Welbilt, Inc.
Q3 2018 Earnings Call Transcript

Published: 5 Nov 2018

[Operator:]

Good morning. My name is Kasha, and I will be your conference operator today. At this time, I would like to welcome everyone to the Welbilt Inc. 2018 Q3 Earnings Call and Webcast. All lines will remain on mute for the duration of the call. After the speakers' remarks, there will be a Q&A session [Operator Instructions]. Thank you. I'd now like to turn the call over to your host, Mr. Richard Sheffer. Please go ahead.

[Richard Sheffer:]

Thanks, Kasha. Good morning, and welcome to Welbilt's 2018 Third Quarter Earnings Call and Webcast. Joining me on the call today is Josef Matosevic, our Interim President and Chief Executive Officer and Haresh Shah, our Chief Financial Officer. In addition, Bill Johnson, our incoming President and Chief Executive Officer will provide some comments today as well. Before we begin our discussion, I need to review our Safe Harbor statement with you. Any statements in this call regarding our business that are not historical facts are forward-looking statements and our future results could differ materially from any expressed or implied projections or forward-looking statements made today. Our actual results may be affected by many important factors, including risks and uncertainties identified in our press release and in our SEC filings. We do not undertake any obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or other circumstances. Today's presentation and discussion will include both GAAP and non-GAAP measures. Please refer to the last five pages of our earnings release for our non-GAAP reconciliations and other important information regarding the use of non-GAAP financial measures. You can find a copy of the press release and the presentation slides for this earnings call in the Investor Relations section of our Web site, www.welbilt.com. Now, I'd like to turn the call over to Bill.

[Bill Johnson:]

Thanks Rich and good morning. I'm very pleased to be able to address you today one week after joining Welbilt. After competing with Welbilt previously, I'm excited about the opportunity to lead one of the best companies in the industry that has a strong culture of innovation and continuous improvement. Welbilt has a complete portfolio with some of the most iconic brands and is focused on creating solutions for customers, not just products. I see great promise in the Company's strategy to pursue leadership in both connectivity and automation, both of which will become integral and drive productivity improvements in commercial kitchens over the next few years. I believe the Company has the right strategy and a strong management team to maximize results for our customers, deliver profitable growth and create value for our shareholders. One of my key priorities is providing the necessary focus so the team can win. I'm excited to dig into our operations and meet with our customers over the next weeks and months and overtime meet many of you who are on the call today. I appreciate the board of directors' support and confident in choosing me to lead this great company and look forward to transitioning into the CEO role. As many of you know, Josef played a key role in developing and executing our operating strategy and has developed very strong customer relationships over the last three years, and I look forward to working with him to drive profitable growth. On behalf of the board of directors, I would like to thank Josef for the outstanding job he did in leading the Company during the transition. With that, I'll turn the call over to Josef for summery of the third quarter results.

[Josef Matosevic:]

Thank you, Bill and good morning everyone. Before I begin my comments on the quarter, I would like to thank the board for their trust in me to lead this great company over the last few months. I look forward working with Bill over the upcoming weeks and months, while I continue to partner with our customers and our operations team to drive profitable growth. Shifting now to our earnings. We are pleased to have delivered another quarter of organic net sales and adjusted operating EBITDA growth. As you saw in our press release this morning, you can see on Slide 3 of our presentation, we delivered 3.8% organic net sales growth in the third quarter. We have benefited from increased volume with large chain customer and from pricing in the general market in Americas. While some of the rollouts that we have experienced in the first half of the year have ended, we are still seeing large chains in the Americas buying equipment at a higher rate in either 2016 or 2017. We also saw the high inventory levels in the aftermarket channel have now been resolved and we were able to grow KitchenCare sales in the Americas, in the third quarter. Our topline also benefited from the Crem acquisitions this quarter as it contributed over 5% of inorganic growth. We are pleased with the 6% increase in adjusted operating EBITDA in the third quarter. Considering the current inflationary environment and mix headwinds, we are also pleased with our adjusted operating EBITDA margin in the quarter. Material cost inflation did increase this quarter, driven by section 232 and 301 tariffs and rising freight costs. Our team is working hard to minimize the impact on our margins. We do see continued mix headwinds this quarter, which was driven by the mix within individual brands in our portfolio. The headwinds from the first half was driven by the soft KitchenCare aftermarket sales and to ramp up costs related to large chain rollouts abated at the end of the third quarter. Moving to Slide 4. This was the 13th consecutive quarter of year-over-year adjusted operating EBITDA improvement as we continued our relentless pursuit of operational improvements in our business. Despite headwinds to our margin, we are continuing to deliver more dollars of profit both in total and from organic operations. We continue to expect the total EBITDA dollar from organic operations will increase for the full year. I will now let Haresh get into the details of the quarter. Haresh?

