RBC Bearings Incorporated
Q2 2013 Earnings Call Transcript

Published: 31 Jul 2013

[Operator:]

Good morning, and welcome to the Regal Beloit Second Quarter 2013 Earnings Conference call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Mr. John Perino, Vice President of Investor Relations. Mr. Perino, please go ahead.

[John M. Perino:]

Thank you, Amy. Good morning, and welcome to the Regal Beloit second quarter 2013 earnings call. Joining me today are Mark Gliebe, Chairman and CEO; Jon Schlemmer, COO; and Chuck Hinrichs, Vice President and CFO. Before turning the call over to Mark, I'd like remind you that the statements made in this conference call that are not historical in nature are forward-looking statements. Forward-looking statements are not guarantees since there are inherent difficulties in predicting future results, and actual results could differ materially from those expressed or implied in forward-looking statements. For a list of those factors that could cause actual results to differ materially from projected results, please refer to today's earnings release and our filings with the SEC. On Slide 2, we mentioned we're presenting certain non-GAAP financial measures related to adjusted diluted earnings per share, adjusted gross profit, adjusted gross profit as a percentage of net sales and adjusted income from operations and free cash flow. We believe these are useful financial measures for providing you with additional insight into our operating performance. Please read this slide for information regarding these non-GAAP financial measures. And please see the appendix, where you can find reconciliations of these measures to the most comparable measures in accordance with GAAP. Now I'll turn the call over to Mark.

[Mark J. Gliebe:]

Good morning, everyone. Welcome, and thank you for joining our second quarter call, and for your interest in Regal. We'll follow our normal agenda, I'll make a few opening comments. Chuck will go give a financial update. Jon will provide color on products, markets and operations. I'll summarize and we'll move to Q&A. For the second quarter, Regal delivered top line sales performance that we had expected. Our commercial and industrial markets improved slightly over Q1, but still sluggish versus prior year. HVAC sales were in line with our expectations, but offset by the customer dynamics we discussed in Q1. We did see strength in other residential markets outside of HVAC due to improved end market conditions and new product sales. The challenge for the quarter is that we had a few unusual events that impacted our performance, and Chuck will lay these out for you in detail during his comments. Aside from these unusual events, our gross margins remain resilient to the weaker demand, speaking to the benefits coming from our recently completed synergy programs. Our EPC synergy work was completed this quarter with the final facility closure. We are beginning to realize those benefits and expect to see the remainder of those benefits in the ensuing quarters. With the completion of the EPC synergies, we have shifted our resources to our simplification initiative. As you know, we recently announced the closure of our Springfield, Missouri facility and the transition of that production to existing Regal sites. Jon will cover the operational impact and estimated savings of these efforts. Free cash flow for the quarter came in at 127% of net income. On a year-to-date basis, we are again achieving our goal of cash flow to net income greater than 100%. To spur growth, we launched 17 new products during the quarter after launching 20 new products in the first quarter. We know that over 1/3 of our sales come from products launched in the last 5 years. And we are focused on continuous innovation around energy efficiency to help improve our margins longer term. Finally, we incurred approximately $3 million of expense in the quarter for activities relating to acquisitions. While we did not get one over the goal line, you can be assured that we are actively pursuing acquisition opportunities that meet both our strategic and financial hurdles. We will remain aggressive and yet prudent. And we intend to continue to be a consistent and successful acquirer. As we look to the third quarter, our guidance reflects typical residential HVAC seasonality. And the end market strength is somewhat offset by the customer dynamics we experienced this quarter. Further, we expect a slight improvement in our commercial and industrial markets and modest growth in China. The good news is that the C&I market seems to have stabilized. And we expect the residential market will be a continuing tailwind going into 2014. With that, I will turn it over to Chuck Hinrichs.

[Charles A. Hinrichs:]

