The Timken Company
Q1 2013 Earnings Call Transcript

Published: 24 Apr 2013

[Operator:]

Good morning. My name is Camille, and I will be your conference operator today. As a reminder, this call is being recorded. At this time, I would like to welcome everyone to Timken's First Quarter Earnings Release Conference Call. [Operator Instructions] Mr. Tschiegg, you may begin your conference.

[Steve Tschiegg:]

Thank you, and welcome to our first quarter 2013 earnings conference call. I'm Steve Tschiegg, Director of Capital Markets and Investor Relations. Thanks for joining us today. And should you have further questions after our call, please feel free to contact me at [phone]. Before we begin our call this morning, I wanted to point out that we posted to the company's website this morning, presentation materials to supplement our review of the quarter results as part of the earnings teleconference call. This material is also accessible via a download feature from our earnings call webcast link. With me today are Jim Griffith, President and CEO; Glenn Eisenberg, Executive Vice President of Finance and Administration and CFO; and Group Presidents Chris Coughlin and Rich Kyle. We have remarks this morning from Jim and Glenn and then we'll -- all of us will be available for Q&A. [Operator Instructions] Before we begin, I'd like to remind you that during our conversation today, you may hear forward-looking statements related to future financial results, plans and business operations. Actual results may differ materially from those projected or implied due to a variety of factors. These factors are described in greater detail on today's press release and in our reports filed with the SEC, which are available on our website at www.timken.com. Reconciliations between non-GAAP financial information and its GAAP equivalent are included as part of the press release. This call is copyrighted by The Timken Company. Any use, recording or transmission of any portion without the expressed written consent of the company is prohibited. With that, I'll turn the call over to Jim.

[James W. Griffith:]

Thanks, Steve, and good morning, everyone. In our earnings announcement earlier today, we reported first quarter earnings of $0.77 per share or $0.80 adjusting for the impact of charges relating to our previously announced plant closures. Sales were $1.1 billion, in line with our expectations. Results in the quarter reflected lower demand across our end markets, including oil and gas, industrial distribution and the off-highway market sectors. As indicated last quarter, these reductions in demand reflect inventory adjustments as our customers adapt to lower commodity prices and the resulted lower-than-expected mining and drilling activity. In the face of lower demand, we maintained double-digit operating margins across all 4 segments, reflecting the benefits of our integrated business model. It's a model consisting of a relentless focus on creating customer value, growing where differentiated and an ongoing focus on operational effectiveness. Our results demonstrate this strength as we once again proved our ability to deliver solid margins, while operating around 55% of capacity utilization for the quarter. We have made significant progress in our efforts to strategically deploy our capital, to drive value for customers and for shareholders. This quarter, we completed 3 investments, bringing online new equipment that will improve the profitability of our Steel business. The new forge press can unlock new market opportunities and operating efficiencies for us while the thermal treatment line and the new finishing line incorporated -- incorporate the latest technologies and offer additional capacity and significant cost reductions. Together, these investments will enhance our long-term competitiveness by giving us unique capabilities, greater differentiation and improved cost structures. Similarly, the acquisitions of Smith Services and Interlube Systems further broaden our product and service capabilities, creating new opportunities for growth in key end markets including construction, mining and heavy industries. Interlube provides an entry for us into the lubrication market, increases our opportunities for cross selling and the development of new product lines. Smith Services continues to expand the scope of our growing services and aftermarket business. In addition, we completed a strategic investment within our rail business through an asset purchase agreement with Greenbrier that expands our rail bearing reconditioning services. We leveraged the strength of our cash flow and balance sheet to make additional discretionary pension contributions, continuing our plans to substantially fully fund those plans by the end of the year. We remain confident in our ability to deliver strong performance in 2013. As we indicated last quarter, our outlook is based on an expectation that the customer inventory adjustments, which depressed demand in the second half of 2012, would phase out through 2013, and we would see stronger demand as the year progresses. Our first quarter was slightly better than expected and we are seeing improved order volume as we enter the second quarter. Having said that, our lead times are less than 12 weeks in much of our business, so complete visibility into second half activity continues to evolve. We are demonstrating the benefits of our efforts to drive efficiency across the company, which manifests itself as sustainable margin levels in spite of lower demand and operating levels. Our confidence is further supported by a number of key items. The first is our ability to leverage the synergies inherent in our operating model to offer products with differentiated value in the marketplace. Second, we have the benefit of the strategic capital investments we've made, including most recently, in our Steel segment. Third, we have a notable shift in our structural earnings power, as evidenced by our financial performance. Beyond that, we have the strength of our balance sheet supporting additional investments focused on growth, as well as funding pension obligations and returning capital to our shareholders. We continue to successfully execute the proven strategy that has enabled us to advance as a global industrial technology leader and deliver strong returns to our shareholders. Our ability to leverage the strengths across our business remains a tremendous source of competitive advantage, and we remain committed to continue leveraging that advantage. Glenn will now review our financial performance for the quarter.