[Haresh Shah:]

Thanks Joseph and good morning everyone. Looking at Slide 5, I will make a few comments on our topline results within the segment. Starting with the Americas, our organic net sales increased 5.4%, primarily driven by continued strong demand from large chain customers for hot side equipment and an increase in kitchen care aftermarket sales. Cold side products were down in the quarter as general market demand for ice machines and walk-in refrigeration has been weak. In EMEA, organic net sales increased by 1% this quarter despite tough comps from last year when sales increased 10%. In APAC, organic net sales decreased by 2.4% against tough comps from last year when sales increased 8%. Moving to Slide 6, our simplification and rightsizing initiatives generated another $10 million of year-over-year savings in the quarter. Our simplification and rightsizing initiatives are comprises seven categories; within simplification, we include kitchen care improvement, 80/20 products cost and platforms, purchasing and supply chain improvements, and lean manufacturing; within rightsizing, we include manufacturing capacity reductions and headcount reductions. As a reminder, we won't quantify savings for these individual categories, but we will discuss them qualitatively to show our implementation progress. Overall, we continue to see significant runway remaining to enable the completion of our 1,000 basis point margin journey; within simplification, we are still in the early stages of purchasing and supply chain improvements and lean manufacturing; we are near the midpoint of the product line simplification of 80/20 and on Product Costs and Platforms; and are in the later stages of KitchenCare improvement and the customer line simplification component of 80/20 as it relates to pricing. In rightsizing, we are in the later stages for both manufacturing capacity and headcount reductions; having already completed 75% of the capacity reductions that we originally targeted. As we continue to make progress on our simplification initiatives, they will create additional rightsizing opportunities in the future. In the third quarter, the majority of the savings we achieved came from the continued benefits from 80/20 and from product costs takeouts. We have started to implement lean manufacturing in a systematic way in the first wave of plants this year and we will continue this process over the next few years as we deploy the Welbilt production systems to all of our manufacturing plants globally. On Slide 7, I have a few comments on some of the third quarter adjusted operating EBITDA margin drivers. As we previously mentioned, Crem’s margins are slightly below our consolidated average and were slightly dilutive by 30 basis points. While diluted to margins, we do expect them to be accretive to earnings and EPS for the full year. Excluding this 30 basis point impact, our margins from organic operations decreased 20 basis points in the quarter. Reviewing other drivers of margin our simplification and rightsizing initiatives had a positive 240 basis point impact. Material cost inflation was a 170 basis point headwind, which was partially offset by net pricing in the quarter. We did increase prices in June and started benefiting from that in the third quarter, which help to offset some of the impact from the Section 232 tariffs on raw materials and from rising freight costs. However, the price increase was announced prior to the enactment of the Section 301 tariffs, so we will not be able to offset those this year. The last item to comment on is the net 120 basis point headwind from volume and mix. Volume was positive and we expect that to remain the case throughout 2018. As Joseph mentioned earlier, mix was negative again in the quarter, largely driven by unfavorability within individual product lines. Moving to Slide 8, we generated $38.6 million of free cash flow this quarter. While this is less than what we generated in last year's third quarter, the decrease is mainly due to higher accounts receivables from the stronger organic growth plus higher inventories due to a couple of supplier issues late in the quarter. These supplier issues had the effect of temporarily increasing component costs for some of our cold-side products. The underlying operational issues are mostly resolved but the related costs are currently reflected in our inventory and carrying costs. We paid down $48.2 million of debt in the quarter, while our cash balance decreased by $10.5 million. Last month, we amended our credit agreement to increase our revolving credit limit from $275 million to $400 million, and to increase our term loan B facility to $900 million from $815 million. We were able to lower the spread over LIBOR on a term loan B to 250 basis points which is another 25 basis point reduction. Cumulatively, since March 2016, we have reduced the term loan B spread by 225 basis points. As part of the amendment, we updated our financial covenants and other terms and conditions. We see this amendment as an important step in fixing our capital structure and is consistent with our goal of creating a strong and flexible balance sheet, while improving our overall financing costs. Finally, on Slide 9, we are adjusting our 2018 guidance for organic net sales growth, adjusted operating EBITDA margin and adjusted diluted net earnings per share. I'd like to make a few comments on these items. First, we increased the bottom end of our organic net sales range by 1% and narrowed the range to 3% to 5% growth for the full year. We expect to see sustained growth from our large chain customers as they are investing in new for their kitchens. We expect the general market in the Americas to remain stable through the balance of 2018, while we expect better general market conditions in EMEA and APAC. For KitchenCare aftermarket sales, the channel inventory issues have abated as we've previously discussed. However, KitchenCare will face a tough comparable in the fourth quarter due to last year's strong finish. To round out our sales discussion, we expect Crem to increase sales by 4% for the full year and foreign currency translation to add 1% to sales for the year. Therefore, on a GAAP basis, we expect net sales to increase by 8% to 10% in 2018. Our adjusted operating EBITDA margin is now expected to be between 18.1% and 19.1%. This reflects the 20 basis points dilutive full year impact from the Crem acquisition and another 20 basis points impact from the new Section 301 tariff that were imposed in the third quarter. The major change in our forecast is that we now expect mix to be negative for the full year. There were three primary drivers for this revision; first is a negative mix in certain product lines in the third quarter that prevented it from turning positive; second is a tough comp for KitchenCare in the fourth quarter versus last year with aftermarket been above average from a margin standpoint, this will be a mix headwind; finally, the additional cost from the supplier issues that are currently in inventory are expected to impact margins in the fourth quarter. Our adjusted diluted EPS guidance range has been changed to $0.73 to $0.81 per share. This range assumes $141.4 million fully diluted shares outstanding and 26% to 28% effective tax rate, excluding the impact from the $2.6 million Tax Cuts and Jobs Act charge that is added back to our adjusted diluted EPS. Before we move to Q&A, I need to call your attention to the Form 8-K that we filed earlier this morning. During our third quarter closing procedures, we identified areas relating to tax that impact prior year periods. Management has determined the impact on 2016 to be material, so we will be restating our 2016 financial results. Please refer to the 8-K for our complete statements. That concludes my comments. Operator, we will now open up the call for questions.