Thank you, Mark, and good morning, everyone. Our earnings in the second quarter 2013 were $1.13 per share on a GAAP basis. Restructuring charges in the quarter were $1.4 million or $0.02 per share as our teams completed the hard work of the EPC synergy program. We also brought a tax credit of $900,000 or $0.02 per share as another of our China plants qualified for high technology status, which lowers their income tax rate. The $0.02 EPS adjustment reflects the tax credit applicable to the prior year. This tax qualification will positively benefit our effective tax rate in China in 2013 and future years. Net of these items, our adjusted earnings per share were $1.13. As a reminder, the average number of our shares outstanding in the second quarter was 45.3 million, an increase of 7.9% from the prior year. The higher number of shares accounts for $0.09 per share or 25% of the decline in EPS as compared to the prior year. Our second quarter net sales were $822 million, a decline of 4.9% from the prior year. Sales were in line with expectations. Sales prices declined approximately 0.7% from the prior year primarily due to the 2-way material price formulas with our larger customers, which reflects a similar decrease in our commodity input costs. The impact of foreign currency exchange rates reduced our total net sales by 0.7% and reduced our total international sales by 2.3% during the second quarter. As Mark mentioned, we are pleased with our stable gross margin even with the headwind of lower sales volume. Our second quarter cost of goods sold included $3.6 million of higher inventory costs resulting from the Venezuelan currency devaluation. The higher-cost inventory turned in the second quarter and negatively impacted our COGS by $3.6 million. In the second quarter, we recognized the $2.1 million LIFO benefit, an accounting adjustment to estimate our year-end LIFO reserve. And finally, $1 million of the total $1.4 million of restructuring charges were charged to our cost of goods sold in the second quarter. Our operating expenses also included some unusual items in the second quarter. We incurred $2.9 million of acquisition diligence costs that exceeded our earlier estimate for the quarter. Also, during the second quarter, we recorded $1.4 million of net bad debt expense. Included in our operating expenses for the quarter were $400,000 of restructuring charges and an incremental $200,000 of SG&A from the acquired business. Our free cash flow was a strong 127% of net income for the second quarter, and was over 109% of net income for year-to-date 2013. On Slide 10, we provide summary data on other financial highlights in the second quarter. Our capital expenditures in the quarter were $26.6 million, on pace for total capital spending of $100 million in 2013. You will recall that in 2013, we are investing in 2 large capital projects, the expansion of our Unico plant in Wisconsin and our C&I motor plant in China. Our effective tax rate in the second quarter was in line with our guidance after adjusting for the China tax incentive that I spoke about earlier. We expect our ETR to approximate 26.5% in the third and fourth quarters of 2013. As I mentioned earlier, our free cash flow in the quarter was a strong $65 million or 127% of net income. In the lower right section, we provide some data on our quarter-end balance sheet. Our total debt decreased $54 million during the quarter to $769 million. We repaid our $55 million term loan and expect our net interest expense in the third quarter to decline to $9 million. Our credit metrics continue to improve as our debt to EBITDA was below 1.9x and our net debt to EBITDA was 0.9x. Our guidance for the third quarter is $1.08 to $1.16 of earnings per share on a GAAP basis. Adjusting for the expected $0.02 of restructuring charges for our simplification initiative, our adjusted EPS guidance is $1.10 to $1.18 per share. Jon Schlemmer will provide more color on the restructuring activities. Mark commented on our market assumptions for the third quarter guidance. And we have summarized them again on this slide. We expect pricing to be down slightly in the third quarter, similar to the price decline we experienced in the second quarter, due to the impact of our 2-way material price formulas related to expected lower commodity input costs. Now I will turn the call over to Jon Schlemmer.

[Jonathan J. Schlemmer:]

