million or so. Those were really the only three large orders that have been booked the whole year. And so since Q1 everything else in the front log has been pushed out from a systems perspective but the underlying components at aftermarket has continued to be pretty solid. And we’re pretty pleased with the progress there. Then it really comes down to power and energy. We had a second half 2015 run rate of orders of 150 million to 155 million Q3 and Q4. In Q1 and Q2, it stepped down in the 130s and then here in Q3 we stepped down to about 120 or so. And so really it all comes back to power and energy, as Marc indicated earlier. They’re difficult markets to predict. And remember that the OE pump business which is our probably least profitable product line in the power and energy segment was the first to decline. And what we’re seeing now is relatively significant declines in the valves and the aftermarket revenue streams which are the higher margin than the average in the segment, and that’s really what’s hurting us the most right now.

[Marc Michael:]

Yes, and I would just add on that again, I think an important understanding is, is that our core business in industrial and food and beverage again over the last – throughout this year and even going into last year has been – again, I think really stable is a good way to describe it, really consistent with the absence of these large projects. And the oil and gas part of our business in P&E has been the real challenge. And even in power and energy, the conventional power piece which is smaller and the nuclear which is more lumpy has been pretty good for us, so oil and gas has been really the type of product. And it is reaching what I would describe as very low levels on the OE side of the business.

[Ronald Weiss:]

Makes sense. And then if you could just talk on some of the pricing dynamics versus the volume declines and what’s that looking like?

[Jeremy Smeltser:]

We haven’t seen a lot of change as the year has gone on. We remain very competitive in P&E and it has been – it remains very competitive. Marc mentioned this earlier on the industrial side when large projects do come along and we have chosen to walk away in some of those projects, in fact most of those projects this year. In food and beverage, I don’t think it’s really a pricing or competitive issue. I think it’s a macro issue for that space as people are just deferring large capital decisions. We’re really not seeing a lot of large dairy projects actually get placed anywhere in the marketplace right now.

[Marc Michael:]

Yes, and I’ll just add on to that. Our run rate business, the pricing here has held up pretty good. It’s been pretty consistent throughout. So it’s really been this OE piece in the large orders that’s been challenging.

[Ronald Weiss:]

Great. Thanks, guys.

[Marc Michael:]

Sure.

[Operator:]

Thank you. Our next question comes from the line of John Walsh with Vertical Research. Your questions please.

[John Walsh:]

Hi. Good morning.

[Marc Michael:]

Good morning.

[John Walsh:]

Was just curious thinking about these additional cost actions and if you’d characterize them as kind of structural in nature or if some of them is more variable whether kind of rightsizing the workforce and that comes back if sales kind of surprise a little higher than you think? How do we think about the incremental cost actions?

[Marc Michael:]

As we complete our 2017 planning process and we’ll look at the expected order intake and the subsequent revenue profiles, some of it will be I anticipate related to the order levels. And then we are continuing to work through structural change. A lot of that has taken place this year but we’ll continue to look at the opportunities that we may have to continue to improve our cost based on the realignment that we’re doing, the structural changes that we are making; so in the footprint, in our structure around our functional support groups. So it will be a combination of the two and we’ll quantify that as we complete the 2017 planning process.

[John Walsh:]

Okay. And then as a follow up focusing still on price and maybe the price cost gap, how do we think about that in that bridge to 2018? Is that a neutral? What are you trying to have embedded in there from the guide there?

[Jeremy Smeltser:]

Yes, we’re basically assuming an environment consistent with what we are seeing right now. Given the volatility of the market, that’s the most appropriate way to look at it.

[John Walsh:]

All right, thank you.

[Marc Michael:]

Thanks, John.

[Jeremy Smeltser:]

Thank you, John.

[Operator:]

Thank you. Our next question comes from the line of Ryan Cassil with Seaport Global. Your questions please.

[Ryan Cassil:]

Good morning.

[Marc Michael:]

Good morning, Ryan.

[Jeremy Smeltser:]

Good morning, Ryan.

[Ryan Cassil:]

Just a question on food and bev, you’re talking about the modest front log increases that’s been sort of fits in. There was a thought out there that early next year you might see some of those beginning to convert into orders. Just given where we are today, is that still the thought or are you kind of more cautious on thinking about the conversion there?