[Operator:]

Thank you [Operator Instructions]. And our first question comes from the line of Jeff Hammond from KeyBanc Capital Markets. Your line is open.

[Jeff Hammond:]

So just on - I guess on the margins. Can you just elaborate on this cold side issue? Is it largely resolved? Is that carryover into '19? And just as you look into '19 and I know there is lot of headwinds this year. But how do you see those staying the same or changing as we look into '19?

[Josef Matosevic:]

Jeff, you mentioned our supplier issue?

[Jeff Hammond:]

Yes.

[Josef Matosevic:]

Yes. So when we look at the two key drivers in the supplier issues, Jeff, it was relating to the cold side business with a couple of key issues; one a compressor issue and one on the wire and hardness issue. The compressor issue is largely behind us and the wire hardness issue will be behind us in Q4. We don't expect a carryover into 2019 at this point.

[Jeff Hammond:]

And then just as you look at rollout visibility, general market, restructuring actions some of your internal initiatives. How should we start thinking about margin stabilizing and turning positive again as we move into '19?

[Josef Matosevic:]

Jeff, we are as a team here, we are extremely excited for 2019. We're going to get through this year here and finish as strong as we can and we have 1,000 basis point journeys that we are staying true and there is no shift or deviation from that standpoint. In terms of strengthening of the margin, we have once again key pillars in the 1, 000 basis point journeys that are looking extremely exciting, the plans are in place, the execution has started. And quite honestly, the 1,000 basis point is the bible, so we would stay true to that.

[Jeff Hammond:]

And then just you did some refinancing of your capital structure here on the last quarter, so that’s positive. Can you just talk about anything else you're contemplating? I know you have some high cost debt out there and what you might be able to do from a saving standpoint? Thanks.

[Haresh Shah:]

You are right that was the first step of us working on our balance sheet. We are looking at all options. I don't want to get into details on timing of what exactly we are going to do, but we know when the high-yield are callable, we are looking at all these scenarios there, so more to come in the future.

[Richard Sheffer:]

The only other color to put on, so when we were talking about the high yield notes that’s the $425 million of 9.5% notes that become officially callable mid-February. There is still a premium that we would have to pay at that point if we decide to call them at that point of 7 and an 8 premium over and above par. So it's not pre to do it. But given current market conditions, there would be annualized interest savings. So we are looking at it pretty closely right now.

[Operator:]

And our next question comes from the line of Mig Dobre from Baird. Your line is open.