Thanks, Chuck, and good morning. I'd like to start by giving some color on the end markets and customer demand. As Mark mentioned, overall revenues for the quarter came in as we had expected. In C&I, we got off to a slow start with orders in the North America commercial and industrial motors business stabilizing, however, in the back end of the second quarter. And we ended the quarter with revenues down 3.8% compared to the same period prior year, excluding the impact of the divested pool and spa motor business. We experienced sales strength in a number of end markets including agriculture, commercial food, industrial pump and a slight improvement in commercial HVAC sales. End markets where we experienced weakness included commercial construction, distribution, oil and gas and markets that were impacted by reduced government spending such as municipal water and highway construction. The decline in our mechanical business was substantially driven by reduced demand in oil and gas. Sales in our North America residential HVAC business decreased 6.8% compared to the prior year. The single largest driver of the decline was the customer dynamics we identified during our first quarter call. We had additional top line pressure at our larger customers where we have 2-way material price formulas. Sales, however, in our residential non-HVAC products increased compared to prior year, reflecting the improved residential market conditions. On the international front, we continue to experience challenging end markets in Europe, India and Australia. We did see some quarter-to-quarter improvement in our China business. However, we remain cautious given some of the recent headlines in China. Since the beginning of the year, we have increased our focus in Latin America by increasing the size of our selling team and adding more new products for these customers. So far, we're pleased with the results. And the growth is helping to offset the weakness in Europe and parts of Asia. We plan to accelerate these actions and expect to see more success going forward. During the quarter, our teams launched another 17 new products. That makes 37 new products launched this year in addition to the 60 products launched in 2012 and the 50 launched in 2011. We're continuing to find ways to innovate our products, bring more value to our customers and offer energy-efficient solutions in a wide variety of applications and end markets. Our innovation initiative is vital to our growth. And our customers are taking notice. For the third year in a row, our annual customer survey shows a year-over-year improvement in our customers' perception of Regal as an innovative company. And speaking of being recognized by our customers as an innovative company, I'm pleased to report that 2 of our HVAC products were just recently recognized in the 2013 Dealer Design Awards Program. This was reported in the July 22 edition of Air Conditioning, Heating & Refrigeration News. The awards are judged by contractors who are active in the industry. Here's our new Evergreen EM motor and control, which received the Gold award in the high-efficiency residential equipment category. This is our fourth generation Evergreen product, and was developed using direct feedback from contractors to offer a replacement motor for mid-tier ECM motors. The motor and control system features Genteq's patented Rotation Sensing Technology. This eases installation and reduces SKUs for the contractor. These motors offer a great replacement choice for not only Genteq motors, but also for equivalent competitor motors. We're continuing to expand the Evergreen line of products to offer the contractor more options for both repairs and also energy-efficient retrofits. Last year, we launched 2 gas pre-mix blowers developed for high-efficient pre-mix boilers found in modulating residential boilers and water heaters. This past quarter, we launched 2 additional gas pre-mix blower systems to expand our product offering. The new blower systems give us the ability to meet the requirements of larger commercial equipment found in applications such as hotels, restaurants and office buildings. Our largest gas pre-mix blower can operate burners rated up to 700,000 BTUs. These systems combine our latest technologies and permanent magnet high-efficiency motors, variable speed electronic controls and efficient air moving blowers. This is a growing segment in North America as this technology is very efficient and provides very clean gas burns to meet ultralow NOx requirements. Our designs offer advantages in size, noise and efficiency. We're having initial success in North America with the new platform. And we're now looking to expand into Europe where gas pre-mix technology is used extensively for both water and the heating of residential homes. New products can often take time to deliver real growth. As an example, several years ago, we launched a focused effort with energy-efficient retrofits in North America commercial refrigeration applications. New products were developed and launched to enable retrofits over several years in a wide range of supermarket applications. Upon that success, we then expanded this effort to include HVAC applications in commercial high-rise buildings, where we're gaining momentum in North America. Recently, we've expanded these programs to go after commercial retrofits in international markets. As an example, electricity is very expensive in parts of Central America and can cost up to $0.25 per kilowatt hour. A recent pilot retrofit at a large retail chain yielded a payback less than 2 years. So the customer's now interested in rolling out the program across their entire chain of stores. As Mark mentioned, we completed the EPC synergy program ahead of our original schedule. We closed and consolidated 4 manufacturing plants in Juarez as we planned. And we expect to see additional benefits from this program going forward. Now we're ramping up our simplification initiative. During the second quarter, we announced the closure of one of our fractional motor manufacturing facilities located in Springfield, Missouri. This decision is all about simplifying our manufacturing footprint to drive efficiencies in both costs and lead times to our customers. We will be consolidating this production into our existing Reynosa, Mexico and McAllen, Texas facilities. The transition will begin in the second half of this year and will be completed by the end of 2014. The restructuring costs necessary to implement are shown on the chart. We expect the benefits to be in excess of $15 million to be spread out over 2014 and 2015. At the same time, we're making real progress on our design platform simplification efforts. This chart is an illustration of the impact of just one of our design platform rationalization programs. In fact, we will eliminate one of these design platforms as we relocate the Springfield manufacturing facility. As you can see from the chart, the part count is significantly reduced, making it easier for us to improve our efficiencies and gain leverage on our material purchasing. While the benefits of this effort are difficult to calculate, we are convinced that these efforts will have a long-tail benefit into the future. The decision to close our Springfield facility was a difficult one. Our employees in Springfield have done an excellent job over the years serving our customers. However, we know that this move is absolutely necessary given our global competitive markets. With that, I'll turn it back over to Mark. Thank you.

[Mark J. Gliebe:]

Things, Jon. So to summarize, we delivered revenues as expected, but we had a few unusual events that impacted our headline performance for the quarter. We held our gross margins despite lower volumes. Our cash flow remains strong with free cash flow to net income over 100% on a year-to-date basis. Our execution has been solid with the completion of our synergy programs ahead of our original schedule and now a real focus on footprint and platform simplification. We continue to launch new products to innovate our product offering and drive growth and margin improvement. We continue to aggressively and yet prudently seek acquisition candidates that meet our strategic objectives and financial criteria. Regal continues to execute on all operating fronts. We have the right people working on the right programs. We have the right products, and we are positioned in the right geographic regions. We are focused on organic growth, growth through acquisitions and operating margin improvements. We are well-positioned for the future. With that, we will take your questions.