[Glenn A. Eisenberg:]

Thanks, Jim. Sales for the first quarter were $1.1 billion, a decrease of $331 million or 23% from 2012. The decline is a result of lower demand, primarily in the company's oil and gas, industrial distribution and off-highway market, as well as lower surcharges. This was partially offset by favorable pricing and the benefit from the Wazee and Interlube acquisitions. Gross profit of $275 million was down $137 million from a year ago. The decrease was driven by lower volume, negative mix and higher manufacturing costs, partially offset by pricing and a favorable change in LIFO reserves. In addition, $3 million of the $4 million in costs associated with previously announced plant closures negatively impacted gross profit for the quarter. The gross margin of 25.2% for the quarter was down 380 basis points from a year ago. For the quarter, SG&A was $154 million, down $11 million from last year due to lower variable compensation and reduced discretionary spending. SG&A was 14.1% of sales, an increase of 250 basis points over last year. As a result, EBIT for the quarter came in at $120 million or 11% of sales, 630 basis points lower than last year. Net interest expense of $5.9 million for the quarter was down $2 million from last year, primarily driven by lower average debt balances. The tax rate for the quarter was 34.1% compared to 34.3% last year. The tax rate for the quarter is higher than our expected annual tax rate of 33% due to timing of certain discrete tax items. As a result, income from continuing operations for the quarter was $75.1 million or $0.70 per diluted share compared to $1.58 per share last year. Excluding the charges related to the plant closures, earnings per share was $0.80. Now I'll review our business segment performance. Mobile Industries sales for the quarter were $397 million, down 15% from a year ago. The decrease was driven by lower volume, led by weaker off-highway demand in mining and construction, as well as the impact of $27 million in exited business related to the company's shift towards higher returning sectors of the mobile equipment market. The Mobile segment had EBIT of $51 million or 12.9% of sales compared to $87 million or 18.5% of sales last year. The decline in EBIT was due to lower volume and higher manufacturing costs, partially offset by lower SG&A. The segment results also reflect approximately $4 million in plant closure costs. Mobile Industries sales for 2013 are expected to be down 5% to 10%, primarily due to lower off-highway demand in lower light vehicle and heavy truck sales, resulting from the company's strategy of focusing on markets which offer long-term attractive returns. For 2013, we expect this market repositioning strategy to reduce sales by approximately $150 million, and for this to be the final piece of exited business from this initiative. Partially offsetting the sales decline is growth in our automotive aftermarket business, while rail is expected to be flat, benefiting from the addition of the Greenbrier bearing refurbishment business. Process Industries sales for the first quarter were $285 million, down 20% from a year ago due to lower volume from both industrial distribution and OE demand, partially offset by pricing and the favorable impact of the Wazee acquisition. For the quarter, Process Industries' EBIT was $43 million or 14.9% of sales, down from $82 million or 23.1% of sales last year. The decrease in EBIT is primarily a result of lower volume as unfavorable mix and higher manufacturing costs were offset by favorable pricing and lower SG&A. Process Industries sales for 2013 are expected to be relatively flat for the year, supported by a second half recovery in Asia, industrial distribution demand and the benefit of our recent acquisitions. Aerospace sales for the first quarter were $83 million, down 10% from a year ago. The lower volume, primarily in the motion control and civil aerospace market sectors drove the decrease in sales. EBIT for the quarter was $9 million or 10.4% of sales compared to $11 million or 11.7% of sales a year ago. The decrease in EBIT reflects lower volume and higher manufacturing costs, partially offset by pricing and lower SG&A. For 2013, we anticipate Aerospace sales to be up 7% to 12%, driven by a strong order book with all end markets expected to be up for the year. Steel sales of $346 million for the quarter were down 35% from last year. The decline was due to lower demand in the oil and gas and industrial sectors, which was partially offset by higher mobile on-highway demand. In addition, surcharges were down $72 million due to lower raw material costs and volumes. EBIT for the quarter was $36 million or 10.3% of sales, compared to $88 million or 16.4% of sales last year. The decrease resulted from lower volume and unfavorable mix, partially offset by a favorable change in LIFO reserves of $6 million and lower SG&A. Last year's first quarter also included a one-time expense of $5 million related to a new 5-year labor agreement. Steel sales for 2013 are expected to be down 7% to 12% as higher mobile on-highway demand is more than offset by demand in the oil and gas and industrial sectors, which despite anticipated improvements throughout the year, are expected to be down versus last year. In addition, surcharges are expected to be down for the year. Looking at our balance sheet. We ended the quarter with cash of $458 million and net debt of $15 million. This compares to a net cash position of $107 million at the end of last year. The change in net debt includes the company's discretionary pension contributions of $66 million net of tax. The company ended the quarter with liquidity of $1.3 billion. Operating cash flow for the quarter was a use of $36 million as the company's earnings were more than offset by discretionary pension contributions and working capital requirements. Free cash flow for the quarter was a use of $121 million after capital expenditures of $63 million and dividends of $22 million. Free cash flow excluding the discretionary pension contributions was a use of $55 million. In this morning's press release, we affirmed our market outlook and confidence that our integrated operating model will sustain strong performance levels. However, we continue to monitor market conditions closely and we'll take actions as needed to support profitability should the economy recover more slowly than we expect. We continue to anticipate an overall decline in sales of around 5% compared to 2012, driven primarily by lower demand and surcharges, as well as the impact of our tactical shift in Mobile Industries. We expect earnings per diluted share to be in the range of $3.75 to $4.05, reflecting the benefits of the structural changes we've made, including in our earnings outlook, our cost of $0.20 per share related to our 2 previously announced plant closures in St. Thomas and São Paulo. For 2013, the company continues to expect cash from operating activities to be $330 million, which includes working capital requirements to support a second half recovery, as well as discretionary pension and VEBA trust contributions totaling $180 million net of tax. Free cash flow is expected to be a use of $120 million after capital expenditures of $360 million and dividends of roughly $90 million. Excluding the discretionary pension and VEBA trust contributions, free cash flow is expected to be $60 million. We expect to end the year with our pension plans essentially fully funded, positioning the company to potentially annuitize a portion of the pension liability. This ends our formal remarks. And now, we'll be happy to answer any questions. Operator?