[Mig Dobre:]

What I am confused about is when I look at your guidance the third quarter itself it's actually not that bad. The big cut in margin comes in fourth quarter by my math it's something like 170 basis points. So, I guess what I'm wondering here is when we're looking from the third to the fourth quarter at these headwinds that you detailed on Slide 7. What exactly is implied for volume mix in the fourth quarter? And what exactly is implied on material cost inflation or compensation or the drag that essentially resulted in this step down?

[Haresh Shah:]

So Mig, let me address the first thing. When you look year-over-year, let’s not forget in Q4 2017, we had true up of compensation, which we were clear about. So that is a headwind we’re facing. Our short-term bonuses were significantly lower last year and we’re accrued at 100% currently. So that's one headwind we’re going in. And then from a continuation, it's really the three main items are the continued 301, the supplier issues, which are behind us but we’re carrying on our balance sheet currently, and then the product mix. I think that's really the factor that's changed. We were expecting to have a different mix, volume mix while the volume is there, we’re selling in our good, better, best products, we’re selling more of good versus best. So that's the margin profile that we’re seeing in the mix.

[Mig Dobre:]

Haresh, I guess the pushback that I would give you on that is if I'm looking last quarter, you were commenting at the time that volume mix was going to become a tailwind in the back half. And you highlighted some of the expenses related to rollouts. You highlighted KitchenCare getting better. Obviously, those two items have helped. But at the time, you knew you're going to have a tough comp in the fourth quarter on KitchenCare. So you knew that. And really the only thing that was unknown was Q3, and Q3 is behind us. So, I'm struggling to see how the fourth quarter can surprise you from a mix standpoint as much as it does. What I am I missing here?

[Haresh Shah:]

I think first, Mig, let me take a step back to what we’ve always said. When you look at our industry, we don't have long term visibility. So for us to say at the end of Q2, we knew what Q4 mix was going to be in hand that’s not -- we’ve been very clear, it's short-term -- in short-term visibility. So A, the mix of product is different. The comment I just made a few minutes ago, we still see strong volume. But from what we expected, that mix of products is changing and that's changing the product -- margin profile. From KitchenCare, yes, you’re right. We knew there was a tough comp in Q4. While we did better in Q3, it was not as high as we expected it to be. So those are the two differences, Mig.

[Richard Sheffer:]

Then I think the last piece -- Mig this is Rich, is the additional expense we’re going to incur from the supplier issues as those products come out of inventory and are sold, we’ll realize the extra cost from those supplier issues and that should show up in mix as well.

[Mig Dobre:]

Can you break out this discreet item, the supplier issue in terms of…

[Haresh Shah:]

Mig, we don’t want to get into the guts of it. Let us get through Q4, we expected to be behind us but we don’t want to start getting into that level of detail here.

[Richard Sheffer:]

It's single digit millions of dollars. I don’t think we want to get more specific than that.

[Mig Dobre:]

Can you provide specifics on 301 and how that impacts the year?

[Haresh Shah:]

Well, the guidance that we gave and which we still feel is in the right range is 20 basis point impact for the year. So while you’re going to see it higher in the second half, it implies 40 basis points for the second half so 20% for the year. So hopefully that will clarify. We haven't seen many other changes with the new or the additional list that we're published but that's the range we're seeing.

[Mig Dobre:]

Last question, if I may. Given all the moving pieces that we have here and frankly the lack of clarity, for instance, on volume mix and how that progresses and lack of visibility. I guess, my question is how confident are you that you can still deliver on this 1,000 basis point margin improvement journey? I think really that's the issue in the quarter, that's the way the stock is behaving the way it is. And that's what everybody's wondering into 2019 and 2020.

[Haresh Shah:]

When we look at the levers that we have, we don't see any structural impediments. We know what the headwinds that have come in, what the different issues that have risen. Longer term, we feel good about the journey. I think this is an opportunity for us and we will, as even Bill mentioned in his opening comments, for us to continue to stay focused. So, we're going to hit obstacles as we go along the way but, Mig, we don't see structurally impediments to that.

[Josef Matosevic:]

We answered this even, Mig, with staying very true to our strategy and continuing to grow our top-line profitably as we started to rolling new products, and we mentioned this few times now. We will put in a position to change the tires we were riding the bicycle, so to say, to adjust engineering changes and apply which came to a cost. And we talked about it as well and then the later part of the year we start seeing the 301 tariffs impacts, we start seeing the product mix in upcoming back as strong as we anticipated to, intend to this one supplier issue. So in our case, Mig, it's not so much are we still confident about our 1,000 points journey. The answer is clearly, yes. It's working through these issues that came up and revisiting our plans, which we have and started focusing executing those plans. So look, we are extremely comfortable going into the Q4 here now and going into 2019, margin will improve, our top-line is strong and trajectory looks really good. So this is as honest as we can get here.