[Operator:]

[Operator Instructions] Our first question is from Mike Halloran with Robert Baird.

[Michael Halloran:]

So good to hear that you're seeing some stabilization in the C&I end markets right now. Maybe you can just talk a little bit about how the trends went through the quarter. I know you talked about stabilization towards the end. What types of growth rates were you seeing maybe exiting? Because it sounds like you're looking at growth starting to resume on the C&I in the back half of the year, and please correct me if I'm wrong there. And what inventory levels look like to your channel partners?

[Mark J. Gliebe:]

Okay. Thanks, Mike. So as Jon mentioned, we started off slow in the quarter in C&I. And then as we went into the back half of the quarter, our order rates seemed to improve slightly and certainly stabilized. No question we have the easier comps on a year-over-year basis. And so we won't see the deterioration in sales that we were seeing on the front half of the year.

[Charles A. Hinrichs:]

And I would add, Mike, I would add that we would -- right now, our view of inventory is that the inventory seems to be at normal levels in the channel for the most part and stable at this point.

[Michael Halloran:]

That makes sense. And then on the HVAC side, obviously, you had the customer loss that you talked about last quarter, and it sounds like there was a little bit of price giveback with how commodities have trended here. When you look at the volumes and you try to normalize for those items, how do you think the HVAC growth looked in the quarter?

[Mark J. Gliebe:]

Well, our best indication is what our customers are saying. And as you probably know, it was a mixed bag. But I would say it was -- from our customers for the quarter, it was probably high-single digits in the quarter. And as we look forward for the -- on a year, on a total year basis, probably mid-single digits for the year. And that trend continuing into 2014 is kind of what we're hearing from our customers.

[Michael Halloran:]

And then on the pricing conversation side, how much of the price decline is based on indexing, qualitatively at least? And how much is it customers coming back to you and saying, "Look, commodities have tracked down. We need a little bit of a giveback here?" And how frequent are those conversations?

[Mark J. Gliebe:]

Well, the majority of any of the price that we discussed here is related to our material price formulas, where we have 2-way agreements with our customers. When copper goes down or steel goes down, we give it back. And when it goes up, we get it. So I would say that was the majority of it. And relative to, is there a different tone out there, I would say we are seeing what we normally see. And that is as copper tails down, people start to ask questions. And as copper moves up, those questions tend to stop. And right now, it's quite volatile. A week or so ago, it was up to $3.15 again. And so it's a quite volatile time.

[Operator:]

The next question is from Nigel Coe with Morgan Stanley.

[Nigel Coe:]

Yes. So obviously the due diligence costs you absorbed this quarter was a rather big number. And I'm wondering can you just maybe give a bit more color around that. Was that one large situation or a number of smaller ones? And so the decision to pull back, was that purely price related? Or was there anything else in the due diligence process that caused you to pull out?

[Mark J. Gliebe:]

Well, we're not going to get into the specific details of what happened with any of our acquisition pursuits. It's no surprise that we are out there looking at different acquisition opportunities. We have been clear about that. And as we've said in the past, those opportunities are -- and some of them are smaller bolt-ons. Some of them are somewhat larger. And then as we have made the comments in the past, some are even larger than the EPC acquisition. But we're not going to get into further detail.

[Nigel Coe:]

No, no, no, I fully understand that. But given that it seems that you were pursuing an opportunity in 2Q, does that push to the right the potential for a larger deal to come through?

[Mark J. Gliebe:]

We're going to remain -- as I mentioned in my comments, we will remain active. Our pipeline remains active. And we will continue to pursue acquisitions that meet our strategic and financial goals.

[Nigel Coe:]

Okay. And then just another one on the pricing. So outside of these commodity-based formulas, how would you describe pricing dynamics in your end markets? Would you say they're fairly stable Q-over-Q, improving? How would you characterize that?

[Mark J. Gliebe:]

Well, we commented that there was, as the result of our 2-way price agreements with our large OEM customers, as copper went down, we had to give some of that back to our customers. Obviously, when copper goes back up, it goes the other way with those customers. And as I had mentioned on the previous question, as copper goes down, you tend to get more questions on price. And as it kind of goes back up, those back off. And I would say right now, it's volatile. Copper is volatile. So it kind of ebbs and flows.

