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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Good afternoon, ladies and gentlemen, and welcome to the Q3 2018 SPX Corporate Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded.
I would now like to turn the conference over to your host, Paul Clegg, Vice President of Investor Relations and Communications.
Thank you, Kenzie, and good afternoon, everyone. Thanks for joining us.
With me on the call today are Gene Lowe, our President and Chief Executive Officer; and Scott Sproule, our Chief Financial Officer. A press release containing our third quarter 2018 results was issued just after market close. You can find the release and our earnings slide presentation as well as a link to a live webcast of this call in the Investor Relations section of our website at spx.com. I encourage you to follow along with the slide presentation during our prepared remarks.
A replay of the webcast will be available on our website until November 8. As a reminder, portions of our presentation and comments are forward looking and subject to safe harbor provisions. Please also note the Risk Factors in our Form 10-K and most recent SEC filings.
Our comments today will largely focus on adjusted financial results. Specifically, we will focus on Core operating results, which exclude the results of the South African projects. And we will separately provide an update on those projects.
In addition to the South Africa projects, we also exclude the Heat Transfer operations from our Core results following our actions to exit the business during Q2. We anticipate reporting Heat Transfer's results as discontinued operations upon completion of the wind-down of the business, which we expect to occur by the end of Q1 2019.
There are other adjustments to our GAAP results this quarter, including those related to our acquisitions during the first half of the year. Our standard practice with acquisitions is to adjust out certain acquisition-related items from our Core results, including deal fees and other one-time costs associated with acquisitions. You can find detailed reconciliations of Core and adjusted figures to the respective GAAP measures in the Appendix to today's presentation.
Finally, during November, we plan to be on the road, meeting with investors. On November 7, we will present at the Baird Annual Industrials Conference in Chicago. On November 8, we will present at the Furey Research Hidden Gems Conference in New York City. And on November 29, we will present at the Credit Suisse Annual Industrials Conference in Palm Beach, Florida.
And with that, I'll turn the call over to Gene.
Thanks, Paul. Good afternoon, everyone. Thanks for joining us. On the call today, we'll provide you with a brief update on our overall results, segment performances, and end market conditions before going into Q&A.
Overall, our year-to-date results keep us on track to achieve full-year adjusted EPS in a range of $2.15 to $2.25, and Core free cash flow conversion of at least 110% of adjusted earnings.
During Q3, we experienced revenue growth in our HVAC and Detection & Measurement segments, our two growth platforms, which now account for more than 80% of our company's segment income.
Operationally, we had another solid quarter in Detection & Measurement. We're seeing strong order rates for our project businesses and are increasing our full-year margin expectations for the segment. The integration of Schonstedt into our radiodetection business is largely complete, and the integration of CUES is going very well.
Overall, we are feeling good about the trajectory of our end markets. And we remain confident in our growth strategy, including our inorganic initiative to build out our HVAC and Detection & Measurement platforms, where we have an active pipeline of opportunities.
Turning to our results for the quarter, we reported adjusted earnings per share of $0.37. Core revenue increased 7.5% during the third quarter and adjusted operating income grew 6% to $26 million. Adjusted operating income margin was similar to the prior year, and up modestly when excluding the effect of deal amortization.
While our revenue performance for the quarter was solid, we also faced some challenges, including a loss of manufacturing days caused by Hurricane Florence, and continued higher net input costs. Even with these headwinds, we're able to grow our overall profit at both the segment level and operating level, and we remain on track to deliver a significant earnings growth for the full year.
Before turning the call over to Scott, I'd like to give you a brief update on the progress we made during the quarter on initiatives in our value creation framework. In our HVAC segment, our competitive position continues to strengthen, supported by our high-efficiency heating products.
During October, we launched two new large commercial high-efficiency boilers, which are drawing significant customer interest. Our NC and MD Everest cooling tower products continue to see strong demand due to favorable economics and decreased downtime when compared to other replacement solutions. We also continue to expand our participation in applications with attractive growth opportunities, such as data centers.
In Detection & Measurement, within our communication technologies business, our front-log opportunities continue to expand. Our new drone detection and specialized signal monitoring equipment solutions are receiving strong order activity, and we continue to increase bookings.
During the quarter, our fare collection business saw increasing customer interest in our unique mobile ticketing solution called the Mobile Link. We believe that this product will help further strengthen interest in our Genfare equipment solutions.
Within our location and inspection businesses, our recent acquisitions are performing well, and we still see significant channel and product line synergy opportunities.