[Mig Dobre:]

I understand that. But I guess if you're talking about mixed headwinds from premium products and less demand and more -- and less feature products and more demand. Isn't that a function of what's happening in the market and potentially a longer term shift that would mean that you either have to rethink your offering or essentially take some other action to be able to drive margin expansion. Isn't that a fair way to think about it?

[Josef Matosevic:]

Well, in general the market has been stable and consistent with the 1% -- 1.5% to 2% growth, and then our QSR segment has been very strong. So, we are gaining market share. We are rolling out new product and technologies. And so there may be short term impacts in terms of mix but that doesn’t mean we're not doing anything about it. Obviously, we have another 23 new product launching here in Q4 that have features and differentiation that the market needs we will continue to stay focused on executing those new products with the lessons learned from 2018. So I am not…

[Bill Johnson:]

And a lot of the operational improvements that we will be driving effect, both good, better and best products. So, we are improving margins on all of those products, going forward.

[Operator:]

And our next question comes from the line of David MacGregor from Longbow Research. Your line is open.

[Rob Aurand:]

Rob Aurand on for David this morning. Can you give us an update just how the discounting environment played in 3Q? You've talked in the past about holding firm and walking away from business as needed. I guess can you quantify that impact? And did you have to walk away from more business than you expected?

[Richard Sheffer:]

It is a little bit tougher environment as you guys noted in your report. We did not walk away from too much from a topline standpoint, we stayed very discipline. And we expect to remain disciplined in Q4.

[Rob Aurand:]

And you talked about taking discretionary cost actions during the quarter to help out margins. Could you give more color on what you did? And I guess how much more room do you have in the fourth quarter to continue taking those discretionary actions?

[Haresh Shah:]

We had a small headcount reduction that we did, it's in our release there that -- and in addition, we're looking at other areas. It's really the controllable spend in terms of what projects are we focused on, where are we prioritizing. So, I think if any area that we can control and look at also from a timing perspective, can we get this done this period, can we differ, so it's across the board in all areas.

[Rob Aurand:]

And just lastly, can you give us an update on the NexGen and how that might have impacted the quarter?

[Josef Matosevic:]

So as we said before, Rob, we have NexGen suites to full volume requirement it will take some time. And we anticipated in Q3 a slight ramp up that ramp-up has started and it will continue into Q4 and going into 2019. So they are almost switched over to all common systems here so we can start the order pattern, very exciting journey.

[Operator:]

And our next question comes from the line of Jaime Clement from BRG. Your line is open.

[Jaime Clement:]

So commentary on hot side versus cold side what is -- I think Americas' cold side down; I think EMEA cold side up; I think APAC cold side down. Was this a net slight disappointment for you versus how you had the quarter pegged in your head?

[Josef Matosevic:]

We were expecting a little bit stronger cold side, especially in the Americas. So that's where we've seen the overall -- I think the ice and cold market and the Americas has been down, we are maintaining or gaining share. But the market overall is down.

[Jaime Clement:]

I would have thought all else being equal, that if potentially your hot side business, on a global basis, was stronger than the cold side that actually might have positive adjusted EBITDA margin ramifications. Am I wrong about that?

[Josef Matosevic:]

No, you are absolutely right that will be the case once we're further along in our journey. We have different products, different locations that are in different stages. So absolutely right when we look at our mid 20s, we would expect hot to be higher than cold. But as you know, we’re still in year three of the journey. We had started with the rightsizing and now we’ll focus on the next piece of -- that will be the margin profile as we move forward.

[Jaime Clement:]

I know that sometimes from quarter-to-quarter, your graphic breakdown of financials, you all don't necessarily think tells a story just because that's just where the sales get booked and that kind of thing. Is there any take away from your segment numbers in this quarter that we should be aware of?

[Josef Matosevic:]

I think if you look at the segments from a top line perspective where in EMEA we’re going to see continued pressure is of course with Brexit and with the political situation in Turkey. Other than that, we feel okay. I would -- as we’ve talked previously on margins, those are impacted by where we manufacture and distribute, so our inter segment pricing. So I wouldn’t focus extensively on the margin. But I think from a top line perspective, we feel good and we know the geopolitical situation in EMEA.