[Nigel Coe:]

Okay. And clearly, I mean we're all waiting for the impacts [ph] on sales. Any visibility in terms of when you might sit right back into possible organic growth? And your comps do get a lot easier in the second half of the year. I'm wondering, do we start to see that trend moving back towards positive growth in 3Q?

[Mark J. Gliebe:]

Well, we mentioned [indiscernible] the 2 key topics there are C&I and HVAC. And we commented that C&I is beginning to stabilize. And we expected slight growth in C&I in Q3. And in HVAC, as you know, we commented that last quarter that we had $40 million to $45 million of headwind due to the customer losses that we described earlier in that quarter. So that's in front of us.

[Nigel Coe:]

Okay. And that range remains a good range to use?

[Mark J. Gliebe:]

Yes.

[Operator:]

Our next question is from Scott Graham with Jefferies.

[R. Scott Graham:]

Jon, is there any way to quantify the amount of benefit you have received so far in the first half from new product sales net of cannibalization?

[Jonathan J. Schlemmer:]

Well, I would say it's difficult to quantify, Scott. But there's no question, as Mark mentioned in his summary of the Q2 performance when he talked about the 17 new product launches and the new products launched in the first quarter in last year. We do measure how much revenue is coming from new products and all the engineering activity in the company. And it's fairly significant in terms of the annual approximated 1/3 of our revenue coming from new product sales. So we know that those products are being adopted. And they're certainly helping us and our growth initiatives in the company. What we haven't seen yet is enough momentum from those new products to offset some of the other headwinds that we've talked about in both the market and the customer dynamics.

[R. Scott Graham:]

Got it. With respect to an earlier question, I believe he was trying to sort of separate out the loss of customer dollars in the HV number versus sort of the rest of the business. And Mark, your response to that question was your customers are seeing upper single digit in the second quarter. Can you explain that a little bit more? I guess what he was wondering, and I guess what I'm wondering as well, I don't want to speak for him, but what your sales were, whether it's volumes or dollars in HVAC, what is that number adjusted for the losses?

[Mark J. Gliebe:]

So you're asking the question, if we subtract out the losses that we tact [ph], then what is our sales adjusted for those losses. Is that the question?

[R. Scott Graham:]

Yes. Then what is your comment of upper single digit your customers are saying mean?

[Mark J. Gliebe:]

Yes. Well, I'm just feeding back the comments that we get back from our customers on their growth rate. And as you know, we have some -- we have -- there are some customers out there who have very weak growth. And there are some customers that have very strong growth. And our mix of their business varies depending on each individual customer. So I would say that probably, our revenues for the quarter adjusted for those losses was probably flat. And so the -- what we have some headwind on is the price we discussed, material price formulas that we discussed, as well as specific customer mix, whether or not our customers were up or down for the quarter.

[R. Scott Graham:]

Okay, that's much clearer. I guess my last question is also about the M&A. We've been, I think, you as well have been waiting patiently for something, too, or a couple of things to book here. I'm just wondering what is the primary hurdle? Is it just coming down to price and you're just walking away from deals? Is it something more than that? Because you're certainly not the only one that has been maybe a little slower than expected on the M&A side. Can you characterize some of the hurdles in that market right now?

[Mark J. Gliebe:]

Well, it always has to be the perfect match. It has to meet our strategic -- and our strategic goals. And it has to be a fit within our company. So there's a variety of reasons that deals either happen or don't happen. And like I mentioned earlier, we're not -- we're certainly not done. We didn't get one over the goal line, but we're certainly not done. And we are going to continue to pursue targets that meet our goals. And so you could count on that occurring. But I wouldn't -- I can't sit here and say there is any one compelling reason why something happens or doesn't happen.

[Operator:]

Our next question is from Jeff Hammond with KeyBanc.

[Jeffrey D. Hammond:]

If I kind of back out some of these one-timers, it still looks like you had a 35% decremental. And it just seems like a high number given some of the EPC savings. And maybe you can just comment overall what price cost was. But maybe just speak to the decremental and why it looks so challenging?

[Charles A. Hinrichs:]

Jeff, with respect to the balance of price versus cost, on a year-to-date basis, it is about balanced. So as we've discussed, the 2-way material price formulas are reflecting the decline in commodity costs even with the timing lag. So I don't think I would put any change in price or input costs into that decremental analysis. But I'm not looking at the analysis that you're completing on the decremental. So it would be hard to comment on it. We've tried to call out some, both the unusual and the market trends that we're seeing in the market that impacted our second quarter.