[Operator:]

We'll take our first question from Eli Lustgarten with Longbow Securities.

[Eli S. Lustgarten:]

Just one clarification. The presentation said LIFO was $15 million. You said $6 million is in Steel, so the other $15 million is in bearings and power transmissions in Mobile or something?

[Glenn A. Eisenberg:]

That's right. The year-over-year change from LIFO was around, Eli, I believe it was a $3 million income versus a $3 million expense in the same period a year ago. So the delta was around $6 million.

[Eli S. Lustgarten:]

Okay. But I guess the $15 million...

[Glenn A. Eisenberg:]

That's correct. That's in the Steel. And then similarly, we had around $4 million of the income and around $9 million of expense in the prior -- for the entire company.

[Eli S. Lustgarten:]

Okay. Can we talk a little bit, the sales numbers in, of course, bearings were -- and power transmission were somewhat softer, I think, than mostly expected, offset by a better Steel. Can you talk about -- your guidance is unchanged in top line. Can you talk about expected profitability in the 3 bearing and Mobile -- bearing and power transmission sectors? I mean, I guess, we were sort of expecting that at least Mobile and Process would be relatively close to where you wound up last year. Is that still the expectation? In other words, has it changed or has it come down a little bit because of the weaker first quarter?

[Christopher A. Coughlin:]

Yes. So Eli, this is Chris. Let me start with Mobile. Revenue was obviously down relative to the huge first quarter we had last year. But it was actually up 10% from the preceding fourth quarter. Of the decrease year-on-year, 50% of that was exited business and volume was the other 50%, rounding numbers a little bit. Moving forward on Mobile, we expect it to be relatively stable relative to first quarter performance and we expect margin performance to stay very consistent with what you saw in the first quarter. The Process area, obviously, was a disappointment for us in the first quarter. We saw significant volume decreases beyond what we would have expected across all geographies and basically all market segments. And a couple of things about it. First of all, I think you see the impact of our business relative to the energy, mining and infrastructure industries, which have a number of challenges as you go around the world. So that's one point on that. The second thing is, in the first quarter, was the first time we saw inventory de-stocking in the distribution channels that was significant. Let's use that term. So we certainly saw some of that going on as well. And then the last point, there's no question that we did not get enough cost out relative to the volumes that we were operating at. And in hindsight, we were structured for a market recovery that did not occur, obviously, based on the revenue. And that certainly put a lot of pressure on our cost structures and our margins. So I think, moving forward on Process, a couple of things, we expect the situation to improve as we move through the year, but the second quarter will still not be back maybe to the levels that we would like. But we expect to see an improvement in the second quarter over the first quarter, and improvement going on throughout the year. On the original equipment side of Process, where we sort of have longer lead times because a lot of that is capital equipment, we clearly have a second half that's stronger than the first half. So we clearly see that in our order books. So that's somewhat encouraging for us. And then margin performance, we expect it to continue to improve through the balance of the year. Now where we will shake out on that for the total year is going to be heavily dependent on your second half assumptions around distribution. We clearly are expecting to see a recovery continuing through the year, but I think, as you know, that is a short lead time business. You don't have visibility around what the second half is going to look like. So you have to use your own kind of market assumptions on that.

[Eli S. Lustgarten:]

Well, defense has held up and so you expect that to be relatively similar, I assume?

[Richard G. Kyle:]

On the Aerospace side, Eli, well over half of that business has visibility to order book 6 months and beyond. So first quarter came in line pretty much with where we would have expected it at the end of the year. We expect the second quarter to be up slightly from a sequential standpoint from the first quarter and then the third and fourth quarters, we have the order book for a significant uptick in the second half of the year on that side of the business to get us up into that range of year-over-year growth of 7% to 10%, I believe, is what the guidance is.

[Eli S. Lustgarten:]

Can we talk about Steel profitability also for the rest of the year?

[Richard G. Kyle:]

Anything specific?

[Eli S. Lustgarten:]

Well, just to get an idea, we had probably a better margin in the first quarter in Steel than, I think, a lot of us expected. And the question is are we going to be able to hold -- will the double-digit margin improve in the second half of the year as the negative impact is lessened?

[Richard G. Kyle:]

At this point, we look at the fourth quarter was the volume trough and the earnings trough and we had the help, as you know, from the fourth quarter on the Steel side from LIFO on the earnings. But if you back that out, it was clearly lower than the preceding and following quarters. From a volume standpoint, we have limited visibility to the order book, but we clearly have most of the second quarter book and expect the second quarter to be up modestly from the first quarter. Third quarter to be up again modestly. And fourth quarter, some normal seasonality which would be down a little bit from the third. So probably in line with Chris' comments in terms of a generally improving situation from our customers' inventory position and end-user demand. And again, we expect the first quarter to be the margin earnings trough and get some leverage on the improved volume as the year goes forward.