In the Engineered Solutions segment, we are completing the structural transformation of our process cooling business, where we are focusing our efforts increasingly on component and service revenue growth. The wind-down of our Heat Transfer operations remains on track, which substantially completes our move away from businesses focused on power generation end-markets.
And now, I'll turn the call over to Scott to review our financials in more detail.
Thanks, Gene. Before discussing our results, I want to mention that this quarter we have begun providing additional disclosures that exclude the impact of amortization expense associated with the acquisitions we completed in the first-half of 2018. We believe this will facilitate more meaningful performance comparison with prior year periods and a clear review of the economic performance of our business.
We plan to introduce margin and income targets that exclude deal amortization on our Q4 earnings call in February, when we provide full-year guidance for 2019.
Now moving to our EPS bridge, on a GAAP basis, we reported earnings per share of $0.15. Our adjusted earnings per share was $0.37 or $0.39, excluding deal amortization. Our adjustments to GAAP EPS are consistent with those we made in Q2. Specifically, we are adjusting out the results of our South African projects, non-service-related pension expense, the results of Heat Transfer and one-time acquisition-related items.
The adjustment for South Africa includes a $4.7 million charge associated with a revision of our cost estimates for the projects. However, we are not changing our expectations for overall cash usage for the projects, as we had already anticipated these cost adjustments as a potential risk item when providing our updated cash estimate.
As a reminder, we expect to use net cash in South Africa of $25 million to $30 million over the life of the projects with the majority deployed this year. Year-to-date usage has been in line with our expectations, including approximately $9 million in Q3.
We continue to expect substantial completion of our role in the projects by the end of next year and are progressing to that end. We entered the year with three work streams remaining, and are now substantially complete with two of them. While we expect our net cash usage associated with the projects to be nominal on an aggregate basis during our remaining time in South Africa, not all periods will be consistent and we anticipate quarters of net cash inflow as well as others of net cash outflow. You can find more details on the projects results in Q3 in the appendix to this presentation.
Moving on to Core segment results for the third quarter. Our revenue performance reflects continued organic growth in our HVAC segment and impact of acquisitions in our Detection & Measurement segment, partially offset by reduction in revenues in our Engineered Solutions segment.
Core segment income increased $1.1 million, while segment income margin declined 50 basis points. The less favorable margin primarily reflects acquisition-related amortization expense of $1.2 million and the effect of Hurricane Florence. Excluding deal-related amortization, segment income margin declined 20 basis points.
Now walk you through the details of our results by segment, starting with HVAC. Revenues for the quarter increased 10.6%, driven by organic growth initiatives. We delivered revenue growth in both the cooling and heating portions of the segment.
The organic growth in cooling, which drove the majority of the Q3 increase, was generated from non-U. S. markets, which tend to have a lower-margin profile. And our heating business saw increased demand for our boilers and electrical heating products. Segment income was flat year-on-year and segment margin decreased to 130 basis points as a result of higher net input costs and a less favorable sales mix compared with the prior year.
Generally, our end markets have been accepting our price increases, and we have made good sequential progress on the coverage of higher input costs through our price actions. As we have worked through our backlog, the level of price offset was somewhat lower than we had anticipated in Q3, though we expect further sequential improvement in Q4.
Given our third quarter results and Q4 expectations, we now expect full year revenue growth of 11% to 12% or above the upper end of our prior guidance range of 7% to 8%. We also expect segment margin to be around 15% compared with our prior 15.5% guidance, primarily reflecting the impact of the items I noted for Q3.
In Detection & Measurement, revenues increased 26% as a result of the CUES and Schonstedt acquisitions, partially offset by the level of projects executed during the quarter. Adjusted segment income margin of 21.8% or decrease of 290 basis points. This decline was driven primarily by acquisition-related amortization expense and a change in our product mix. Excluding the effect of deal amortization, segment margin was 23.3%.
We remain encouraged by the number of frontlog opportunities we see developing in our end markets, many of them for significant projects with high incremental margins, some of which are executing in Q4.
As our project shipment schedules have firmed up for Q4 and early 2019, we're increasing our full year segment income expectations for Detection & Measurement, resulting in higher margin guidance, but somewhat lower revenue growth.
For the full year 2018, our prior expectations were for revenue in the range of $325 million to $335 million and a margin of 22.5% to 23.5%. We now expect revenue of $320 million to $325 million, and adjusted segment income margin of around 24%. The full year margin would be about 100 basis points higher or about 25% if we excluded deal-related amortization expense.