[Jeffrey D. Hammond:]

So maybe as a follow-on, how would you characterize mix overall? And then can you speak to -- I mean does the price cost being balanced continue into the second half? Because it seems like a lot of companies are talking about a pretty favorable price-cost dynamic.

[Charles A. Hinrichs:]

Yes. I think as we go into the second half, we would expect that price versus material balance to remain pretty well-balanced as we've seen it in the first half of the year.

[Jeffrey D. Hammond:]

Okay. And mix impact on the margins in the quarter?

[Mark J. Gliebe:]

There was practically no impact. It was a slight impact for the quarter on mix.

[Jeffrey D. Hammond:]

Okay. And then just on mechanical, I mean it seems like a lot of this pressure is Milwaukee Gear. Where are we in that bottoming process? Any signs of that business is starting to rebound at all or stabilize?

[Mark J. Gliebe:]

No. The business that Milwaukee Gear serves is primarily related to oil and gas, and specifically frac-ing. And as we look on a year-over-year basis, that business was still serving out a very strong backlog that carried over from 2011 into 2012. So today, we would say there's some positive signs, but there's still inventory that our customers are shipping out of. But there seems to be some positive signs there.

[Operator:]

Our next question is from Jamie Sullivan with RBC Capital Markets.

[Jamie Sullivan:]

So a question, I guess, it's on all the moving parts in the quarter, of all the one-times you mentioned, sort of which ones were anticipated? It seems like some of them you may have had some visibility on and were anticipating. Just wondering which did you expect and which surprised you?

[Charles A. Hinrichs:]

Well, Jamie, I guess with respect to some of the larger amounts, the diligence was in excess of what our expectations were. The impact of the Venezuelan devaluation was difficult to estimate or call out. So that would not have been in our guidance. The restructuring charges we have provided, and we were pretty much spot on in that estimate. The bad debt, the net bad debt expense was not in our guidance, but reflected some market trends that we were seeing. I think that pretty well covers some of the unusuals that we called out. LIFO is an evolving calculation that's based on the forecast of principally copper, but also steel and aluminum at the end of the year. And as Mark mentioned, the volatility in those markets make it difficult to put a stake in the ground at any one time.

[Jamie Sullivan:]

Okay. And I guess as you look at 3Q, how much of any kind of those expenses, whether it's due diligence, how much due diligence should we assume going forward?

[Charles A. Hinrichs:]

Yes, it -- we're not able to really give any estimate of that number. As Mark mentioned, we are active. The pipeline is active. And we're continuing to pursue opportunities that meet our strategic and financial goals, but we can't comment on any specific activities or what type of activity that we would expect to see. But the LIFO will likely be less than it was in the second quarter as we to trued it up for the first half of the year. And then we don't expect any further charges from the Venezuelan devaluation unless there would be a change in events down there.

[Jamie Sullivan:]

Okay. And then just one other, if I might. I appreciate some of the detail in the new products. Looking at some of the high-efficiency trends, it looks like sales there are down more than the whole company. I'm just wondering what's driving that down a little bit faster. Was that related to the supply agreement, certain products, end markets, market share? If you can just add some color on that trend?

[Jonathan J. Schlemmer:]

Jamie, sure. So you're right, total sales were down approximately 5% with the high-efficiency sales down closer to 7%. So there was -- down a little bit more than total revenue. I'd say there's probably 2 main factors there. One is that we did see headwinds in the oil and gas end market, specifically in the U.S. So that impacted high-efficiency gearing, the Milwaukee Gear business, for example, and also variable frequency drives from our Unico business. So that was probably the largest factor of why we didn't see an improvement in high-efficiency sales relative to total sales. And then the other factor, as we mentioned, really no help from HVAC mix. So we didn't see an improvement on the HVAC side. So I'd say those will be the 2 that I would call out.

[Operator:]

Our next question is from Julian Mitchell with Crédit Suisse.

[Julian Mitchell:]

I just had a question on the sort of operating expense run rate because I guess even stripping out bad debt adjustments, due diligence and so on, the OpEx run rate quarterly this year seems to be about $120 million to $125 million. Last year, it was more like $115 million. And that was with a higher revenue number last year. So I'm just curious why your sort of your sales are going down, but your OpEx run rate seems to have gone up? And as I say that's even ex-ing out bad debt and due diligence.