[James W. Griffith:]

Eli, this is Jim. Just let me give you a little color on Steel in the first quarter. I think you are seeing the impact of the new business model in Steel that is just good solid execution. There's nothing unusual in the numbers, the margin is what we would expect to earn at this level of utilization.

[Operator:]

And we'll take our next question from David Raso with ISI Group.

[David Raso:]

You mentioned the orders improved as the quarter went along. Could you give us a little more detail where did the orders improve? And how would you characterize the orders for the entire quarter year-over-year? Obviously, we're all trying to figure out the rest of the year that sales need to be up 2% year-over-year to hit your full year number. And I know you mentioned the visibility's not great right now given the lead times are relatively short. But can you just give us some indication where you're seeing the improvement and how the orders were year-over-year from the first quarter?

[James W. Griffith:]

Yes. Let me let Rick start from a Steel perspective and then we'll flip over to the bearing side.

[Richard G. Kyle:]

At the end of last year, again, fourth quarter of last year would've been a trough, everybody pulling back on inventory and order books. We saw an immediate improvement in January from the end of the year and saw that build through the year. So automotive, strong generally across the board on the Steel side. And then the other markets would be certainly not strong from a year-over-year standpoint, but improving and improving again in the second quarter. And that would be -- there's no real -- outside automotive, there's no real areas that stand out. But it would be across the board, oil and gas and industrial markets, et cetera, all generally improving. And then before I flip over to Chris, on the Aerospace side, as I said, that would not be as much of a short-term trend. So the statement of order book improving necessarily wouldn't pull through first quarter, but for the full year, the order book filled in very well in the first quarter and much less uncertainty in that growth projection for the second half than what we would have in some of the other areas.

[David Raso:]

If you can help us a little bit year-over-year, I know it's improving sequentially and it's probably still down year-over-year. But we're trying to get some order of magnitude of how much has the year-over-year decline in orders may be mitigated to see a line of sight to positive growth. Because I'm going to wrap the question up with what quarter do you expect Timken's revenues to be up year-over-year to begin to climb back out? So Rich, I appreciate the color, but if you can just help me year-over-year how to describe the orders for the first quarter?

[Richard G. Kyle:]

Okay. On the Steel side, year-over-year, we still face a very difficult second quarter comp from both a volume standpoint, as well as a scrap surcharge standpoint. So the scrap surcharge started -- dropped significantly late second quarter, early third quarter. So again, on the top line, that would normalize year-over-year on the third quarter and quit being such a drag on revenue. And then from an actual unit volume standpoint, we would expect the third quarter to start seeing year-over-year improvement.

[Christopher A. Coughlin:]

Okay. So let's start with distribution, which I probably have interest. January was a very poor month for us and we saw a lot of just very weak activity related to inventory situations, et cetera. So we've seen an improvement in February and March and April off of those levels. And we're expecting that to continue to improve as we go through the balance of the year. So that's pretty much the situation there. On the OE process, OE side, I think I've already explained that. We see a better second half than first half. And we see that very clearly, given the longer lead times of the capital equipment build cycles. So that's the story on the Process side. By the second half of the year, we begin to hit run rates that are more aligned with previous years, if I can use that terminology.

[David Raso:]

Okay. So again, sort of like the steel comment, third quarter you'd expect to start seeing black numbers again year-over-year?

[Christopher A. Coughlin:]

Well, basically, yes, on a run rate basis, right. The -- now by the way, though, the comps, it depends on -- when you look at last year, remember, the first half was very strong and the second half was weak. So depending on what math you're using, I mean, I think you need to account for whatever base period you're referencing with that statement. On the Mobile side, we've got moving parts. Obviously, as you all know, the mining business is very, very weak. So that business is down a lot and we can all opinionate on when that's going to recover. We're seeing some signs of heavy truck starting to come back. But basically, I think, for Mobile, the first quarter is sort of what you see. You'll see some seasonality in the second half, which is generally a little bit weaker, but I think you get a pretty good gauge on the Mobile just off that run rate.

[Operator:]

And we'll take our next question from Stephen Volkmann with Jefferies.

[Stephen E. Volkmann:]

Jim, I think you said 55% capacity utilization in your opening remarks. Would you guys be willing to give us a ballpark kind of by segment?

[Glenn A. Eisenberg:]

Yes. Steve, if you look at it by segment, again, rounded numbers, Mobile for the quarter was at around 60%, Process at around 55%, Aero at around 50% and Steel at around 55%.

[Stephen E. Volkmann:]

So pretty consistent there. And how much of the surcharge is going to be down for the full year, do you think?

[Glenn A. Eisenberg:]

We haven't forecasted it. Obviously, it's within the expectation of Steel being down 7% to 12%, but it's fair to say that -- look at what it was in the first quarter comparison. But it's going to be more volume than surcharges. But surcharges clearly are playing a role in it.