[Marc Michael:]

Yes. So our front log in food and beverage has been pretty consistent. The mix has changed a little as we’ve moved through the year. As we exited Q3, we saw an increased percentage in our liquid dairy, a decrease in dry dairy, the area that we haven’t really – we really haven’t counted on and we haven’t looked at the business to be achieving or receiving large orders. So we based this on this smaller run rate type order business in systems from kind of the $2 million to $10 million range. So we would expect any large orders to be some benefit to us to leverage from that. Specifically on dry, we’re not expecting and haven’t been expecting the dry part of the market to pick up dramatically in the commodity base products, skim milk powders and the whole milk powders. So don’t really expect that in the first half of the year or for that matter, we’re not really counting on anything for 2017 in the dry space for the commodity powders. There may be some opportunities out there in more of the high value powders like whey powders that could come to fruition, but we again are planning on large orders in the dry part of the business. Now in the liquid area, again this is where our emphasis is because it is the better part of our business in terms of how it has pulled through of our components in aftermarket streams. So the liquid part of our business, the fresh dairy products, the yogurts, the probiotics, the different alternative beverages, this is an area that’s important for us and that’s where we’ve seen the run rate business right now. And we would hope that they’ll be some kind of, I would say midsized projects develop. But again, we’re not planning the business based on those midsized projects. So again, those would also create opportunity for us we would expect as we move through 2017 should they come to fruition. So the increase in commodity prices for skim and whole milk powders bounced off a very low trough that’s kind of developed through the course of Q3. Not doing that is a near-term catalyst that we would see an outbreak of orders in capital deployment coming from the market.

[Ryan Cassil:]

Okay, thanks. That’s helpful. And then as a follow up, just on working capital you saw a little bit of improvement here in the third quarter. Can you just talk about the fourth quarter and do you see that in a more material way or is that going to be more of a 2017 benefit in your view at this point?

[Jeremy Smeltser:]

Yes, we do expect it to actually improve sequentially from Q3 to Q4. We dug ourselves a bit of hole in Q1 that we basically dug out of in Q3 to get back to kind of even, particularly on inventory. And I think we’re going to make further progress in Q4 on all that. The real challenge for us in total working capital is the project milestone payments. And so you’re seeing – it kind of looks like inventory build but it’s really work in process on the larger projects. And as those milestones push out, that we talked about earlier, that also means our cash receipts on those budgets push out. So that will offset some of the working capital improvement that I’m expecting but it really is a timing issue into 2017.

[Ryan Cassil:]

Okay. Thanks, guys.

[Jeremy Smeltser:]

Thanks, Ryan.

[Operator:]

Thank you. Our next question comes from the line of Deane Dray with RBC. Your questions please.

[Deane Dray:]

Thank you. Good morning.

[Marc Michael:]

Good morning, Deane.

[Jeremy Smeltser:]

Good morning, Deane.

[Deane Dray:]

I’d like to go back to that question on pricing and the bridge to 2018, especially for power and energy. Now most of your flow peers are acknowledging, especially this quarter, that when there is a recovery and orders do start to come in that that's when typically you’ll see more pricing pressure where companies just want to fill up their factories and run their businesses more for cash. Is that a scenario that you’re anticipating? And sometimes it won't be as severe because you've got more custom products which tend not to have too much in the way of direct price competition. But just take us through that dynamic, if you could.

[Marc Michael:]

Sure. And I think the first part I'll do is remind you we’re not assuming an uptick in order levels. And so that wouldn't necessarily come into play as it relates to the framework we have presented here. But still obviously a valid point and something that particularly on the OE pump side of the business has been experienced in the marketplace in the past. What I would say is, for us our OE pump business right now is at a very, very low level. And so we will remain disciplined even as that comes back. We’re not going to ramp up our throughput capabilities for business that isn’t attractive from a tease and seasoned and profitability perspective. I would also just remind you too that our larger exposure right now is probably on the OE is in the valves business in midstream and that has historically not been as volatile from a pricing perspective as the market firms. And so I think that's probably something that's on our side as well. But again not necessarily impactful to the 2018 framework we presented today.