[Charles A. Hinrichs:]

Thank you, Julian. You're right. On a year-over-year basis, our operating expenses were up about $11 million from the prior year. And I accounted for almost half of that in the 4 items that we called out on that slide. The other increases, we have controls in place on our headcount and spending. But there is the expected inflation in salaries and benefits that occurred in the second quarter. We would expect our third quarter operating expenses to be lower sequentially as we look forward.

[Julian Mitchell:]

Okay, got it. And then secondly, around the cost savings, yes, you laid out the sort of the restructuring charges into next year. How confident are you that you can kind of retain the $15 million of annualized gross savings? Because I guess the evidence from the last 9 months of earnings reports would be that, yes, savings are being generated on a gross level, but the ability to retain those and not give them up in price or inflation seems to be pretty limited. So of the $15 million, how much should actually drop through into your reported earnings?

[Mark J. Gliebe:]

Well, first of all, some of the reason that you see the margins is related to our volume as opposed to anything else. And so -- and that's a fair comment in terms of what we have executed so far. And we would still expect more benefits from the programs that we have executed thus far. And part that is because when you take on projects like that, closing 4 or 5 facilities, you tend to have inefficiencies right after the transition. And we did experience some of that in the second quarter. So we still expect benefits coming from those programs in the time to come. Relative to the $15 million, there's always some level of that, that you work with the customer to make sure that as they transition the product from one facility to the other, there is typically some giveback. But the majority of that $15 million, we will see go to the bottom line.

[Julian Mitchell:]

Okay. And then just lastly, the timing of the sort of ramped-up manufacturing simplification plans. Your organic sales have already been down, I think, for about maybe 8 consecutive quarters or so. The timing of the manufacturing simplification now, I mean is that reflecting a changed view on the medium term kind of forward sales? So I guess you talked about orders stabilizing, which should be positive but at the same time, there's a stepped-up cost-out plan.

[Mark J. Gliebe:]

Well, as you know, we've been talking about simplification for about 1 year, 1.5 years at this point. And it's not just in manufacturing, but it's in our design platforms. It's in our supplier base. It's in all aspects of the company. And we had our hands full absorbing the EPC acquisition. And we had to complete that before we could take on a bunch of heavy lifting in the simplification. But we -- I would say, we did certainly accelerate some of what we were doing in simplification just simply because our volumes are not where they need to be.

[Operator:]

Our next question is from Josh Pokrzywinski.

[Joshua C. Pokrzywinski:]

Just a first question on the HVAC business. How has July reorder activity been? And how do OEMs see their own inventories at this point?

[Jonathan J. Schlemmer:]

Josh, I would say that I'd characterize it as we started the quarter, I think, pretty strong, I would say. We felt pretty good starting the quarter. Remember toward the end of June, we had a lot of heat. And we had orders -- customers giving us a lot of positive comments about demand and their expectations going forward. So we had a decent start to the quarter. That's held through July, and I would say that the past couple of weeks though with the unseasonably cool weather. We're not getting a lot of comments from the customer side in terms of being ready for an increase in order rates. But our orders have held stable so far. As Mark had mentioned, we're still expecting -- most customers are still talking fairly positive about the market dynamics in the second half and carrying into 2014. Inventory, we would say that on the HVAC side, the inventory levels appear to be somewhat normal and stable at this point. There were some comments about the cooler weather and some of the channel being hesitant to restock and being concerned about carrying that inventory into the heating season, especially with the recent weather trends.

[Joshua C. Pokrzywinski:]

Okay, that's helpful, Jon. And then just shifting back to the M&A pipeline and the plans there, how much of your cash would you classify as acquisition-ready right now? So I guess excluding any trapped cash or kind of frictional cash to run the business, what could you spend today without having to tap capital markets or a revolver?

[Charles A. Hinrichs:]

Thank you, Josh, for the question. I think maybe the best way to answer it is that we certainly have the $203 million of equity that we raised in December of last year available, plus access to our existing credit facilities and the ability to take on some additional debt, which many have estimated would give us a total of up to $1 billion of acquisition firepower. So those would be the kind of 2 data points that I would give you in terms of our cash and debt capacity at the present time.

[Joshua C. Pokrzywinski:]

Okay. So I guess the way I'd look at it though is that you guys have also generated $100 million or so in free cash since the equity offering. So is that being absorbed elsewhere? Or shouldn't that be additive to the $200 million?

[Charles A. Hinrichs:]

It's additive, but we also, as we commented on in the second quarter, paid our $55 million term loan. And the cash is being earned and generated around the globe. So depending upon the acquisition and the ability to acquire assets in those international operations, the ability to deploy that cash would be dependent upon the specific opportunity.