[Richard G. Kyle:]

Second quarter should be similar to the first quarter in terms of the decline and then the third and fourth quarter on a year-over-year basis. Assuming a relatively flat scrap market through the second half of the year would eliminate that reduction. So it would all be taken in the first half of the year.

[Stephen E. Volkmann:]

Okay. Great. And the exited business, the $150 million that's kind of the last tranche here, how should we think about the margin on that business?

[Christopher A. Coughlin:]

Well, the margin on it is pretty decent, right, because it's the business that we repriced when we exited -- to exit the market. So I -- you should think of it as the run rate of the Mobile business.

[Operator:]

And we'll take our next question from Ross Gilardi with Bank of America Merrill Lynch.

[Ross P. Gilardi:]

I just wanted to delve into Steel a little bit more and the supply-demand situation right now. So it seems like if you look at it year-on-year, sales were down 35% year-on-year. But as you said, $70 million of that or so was surcharges. So it looks you're down about 15% year-on-year, if we adjust for that. So clearly, demand right now is pretty weak. The market, I would think, has taken on more excess capacity. So what makes you confident and a little bit more detail that you can sustain a double-digit margin under these conditions, given that you're operating at pretty low capacity utilization right now and you've got additional supply coming into the market over the next 12 months?

[James W. Griffith:]

Well, let me step back and answer that at the corporate level. And I presume, because you're talking about additional supply, you're really talking about the Steel business from that perspective. And so Rich can add to it if he wants. The first answer to your question is demand in the market is improving for our products. And it's being driven by a strong auto market and the onshoring that is going on of transmissions, particularly, in that market. And secondly, this inventory adjustment of our customers is real. You saw it in Caterpillar's announcement. Doug was really clear about what they're doing from that point of view. We see it in the oil and gas market where we can actually see the rate of -- they are drilling and we compare that to our order book. And there's a dramatic difference because their -- they over inventory for where they thought the market was going and they're going through an adjustment. So the first answer is we're expecting overall demand in the market to improve as we go forward. And then secondly, my comment to Eli's, this reflects -- the first quarter in our Steel business reflects the new flexible cost structure that we've put in place and now you add to that the impact of capital programs that we've got coming on which are significant in terms of their ability to reduce costs. And we're pretty comfortable with the ability to continue to operate at those kinds of levels. Rich, you want to add to that?

[Richard G. Kyle:]

Yes. I would just add that you've seen the result of an effort over a period of several years to shift away from focusing on a high utilization model and selling capacity versus focused on attractive markets and product and application differentiation. So we are in a position where we can sustain good margins running at a relatively low utilization rate. And as Jim said, we expect the demands for those products to pick up which would further improve that situation. And then, again, you put the surcharge piece aside, but recognize that our customers are paying significantly less for a ton of steel today than they were a year ago based on that surcharge mechanism. But again, with focus on the applications and differentiation that we have, essentially the base price is held through this year.

[Ross P. Gilardi:]

Okay. And then I just had a question on acquisitions. Clearly, your 3-year targets for $7 a share on your revenue targets incorporate some significant contribution from acquisitions. Can you talk about your appetite for a larger deal right now? And then you had cited the weakness in mining previously. Would you be willing to increase your exposure to the mining sector right now if attractively valued properties were available?

[Glenn A. Eisenberg:]

Ross, let me at least take the first cut of it. The pipeline for M&A continues to be pretty good. Obviously, you've seen us now start to execute on type of transactions that we've normally done, which has been on the smaller side, very strategic fitting with an existing platform that we have. And so we continue to be encouraged that we're able to redeploy capital through acquisitions on attractive returns, especially given the synergistic nature of what we're acquiring. We continue to have a strong balance sheet. We continue to have ample liquidity. We continue to look at good properties that are out there. So as a general rule, we look at all the properties that would have interest that would fit well with us. And then obviously, very disciplined relative to our criteria of what it would take to do the transaction. So we'll continue to pursue it, it's a key part of our strategy, as you know. But having said that, when we give those 3-year targets out there and we say roughly 1/2 of the top line growth is from acquisitions, which is again how we would plan and want to see it happen, the other key financial metrics that we give the 3-year targets from, from earnings growth to free cash flow to return on invested capital are all irrespective of our ability to do those acquisitions. We just redeploy that capital into other areas to continue to drive that kind of performance for the company. As it relates specifically to mining, Chris?

[Christopher A. Coughlin:]

Yes. On mining, well, first of all, we like the mining business a lot. So I mean, let's be clear. It is a great market for us. It's a very profitable market. So we're very strong on the mining thing. The second thing on mining, we are very bullish on the long-term prospects around mining, globally across. The issue with mining is volatility. And so -- and this has always been the case for us, we've always dealt with that volatility. So the issue for us is not that we don't like mining and don't want to grow in mining and all that kind of stuff. Our issue is we need long-term to increase our exposure to areas like food and things like that, that have less cyclical nature. But yes, we're pro-mining and we'll continue to grow mining as we move forward.

[Operator:]

[Operator Instructions] And we'll take our next questions from James Kawai with SunTrust.

[James Kawai:]

Can you walk me through the Steel margins sequentially, exclusive of the LIFO gains because when you do that, it suggests that we went from low single-digits in the fourth quarter to 9% or so in the first quarter. So that would suggest almost 100% conversion rate on the sales increase there. So maybe walk us through the dynamic there, kind of specifically what happened.