[Deane Dray:]

Great, that's helpful. And then I just want to go back. In your answer to Nathan's question on the execution challenges in the food and beverage business on the large orders, that was really helpful in terms of kind of the granularity about the impact on the delays that are on your side and subcontractors versus delays from the customer and the reserves and so forth. That was really helpful. Did I hear earlier, and I might have missed this, on execution challenges on the power and energy side on large orders, do you have the same sort of description about what's going on there? And that would help us frame what that issue is.

[Jeremy Smeltser:]

Yes, that's quite a bit different of an issue. That's really within our actual factories. On the food and beverage side, those are construction on customer sites. And that really I would say is more blocking and tackling around engineered to orders, so they are custom. We’ve had a few supply chain challenges and we’ve had a few customers who conveniently don't show for a late quarter inspection to push delivery out into the next quarter and delay the cash flows, which a lot of folks experienced in a market where demand is so challenging and our customers in P&E have pretty challenged cash flows. So I think it's more blocking and tackling a little bit on our side which we expect to improve on in Q4 and the customer environment I think we all expect it to remain pretty tough in Q4 and into next year.

[Deane Dray:]

Got it. And just last question for me, Jeremy, could you just clarify your comments on the debt covenants, potential timing, how close and what the remedy might be?

[Jeremy Smeltser:]

Sure. So we’ve had preliminary discussions with our lead banks, as you would, when you get down to – I think right now we're about a 5% cushion to our midpoint model. On the covenant, you start talking about what a potential amendment would look like, what it would cost, what would be the trade-offs? And that really drives what I said earlier which is we’re confident we could move it up for short-term relief. To put some thoughts around ranges, I never want to get ahead of the marketplace because the market will determine that. But to have a 12 to 18-month temporary increase in that covenant within the five-year credit facility is very doable. And as it relates to how big, half to three quarters of a turn of EBITDA is a pretty reasonable thing to think about given our profile and our historical cash flows. And the cost wise, these kind of amendments typically aren't terribly expensive. I'll just point you to our amendment earlier this year which is about $3 million. They had a slight impact in our pricing grid for the period as the relief. That's a reasonable expectation of our lenders but not material given the overall interest rate environment. 25, 35 basis points probably is something reasonable to think about. So again, I definitely don't want to get ahead of the market but just to give people a framework, we’ve had the conversations. I’ve been in this situation before. These are all things that we can address as necessary.

[Deane Dray:]

Got it. Thank you.

[Jeremy Smeltser:]

Thanks, Deane.

[Marc Michael:]

Thanks, Deane.

[Operator:]

Thank you. Our next question comes from the line of Robert Barry with Susquehanna. Your questions please.

[Robert Barry:]

Hi, guys. Good morning.

[Marc Michael:]

Good morning, Robert.

[Jeremy Smeltser:]

Good morning, Robert.

[Robert Barry:]

Given how much restructuring you’re doing, I'm just curious to what extent just all this moving stuff around might be creating some operational frictions or perhaps in some cases you’re even kind of proactively slowing order intake activity just because it might be harder to be, say, responsive to delivery times. Is that dynamic at play at all here?

[Marc Michael:]

Yes. So, first, we’re definitely not slowing order intake. Every day we’re looking for new opportunities with our customers to generate order intake. As far as the restructuring, the transitions, the realignment, the factory consolidation, again we plan for some level of inefficiencies as we’ve moved through the year. We saw that develop in Q2 as we moved some of the operations around in Poland and we saw it to a much lesser extent as David Kowalski and his team worked on transitioning and improving upon all aspects of how we’re executing for our customers and the products that we supply out of Poland, so a big improvement in Q3. So there some level of inefficiencies that clearly do develop and we account for that in some form or fashion. But as far as executing for our customers accepting orders, that's our primary focus and we’ve in no way slowed that down by any means.

[Robert Barry:]

Yes. And where I was going is I think in this environment, customers are demanding very short lead times and maybe it’s just sometimes harder to be as competitive on the lead time.