[Operator:]

And our next question comes from the line of Rob Wertheimer from Melius Research. Your line is open.

[Rob Wertheimer:]

I wonder if you could just review for us the Section 301 tariff. Was it the July list or the September list that has inflated costs? And then what is the pace of your pricing to offset that, the timing and speed at which you do it?

[Richard Sheffer:]

It really was the July list that impacted us. So from what we see and what we discussed on our August call, it’s still same consistent there. We just have to see if there’s going to be additional list that come out over the next few months, where that all goes. So again, 20 basis points on the full year, which implies a higher number in the second half, because it didn't really start until July.

[Josef Matosevic:]

And I think on your second part of the question, we are not going to be able to price that this year. So we’re going to consider that as we look at our 2019 price increases.

[Rob Wertheimer:]

And was there anything different in your closing procedures this quarter that caused the tax issue to pop up?

[Haresh Shah:]

It is the further refinement of the new tax rules. And if you may know in September, they published hundreds of pages more of guidance on clarity what we needed to do and that drove that review back for us.

[Operator:]

And our next question comes from the line of Walter Liptak with Seaport Global. Your line is open.

[Walter Liptak:]

I wanted to ask about going back to one of the prior questions about the simplification and profit improvement, going forward. You’re looking at Slide 6, you've got a lot more benefit of early stage for purchase and lean. And it also sounds like there might -- you guys might need put in a new bucket down there for some headcount reduction or restructuring too. But I wonder if you can talk about just the timing of when you think you’ll get those and if this is really more of a deemphasizing of 80/20 or is that something that’s ongoing?

[Richard Sheffer:]

No, I would say, Walter, we’re certainly focused on 80/20. We're focused all of the initiatives that you referenced there in the 1, 000 point journey. We're redoubling our efforts in some of these areas and putting more resources to drive it out, drive these costs out, because they are real, and there are real costs that we can address. And you and I've been together in the past and so you understand my background is operationally focused and driving out driving out cost. And so I'm really committed to making sure that we get that done here.

[Walter Liptak:]

And then if I can just switch to the inter-segment pricing that you guys have called out. Can you help us understand how the intersegment pricing works? And why we shouldn't be focused on profits in Europe versus North America, but I guess look at it more collectively?

[Haresh Shah:]

The way to think about it is as we sell products in a region regardless of which region it is, if it's manufactured in that region we'll see the margins there. If it's manufactured in a different region and distributed there, the manufacturing region will get the margin and the selling region will get a smaller markup. So, that's the easiest way to think about it is a manufactured versus the distributed products in region.

[Richard Sheffer:]

And that can change quarter-to-quarter depending on the mix of products that are sold in any individual region and the quarter. So again, both from a top-line standpoint, it's fair to focus on the results of each of those regions but from a margin standpoint, please stay focused on the overall consolidated margin.

[Walter Liptak:]

And I wonder if you could just give us a little bit more clarity about the supplier issue and what region of the world that cold side supplier issue came up. I imagine its Americas, but I just want to be sure.

[Haresh Shah:]

Josef went through it, so I'm not going to repeat what he talked about. But yes, it is in the Americas.

[Operator:]

[Operator Instructions] Our next question comes from the line of Joel Tiss from BMO Capital Markets. Your line is open.

[Joel Tiss:]

I wonder if -- you guys haven’t talked about this ASC 606, the revenue recognition, I just wondered if that has any impact in 2018 or in the quarter?

[Haresh Shah:]

Immaterial, no real change -- our normal revenue, as you know, Joel, is really ship. We build the product and we shipped it. So there is minimal impact to us and nothing worth calling out.

[Joel Tiss:]

And then that Taco Bell contract from a year ago. Is that any part of the negative mix or that’s also more immaterial?

[Haresh Shah:]

Yes, the first half was the majority of it. We saw some coming in also a little bit more in third quarter. So that contributed a little bit to the mix also in Q3. And that’s -- but let me just clarify. It's not specifically that one contract. It's the startup cost that we had. The reason for again the strong growth that we've seen in the QSR is continuations of the project, not -- I want to be clear. Not just one contract but the numerous rollouts that we had. They continued a little bit into Q3 and that was a mix issue, because we had the startup costs associated with that.

[Joel Tiss:]

Is there better long term visibility on your chain business versus your other business, just because they have bigger departments and longer-term plans?