[Richard G. Kyle:]

I think your math is close when looking at it. But the utilization of the plants in the fourth quarter was 45-ish percent jumping up to 55-ish percent in the first quarter. We took inventory down. So we underproduced to shipments, as well as the decline in revenue. So we did get good leverage on the incremental production but there was certainly an inventory imbalance there between the 2 quarters.

[James Kawai:]

Got you. So that would suggest that the fourth quarter is more depressed and the first quarter is more reflective of normalized earnings there?

[Richard G. Kyle:]

Yes.

[James Kawai:]

Got you. And then relative to the new Steel projects that were in place, how much of the benefits were fully expressed or reflected in the first quarter margins? Or are the cost synergies or the benefits of those new projects, are they uncommon [ph] and have you been able to quantify that for people?

[Richard G. Kyle:]

First quarter and also in the second quarter, we would say we are receiving benefits but the costs are still offsetting those benefits. So we would expect to see positive impact from the 2 projects that are completed in the second half, but even that we would expect to get throttled to some degree by some increasing costs for the caster project which comes online next year. So we have very, very minimal benefit this year and some of the fourth quarter, but really expect to see the full benefit of those in 2014.

[James Kawai:]

Got you. And in order of magnitude, if you do an IRR on the $85 million, I mean, I would think it would suggest at least a couple hundred basis points of cost step down or a margin pickup?

[Richard G. Kyle:]

Well, half of that $85 million was roughly for the forge press and the primary objective of the forge press was new product capabilities and large sound center bar. The second benefit of that would be capacity and the third would be costs. So if you look across those, on the product capability, we are producing the product today. We are selling the product into the market, but we have to penetrate that market. So that's a ramp up through the course of the year, but we are getting revenue and margin benefit from that today. The capacity benefit is not being utilized today. The cost benefit is just starting to kick in.

[James Kawai:]

Got you. That's helpful. And then just kind of a final question for Glenn. Just big picture on the cash flow this year. If I look at your net income as kind of a starting point and using your guidance as a basis, it kind of suggests somewhere close to $400 million. And then you throw on depreciation, probably at least $200 million. And it would suggest a $600 million operating cash flow starting point, assuming working capital is going to be fairly neutral because core -- organic growth is down quite a bit. Could you kind of step us through how you get down to $330 million as your starting point for guidance this year on the cash flow?

[Glenn A. Eisenberg:]

Well, let me start off with the, if you will, the midpoint of the guidance that we would have given from earnings and kind of work your way back. If you take the, call it, the $390 million of earnings, you can get to work your way through to get to an EBIT number of, round it, call it $600 million. You throw the DA in there, you're around $800 million, so you're starting at that level. We've talked about the pension and OPEB on a pretax basis is around $280 million-ish, if you will, to get to the $180 million net of taxes. Obviously, you back out the taxes, the interest should be holding, call it around $30 million. And then you back out $90 million of dividends, $360 million of CapEx, all the numbers that we've given you, really, the only variable left is working capital. We commented that from a working capital standpoint, we expected it to be a use of cash, given the second half recovery that's expected. So you net all those and you'll get to, call it, the $120 million of use of cash, and then obviously backing out the discretionary pension and OPEB gets you to a positive $60 million. So again, strong earnings, some use of cash for working capital. Again, sizable amount going into our pensions. And then a sizable capital investment program this year that will start to come down in the future.

[Operator:]

And we'll take our next question from Steve Barger with KeyBanc Capital Markets.

[Steve Barger:]

I want to go back to Process. You said there was significant de-stocking in the quarter. Can you quantify how much of the 20% decline came out of the distribution channel and talk about how much the distribution underperformed market demand if you can get to that number?

[Christopher A. Coughlin:]

Well, we -- I can't give you a precise number on de-stocking. I mean, that's talking with our distributors and working through that. We measure that, very clearly, in North America, but you don't see a lot of that globally. And in -- globally is clearly where the inventory de-stocking was the biggest issue, although in North America, a little bit of it. So that's that point.

[Steve Barger:]

Well, is the de-stocking still taking place to the same magnitude so far in April? And any expectation for how long that may last?

[Christopher A. Coughlin:]

Well, it's all going to be based on market activity, right? So as the demand picture improves, obviously, with the replenishment models we'll throttle the inventory up and down from a distribution standpoint, on the basis of market activity. So that's what it's ultimately tied to and that's sort of how that works.

[Steve Barger:]

Right. I guess the question is are you seeing that start to throttle back up at this point?

[Christopher A. Coughlin:]

Well, we clearly have seen an improving incoming order rate since January, which I referenced before. We expect that incoming order rate to continue to improve as we move through the balance of the year. So that's, I guess, as far as we want to comment on it.

[Steve Barger:]

Okay. I did get on the call a little late. I did hear you say that most of 2Q is booked in Steel. What end markets are strong there or maybe where are the customers most optimistic and are coming in to place the orders?

[Richard G. Kyle:]

From a year-over-year standpoint, the only market that would be strong would be automotive. From a sequential standpoint, we're seeing a gradual improvement, I would say, across the board. And again, no areas besides automotive, though, stand out in that improvement but a clear rising of demand for the product in general.