[Marc Michael:]

For the majority of our factories, we’re at market lead times. We’re competing in the market every day. We understand what those requirements are. In regards to Poland, our lead times we expect to improve there pretty significantly from what our prior lead times were even though there is some short-term implications that do arise in some cases when you’re moving. But as we go into 2017 and we look at our lead time profiles, we expect those to be within market requirements. And again, you may have some bumps on the road as you do some of the different changes but we can overcome that, and I guess we’ll be at market lead times or better as we move into 2017.

[Robert Barry:]

Got you. And I think at 2Q, you kind of quasi-directed us to I think about as a framework food and bev revenues being about flattish and power and energy being down mid-to-high single. What’s the outlook there now? Should we kind of ratchet each of those down a little bit at this point?

[Jeremy Smeltser:]

Well, the way I do it, Robert, is typically look at 12/31/15 backlog and then go ahead and look at the September 30 backlog we presented today. And so for industrial you’ll see, as I said earlier, it’s exactly flat. For food and beverage, it has increased about $12 million over the nine-month period though that’s likely to reverse in Q3 as we start to execute on the large projects that we announced in Q1, and it may be flat to slight down at year end. And then power and energy is down about $55 million or so from year end to now and that’s where you kind of think about that $55 million decline and think about that across the enterprise from a $2 billion kind of current revenue level. I don’t know any better way to do it right now when we don’t have the forward look on the power and energy orders as they continue to be volatile.

[Robert Barry:]

Got you. And could I just sneak one more in on midstream? Can you just give us an assessment, your assessment of the midstream? I think your business is mostly U.S. or North America?

[Marc Michael:]

That's right. Our valves business is mostly North America. It's continued to be quite slow in the midstream for valves business. There have been projects that are approved but those have continued to shift. And there is no indication of a significant uptick out there in terms of just overall requirements in the market. Again, those projects are still there but we expect the midstream to continue to be at low levels that we’re seeing today as we move into 2017.

[Robert Barry:]

Is Dakota Access a significant factor for you yet?

[Marc Michael:]

No.

[Robert Barry:]

Okay, great. Thank you.

[Marc Michael:]

Thank you.

[Operator:]

Thank you. Our last question comes from the line of Chase Jacobson with William Blair. Your questions please.

[Chase Jacobson:]

Hi. Good morning.

[Marc Michael:]

Good morning.

[Chase Jacobson:]

I don’t mean to belabor the point on this, but I think it’s the EMC analyst in May [ph]. On the food and beverage project, can you help us kind of give us some color on the overall size of that project just given how large the charges are? And also what are the – what impact does this lower execution have on revenue versus your original expectation? And then second question, unrelated; in the power business, one of the positives you mentioned was that conventional power remains steady. Could you just expand on that as well? Thanks.

[Jeremy Smeltser:]

So the overall project size there is in the $75 million to $100 million range depending on how many phases the customer chooses to go with. From a size perspective, I’d kind of start there. As Marc mentioned earlier, it’s still a profitable project for us even after we put these additional costs and timelines into the whole construction schedule. As it relates to revenue, not very significant at all on the quarter given where we are from a percentage of completion perspective. On conventional power, it’s a small part of our business but it remains relatively steady. I would say nuclear is where we’ve actually seen a bit of an improvement. We had a nice $8 million [indiscernible] back in Q2. And then I think Marc mentioned earlier today, $18 million UK nuclear order that was received in the quarter. And there’s quite a bit of that in the front log too, which is encouraging although much longer cycle to turn into significant revenue.

[Marc Michael:]

Yes, and I would just mention a little more color on the conventional space. While it is a small part, it aligns a lot with our turbine bypass valves that go into the natural gas space. So it’s a nice part of the business that has some opportunity for modest growth for us as we look at number of natural gas plants being built around the globe.

[Chase Jacobson:]

Thank you.

[Marc Michael:]

Thank you.

[Ryan Taylor:]

Thanks, Chase. This is Ryan Taylor. We’re at the end of our call now. I appreciate everybody joining. Thanks for being with us on the call today. And as normal, I’ll be available throughout the day to answer any follow-up questions you might have. Thanks, and we’ll see you next time.

[Operator:]

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.