[Richard Sheffer:]

You tend to have rollouts in that area. And so once you get the rollout, they can be multiyear rollouts in some cases. But for sure, they are longer periods of time. So they are little more predictable. Although, there will be fluctuations from quarter-to-quarter depending on what goes on within their businesses.

[Haresh Shah:]

And I think one key learning for us as a company was, until we get that purchase order in hand, we learned in '16 we heard it was coming it was coming. The actual order didn’t come. We have the visibility of the rollout and the projects but the exact timing of orders coming in and not shipping that could fluctuate.

[Operator:]

And our next question comes from the line of Nick Midgley from Intermede. Your line is open.

[Nick Midgley:]

I just had a couple of questions, just going back to Slide 7. The first was just looking at that material cost inflation and thinking specifically about the Section 301 tariffs. I mean did the third quarter play out in line with your guidance by the end of the second quarter? And then maybe I'll wait to ask second one.

[Haresh Shah:]

The Section 301 that we experienced in the quarter was fairly aligned with our expectations. But just to be clear, this is more -- that bucket is more than just 301, so that’s going to have all of our material cost inflation. And in my prepared comments what I talked about outside of 301, some of those other inflationary headwinds were offset by the net pricing.

[Nick Midgley:]

So when we look at -- I guess this goes to your comments. So I mean when we look at the key delta relative to guidance from the second quarter, that’s mainly the volume mix and the suppliers you had. And maybe just focusing on the volume mix, I think, it's been tax rise as good versus better products. I wondered if you could just maybe give a little bit more color on the types of products going into type of products little bit more. And specifically I'm interested in the fitKitchen rollout and what effect that has on mix through the quarter?

[Haresh Shah:]

We don’t want to get into specifics. We don’t talk about which products. As you know, we talk about hot cold and then QSRs and general market. So, I don’t want to get into levels of product, but we are happy to talk about the kitchen a little bit more.

[Josef Matosevic:]

The kitchen rollout backlog remains to be very strong. What you have seen here is we are under process of incorporating some of the lessons learned that we encountered in the first half of the year before we very aggressively start rollouts again. But the customer interest is extremely strong, brands are performing very well, quality of the product is good. So the only slight pause is incorporating of lessons learned in the first half.

[Nick Midgley:]

So just to clarify, I mean, do you view this volume mix impact you've seen in the third quarters is -- I mean, could you cost that as fully or in the realm of typical variation or variance? I'm looking at 2019. Are you still confident about the trajectory and the organic growth and margin improvement?

[Haresh Shah:]

I think Josef covered it earlier. These variations happen. We anticipate that to continue into Q4. But structurally, we don’t see that as a change.

[Josef Matosevic:]

And it tends to be a little lumpy from quarter-to-quarter anyways. So our backlogs are not long time backlog, so our visibility is difficult to predict, but quarter-to-quarter it smoothes out.

[Nick Midgley:]

So you are not really seeing any fundamental structural change in the end markets?

[Josef Matosevic:]

No.

[Operator:]

Our next question comes from the line of Jamie Clement from BRG. Your line is open.

[Jamie Clement:]

So out of curiosity, I think that when companies talk long-term multi-year margin improvement stories and investors are more interested in the shorter run and stuff like that. What’s your -- for your full year, your EBITDA margin is lower to mid range of your guidance. And let's say next year, the market is up 3% or something like that and maybe you win some share on top of that and your margins are back up to where they were in 2017. Is that an acceptable outcome for you guys?

[Haresh Shah:]

We’re committed to the journey. So we’re not looking to go backwards. There’re going to be obstacles, which we have talked about. So if the question is are we backing off from our margin journey? The answer is clearly no. And Josef was very clear on that earlier. So, we’ll continue to focus on that. We feel again structural impediments. There are no structural impediments to this. We are going back to -- Bill again talked about the focus on the business, so this is back to the basics and operational excellence.

[Richard Sheffer:]

We don't want to talk too much more about 2019 at this point. We’re in our budgeting process. And we'll provide our 2019 guidance on our next call.

[Operator:]

And our next question comes from the line of Mig Dobre from Baird. Your line is open.

[Mig Dobre:]

A couple of small items, I guess first one is back to compensation. I am trying to understand what the driver of this compensation bucket is. Is it is primarily topline sales commission and things of that nature. How does margin profitability play into this bucket here?