[Steve Barger:]

Okay. And for the new product capability, and you talked about needing to penetrate new markets, where is the biggest opportunity in the Steel segment there, and where are you focusing your initial efforts to drive new sales?

[Richard G. Kyle:]

It's across a broad array of industrial markets. Certainly, oil and gas is a big consumer of that product, mining. Anywhere that you would use large forged product that goes into demanding applications. Oil and gas is certainly a target market for us with that asset.

[Steve Barger:]

Okay. And last question. Inventory continued to come down in the quarter. Can you talk about what segments saw the biggest step down? Was that primarily Steel? And where -- and how much more needs to come out?

[Richard G. Kyle:]

In Steel, I would describe our internal inventory levels as appropriate. So we're making no concentrated efforts there to rightsize them with the market position. They're in good condition. And the vast majority of that actually happened in the fourth quarter.

[Steve Barger:]

So where did most of the inventory come out in the quarter?

[Richard G. Kyle:]

Yes. It came out in Steel.

[Steve Barger:]

Oh, I thought you said that was in 4Q. Okay.

[Richard G. Kyle:]

The majority -- we took a big internal reduction in the fourth quarter and there was another reduction in the first quarter.

[Operator:]

And we'll take our next question from Stephen Volkmann with Jefferies.

[Stephen E. Volkmann:]

I just had a quick follow-up. Just can you update us how you're thinking about share repurchase? I noticed you haven't really done any yet. How do we think about that?

[Glenn A. Eisenberg:]

Steve, as you know, again, as we think through the year, where we've committed capital, if you will, to -- obviously, there are capital investment program, the pensions and share repurchases. So we did around, as you know, 2.5 million shares last year. We have 7.5 million remaining under our authorized program. And so I think it's fair to say, as we think through the year, that we will be back into the market repurchasing shares as we go throughout the year.

[Stephen E. Volkmann:]

Are you precluded right now, for any reason, Glenn?

[Glenn A. Eisenberg:]

Again, we don't comment on kind of those issues, if you will, other than from our standpoint we did accelerate the amount of, call it, pension contributions we've made as we're looking to deal with that issue. I think we gave guidance to kind of the $180 million net of tax for the full year and we did $66 million of it upfront. So clearly, we put more cash into our pensions earlier in the year but I think it's fair to say that as we wind down on that program, you'll start to see a pickup on our share repurchases.

[Stephen E. Volkmann:]

Okay. Good. That makes sense. And I guess more a philosophical question, maybe this is a Jim question, I don't know. But given 55% capacity utilization now, sort of implies that business would have to kind of double from here to kind of really fill up the plant and it seems like that would be a lot. And I guess I'm just wondering whether there's some additional capacity that needs to be rightsized as we go forward?

[James W. Griffith:]

The straight answer to that is no. Again, this is back to the understanding of the new Timken Company. And this is both on the bearing segments and the Steel segment. For us to run at 70% capacity utilization is a really good place to be because it allows us to have industry-leading availability, on-time delivery and that sort of thing, which then supports the premium pricing that we have in the marketplace. We learned that in spades in the Process Industry segment. We translate it into the Mobile segment and we're implementing that, learning that, I'll say, in 2012 and 2013, in the Steel segment. So we've been through the big capacity adjustments that we intend to do. On the other hand, and I think we've had this discussion in the past, we believe there will be a continual range of small restructuring, $0.10 to $0.20 a year for the foreseeable future as we continue to improve the footprint that we have around the world and make sure that we're operating the most efficient plants on a global basis.

[Stephen E. Volkmann:]

Okay. That makes sense. So 70% is kind of what good looks like?

[James W. Griffith:]

Yes. And again, that's a real shift for us. It's a shift for the industry and it is fundamental to the earnings model that we have implemented in the company, across the company.

[Operator:]

And we'll take our next question from Ross Gilardi from Bank of America Merrill Lynch.

[Ross P. Gilardi:]

I just had a couple of follow-ups. Just on the pension plan, what kind of return do you need for the entire plan to finish the year fully funded, taking into account your contributions?

[Glenn A. Eisenberg:]

Well, let me answer it this way because that's just one variable and obviously a lot of things come into play, so you can't take it in isolation. But our assumption on return on assets is normally around 8.25%, would be our longer-term assumptions. But as you know, if we do better than that, we still have the impact on what discount rates will be and so forth. But our view is that with the cash that we're looking to contribute this year and giving our general assumptions that we have in the plan, asset returns, spell out a level, discount rate that we should be, plus or minus, near fully funded. So from a cash standpoint, again, if you look at our 3-year targets, you really see a pickup in our cash flows, in part, we're done with, hopefully, knock wood, the big discretionary contributions we've been making. And then also, obviously, the capital program starting to come by -- or come down, both starts to generate significant cash for the company, which again, fuels into the other uses of our capital going forward.

[Ross P. Gilardi:]

Do you have to be 100% fully funded to move forward on annuitizing a portion of the plan? And do you have to be 100% fully funded to start to transition into a different cash flow prioritization?