[Joshua C. Pokrzywinski:]

Okay, that's helpful. And then, Mark, just a question on the strategy for M&A. If I understood your answer to Hammond's question earlier about drop-through operating leverage in the quarter in the 30s percentile being mostly attributable to volume. So price-cost neutral, mix was fairly flat, does that give you pause on wanting to add to the motor portfolio? Or does that make you want to look outside of motors into businesses that have different volume dynamics or less exposure to raw commodities where you get the splits on around that?

[Mark J. Gliebe:]

We haven't changed our view of the 4 product platforms that we have been pursuing. We've been quite consistent. We have 4 product platforms

[Operator:]

The next question is from Christopher Glynn with Oppenheimer.

[Christopher Glynn:]

So, Mark, free cash flow continues to be a good story. I'm wondering if you could comment if free cash flow to net income for the year could come in the 115% to 120% range? And also what a normalized CapEx figure might look like for 2014?

[Mark J. Gliebe:]

Sure.

[Charles A. Hinrichs:]

Chris, this is Chuck. I'll take your question, and thank you. Our free cash flow -- our goal with all of our commercial teams is to drive that number and keep it above 100% of net income. It can change on a seasonal basis depending upon the flow of working capitals. But over a 1-year or over a multiyear timeframe, our goal is to keep it in excess of 100%. CapEx, as I mentioned this year, will be around $100 million, and includes some larger projects. So I think going forward, that number would not increase materially, and could be down a little bit. So again, that would give us the positive impact on our free cash flow.

[Christopher Glynn:]

Okay. And then you have this dynamic where you've had the aggressive EPC integration and savings, but in the face of organic declines. So I'm wondering if you could articulate a view of what incremental margins you would expect when and if you get back to mid-single-digit type of growth?

[Mark J. Gliebe:]

Yes. I would say probably in the 20% to 25% range is probably the way to think about incremental margins on organic growth.

[Operator:]

- Our next question is from Liam Burke with Janney Capital Markets.

[Liam D. Burke:]

Chuck, Mark, could you -- Mark, could you give us a sense on -- I mean, you spoke about taking the aftermarket effort and consolidating it into the legacy EPC organization. Could you give us a sense of how that aftermarket effort is progressing?

[Mark J. Gliebe:]

Sure. We feel good about that. As you probably can recall, EPC business had done well in the aftermarket. And so we did over a year ago combine the 2 teams under a former EPC leader who's now leading our business. That business experienced growth in the HVAC aftermarket during the quarter. And so we feel quite good about the direction that, that team is headed into.

[Liam D. Burke:]

You talked about Latin America as a new market for you. What -- are you going after HVAC or an industrial or both as you enter that geography?

[Jonathan J. Schlemmer:]

Liam, this is Jon. Both. We have a focused effort on, as I mentioned, the commercial refrigeration space. We have a focus on HVAC and also on the industrial product line. And I'd mentioned also that Unico has been expanding their operations in sales as well on variable frequency drives in the oil and gas segments. So really across all fronts, we have a focus right now.

[Operator:]

Our last question is from Mark Douglass with Longbow Research.

[Mark Douglass:]

Chuck, what was the price effect on HVAC again? Did you quantify that?

[Charles A. Hinrichs:]

No. We just did it for the total business, Mark. So it was about 0.7% of sales. And as I mentioned, it's principally related to the 2-way material price formulas that we have with our larger customers, many of which are in the HVAC space.

[Mark Douglass:]

Right, okay. So 0.7% was for the total business, not just HVAC? Okay.

[Charles A. Hinrichs:]

That's right.

[Mark Douglass:]

And most of my questions have been asked. But looking at alternators these days, what's the relative size of that business? And any update on that market?

[Mark J. Gliebe:]

Yes. I would say roughly a $125 million business for us. And we've manufactured products in the U.S., Mexico and China. And that business has been down for the last number of quarters. We are seeing a small improvement in the third quarter, but nothing yet to celebrate.

[Mark Douglass:]

Is that -- you're seeing a little bit of improvement in 3Q?

[Mark J. Gliebe:]

Yes, yes.

[Operator:]

This concludes our question-and-answer session. I would like to turn the conference back over to Mark Gliebe for any closing remarks.

[Mark J. Gliebe:]

Thank you all for your good questions. We appreciate them, and we appreciate your continued interest and support in Regal Beloit. Have a good day.

[Operator:]

The conference has now concluded. Thank you for attending today's presentation. Please disconnect your lines.