[Richard Sheffer:]

So Mig, we have three drivers of our annual cash bonus; those being organic sales growth; adjusted operating EBITDA margin; and free cash flow in absolute dollars. So as you recall, last year we ended up taking our accruals down. We only paid out 35% of our target bonuses, so naturally if we performed in all of this year that was going to be a compensation headwind when we looked at our overall margins. The other piece that goes in there is our long-term incentive comp. So those -- as most companies -- those are paid out in shares and those are rolling three year programs. So this is our third year since spin, so we had an additional year that we’re accruing for this year where last year we were only accruing for two cycles, the initial year only one cycle. After this, we'll always be accruing for three cycles simultaneously. So LTIP, the long term incentive plan, will no longer be a mix or a compensation headwind, because we're not adding additional programs as another year comes on one will roll off. So this year, it's a combination of both of those that's causing the headwind. Within this, the short term incentive, the mix between those three criteria that I mentioned, organic sales, EBITDA margin and cash flow are roughly equal in their weighting.

[Mig Dobre:]

And then maybe I missed this, but can you -- Haresh, can you give us a sense for what you expect the cash flow from operations to be or free cash flow for 2018?

[Haresh Shah:]

We have not guided to that. But if you look at historically, we generally are in the 100% of net income range.

[Mig Dobre:]

I mean what's going on right now with your working capital is maybe a little bit different in history. So that's why I'm asking.

[Haresh Shah:]

No understood, and we will focus. We have -- we talked about in prepared comment on the AR being up. So that will work itself as we collect through that cash. Our inventory, we've had some build ups for some of the supplier issues, as well as our quick ship inventory we’ve talked about. So, we're focusing on that piece. And I don't expect anything out of the norms. Rich?

[Richard Sheffer:]

Mig, I think one thing to look at. Our working capital utilization metrics are industry best. We're averaging between 10% and 12% of utilization, its least 6% better than anybody else in this industry. And I think this is a company out of necessity that has managed working capital very tight. We have strategically invested into additional inventory for quick ship programs, but we also manage our inventory levels much tighter than anybody else in this industry. And typically, we bring inventory down as we go into year-end. So, that is an operational focus that we will again have this year.

[Mig Dobre:]

I also want to ask a little bit about price cost. So, you're saying that you're going to catch up with 301 with the price increase that you're going to put through at year-end. Is it fair then to expect starting with Q1 '19 based on what do you know today that when we're going to look at something like Slide 7, we're going to see at a neutral net pricing versus material cost inflation dynamic?

[Haresh Shah:]

Mig, let me just clarify that. I don't think we said we expect it to offset. What we said is as we look at the Q1 pricing we will look at the impact and then make the determination. So that is something we're working through real time. I just want to be clear. We didn't say we expect to fully offset. We will have price increases and that's what we're working through now.

[Mig Dobre:]

I appreciate the difference, thank you for clarifying. Last question. Volume mix has been a headwind in the first half that it's going to be a headwind in the second half. I understand that it's difficult for you to forecast mix. But considering the fact that, arguably speaking, the comps are easiest as you go into '19. Is there any reason as to why people should be thinking that volumes will be a headwind?

[Haresh Shah:]

Well, if you think about our first half from a volume perspective, we have large rollouts, significant rollouts in the first half. So we did -- you are not going to have the same rollouts every period. We're working through -- I think one question earlier. We are working with other QSRs. We know the projects that are going on. But the timing of it -- what we know as a fact is first half we had large rollouts with several QSRs in 2018.

[Mig Dobre:]

So you're saying that that’s a volume headwind or a mix headwind?

[Haresh Shah:]

It is actually going to be -- it's a volume from a pure volume, and then that’s where we also had a start up cost issues. So it will be a little bit of both, Mig. But that’s significant top line that we have had in the first half.

[Richard Sheffer:]

It’s a tough comp, but we are not guiding to next year…

[Haresh Shah:]

Mig, we're not talking about '19 yet…

[Richard Sheffer:]

But it does set up as a tough comp and we'll address that more on our next call.

[Operator:]

There are no further questions at this time. I would now like to turn the call over to Mr. Bill Johnson.

[Bill Johnson:]

To conclude today's call, I believe Welbilt has the great strategy and is executing well in the current challenging environment. We have outgrown our end market so far this year and had delivered over 30 million of savings from simplification and rightsizing in 2018. I have confidence in this team to continue delivering profitable growth and de-levering the balance sheet. I am excited to lead Welbilt through its next chapter. This concludes today's 2018 third quarter earnings call. Thanks again for joining us this morning and have a great day.

[Operator:]

Thank you. This concludes today's conference. You may now disconnect.