[Glenn A. Eisenberg:]

No. You wouldn't have to. To the extent that we do annuitize, again, we're looking at the possibility of doing that, you have to pay a premium to do that. So obviously, being in a good funded position enables you to potentially annuitize a portion of it because you'll see your percent funding go down when you pay that premium. What we've said before is that should we go down that route and to get plus or minus fully funded now, we're in a great position to now annuitize a piece of that. And that longer term, rather than cash coming from the company, the expectation is that at some point, interest rates will go up over time, maybe not necessarily in the short-term, but hopefully, that will cause us to then move into, again, a fully funded or overfunded position in the future, which could potentially set us up to annuitize another piece of our liability. The other thing we're able to do obviously, if we become more fully funded, is change our mix of assets to kind of de-risk some of the volatility with our portfolio. But I think the message that we want to convey is it's been a significant issue for us. We've invested a fair amount of capital to deal with it to get it, plus or minus, in that funded position. We believe we're through that as we go through the rest of this year. And hopefully, we won't be talking much about pensions and we'll be talking more about our business going forward.

[Ross P. Gilardi:]

Okay. And then can you just talk a little bit more about what are you seeing in the oil and gas markets? Are there pockets of that end market that are stronger than others? If you could give any granularity on that. And just what are you seeing in China right now?

[Richard G. Kyle:]

On the oil and gas side, I'd say the inventory correction that we saw taking place in our supply chain through the second half of last year and slightly into the first quarter of this year is largely behind us and we're keeping up with steady-state demand going forward through the second quarter. Hasn't been -- so we've definitely downturned trough and bounced back up. But if you look at the actual rig count, it's not a growth number at the moment. It's been more of an inventory correction situation for our end demand.

[Christopher A. Coughlin:]

Yes, on China, this has been a difficult situation for about a year now, roughly. And finally, in the last couple of months, we've begun to see movement up. And that is part of the second half original equipment from process that I was talking about. So we see China beginning to move. It's clearly not back to its peak levels, but I think, for the first time, instead of telling you we're expecting it to move, we can actually say we see it moving. So that's good news. But we'll have to see. Some data came out this week that was not great, but we're cautiously optimistic on China that it has turned the corner.

[Ross P. Gilardi:]

Which markets are you seeing some improvement in China and what would you attribute that to?

[Christopher A. Coughlin:]

Well, a couple. The wind market has started to move some in China. The rail market is moving pretty decently and we're beginning to see some hits in the energy and for us, that's coal and in places like that. But I would say this is a 2-month trend now that we're beginning to see. And I think some other people have referenced it as well. So we're cautiously optimistic that China's turning the corner.

[James W. Griffith:]

This is Jim. Let me come back to the question you asked about the oil and gas market because I think it's -- Rich talked about the near-term impact on us. Just to put in some perspective, we compared the first half of 2012 to kind of what we saw in the fourth quarter and the first quarter, that rig counts in the market are down about 15%. There have been some shift from gas to oil focus, but overall rig counts in North America down about 15%. Our volume has been down and our Steel business has been down almost 50%, which just gives you a sense of why we believe this is an inventory adjustment. And so what Rich was trying to convey to you is we're now seeing that work its way out, which means we'll get a natural uptick as the year goes on in terms of volume from there without a change in the drilling rate.

[Operator:]

And we'll take our next question from David Raso with ISI Group.

[David Raso:]

I'm sorry to go back to this, Process Industries. I'm still struggling a little bit with how much it fell sequentially and what you're seeing in the market currently to get us back to where we have the kind of growth we need to hit the revenue number. Can you help us a little bit on the OE side and maybe anything that's taking place in the market, maybe some incentives on your part or whatever it may be that could get the sequential growth that we'll need to get back on track to year-over-year growth? So maybe on the OE side, are you seeing much sequential improvement? And I'm not trying to pin you to a revenue number for 2Q for Process. But I'm trying to see how much of the hill we're going to climb in 2Q to get back to growth? I'm just not exactly getting the impression yet that we're seeing any material sequential improvement. It's better. I mean, things must have been really bad in January and late last year. But how much improvement are we already seeing to start that climb back up the hill?

[Christopher A. Coughlin:]

Yes, okay. So yes, to your point, I mean, the OE business in the first quarter was, quite frankly, very poor, right? We were off 25%, 30% kind of numbers relative to the year before. And it's been very, very weak. So the second quarter, we'll see it improving -- I'm talking about the OE business now. But to your point, second quarter is not going to be fabulous either, but better. Where we see the improvement now is in the second half. And once again, with the lead times and the booking of that business, that's what we see coming in, in the second half of the year. So that's basically what we see.

[David Raso:]

And can you help us with modeling this. What percent of the business would you ascribe as MRO distribution versus OE in the first quarter?

[Christopher A. Coughlin:]

Yes, use 70-30. Use 70-30. I mean, this gets into how you classify services and some other things. There's some -- there's part of that, that's a classification issue. But I mean, use 70-30, distribution to OE.

[Operator:]

And it appears there are no further questions in the queue. I would now like to turn the call back to Jim Griffith for closing remarks.

[James W. Griffith:]

All right. Thank you for your interest and your questions. Our results this quarter reflect the new Timken Company. We are focused on creating value for our customers and that translates to delivering solid financial results in the face of lower demand. We expect improving results as the year develops, as our demand improves and we appreciate your support of the Timken Company. Thank you.

[Operator:]

This does conclude today's presentation. Thank you for your participation.