In our Engineered Solutions segment, excluding the results of the South African projects and the Heat Transfer business, revenues were approximately $130 million, down around 4% driven by lower process cooling revenues associated with our business model shift as well as the impact of Hurricane Florence on our transformers business.
Core margin declined approximately 30 basis points due to less favorable transformer margins, partially offset by higher process cooling margins. The impact of Hurricane Florence contributed approximately 100 basis points of year-over-year Core margin decline for the segment. One of our transformer plants located in North Carolina was impacted by the storm. The disruption caused by the weaker loss production and under absorbed costs. Given the already full utilization of the plant, it's not possible to make up this shortfall in Q4.
We also experienced modestly higher input costs as well as lower-than-expected productivity at our transformer plant in Wisconsin. The productivity effect was largely due to staffing challenges associated with a tight labor market, which led to some inefficiencies and more training. Based on these factors, we reduced our segment margins expectations accordingly. For the full year 2018, we continue to expect Core revenue for this segment in a range of $550 million to $560 million. And we now expect Core segment margin around 7% compared with 8% previously.
Turning now to our financial position. Our balance sheet remains solid. We ended the quarter with cash and equivalents of around $62 million. In Q3, we generated Core free cash flow of approximately $16 million, which exclude the net cash used for the South African projects. Overall, our cash generation pattern is in line with a typical seasonally strong fourth quarter and similar to last year's cadence. We continue to expect Core free cash flow conversion of at least 110% of adjusted net income for the full year.
Our net leverage, which includes short-term financing for CUES remained at 2.3 times or within our target range of 1.5 to 2.5 times. As we discussed last quarter, we'd expect net leverage to trend down significantly by year-end, towards the lower end of our target range. We feel good about our ability to continue deploying capital to drive shareholder value, including for integrated investments.
Turning to our guidance. For the full year, we continue to expect adjusted earnings per share in a range of $2.15 to $2.25 or an increase of 25% at the midpoint over our 2017 results. Excluding deal amortization, this implies a range of $2.20, $2.30. As a reminder, our guidance includes only a partial year for our acquisitions, so our exit rate would be higher even before taking into account organic growth and operational improvements. We've included some detail in the appendix of today's presentation regarding the full year impact of the acquisitions.
As I just discussed, we've made several adjustments to guidance at the segment level, which you can see summarized here. Overall, we expect Core revenue to be modestly higher than our last guidance update of around $1.4 billion. We also expect a similar level of Core segment income as implied by prior guidance, which is approximately $200 million at the midpoint. However, we are adjusting our expectations for Core segment income margin to be around 14% compared with the prior guidance of 14% to 14.5%.
As usual, in the appendix, we have also included details to help you update your models such as interest expense and tax rate as well as an overview of the key sensitivities driving the upper and lower ends of our guidance range.
And with that, I'll turn the call back over to Gene.
Thanks, Scott. Turning to an update of our end markets. Overall, our businesses continue to benefit from broad secular growth drivers and our end markets continue to reflect generally strong demand. In HVAC cooling, demand drivers remain favorable, and commercial and institutional construction markets are supporting a healthy level of order activity. In HVAC heating, end market strength carried over into Q3 and we saw a steady participation in stocking programs. Overall, the market has been receptive to increased pricing as an offset to higher input costs.
In Detection & Measurement, we have continued to see strong frontlog activity for large projects in communications, technologies and fare collection with a number of new projects progressing towards bids and orders. Run rate product sales are performing in line with expectations, and we continue to see supportive market fundamentals underpinning this demand.
Conditions in the transformer market remains stable. Our backlog continues to cover our production plan through 2018 and well into 2019. And we continue to closely monitor the impact of tariffs on imported transformers, although we have witnessed only nominal changes in the market so far.
Before getting into my closing remarks, I wanted to comment more broadly on the impact of higher input costs on our business model. Structurally, we are primarily a North American focused company and we typically source inputs from the same markets that we sell into. So we don't see a lot of direct impact from tariffs. However, there is clearly a broader secondary impact on the market pricing of inputs associated with tariffs that we have been feeling across several of our businesses. And we have experienced significant increases in freight costs compared with the prior year.
We're continuing our actions to offset the effect of higher input and freight costs, including price increases, contractual changes to recoup the effect of tariffs and operational initiatives to improve efficiency. While, we're seeing a lot of success in these efforts, the pace of margin recovery is somewhat more gradual than anticipated.
On our Q2 call in August, we expected the full year impact from price cost rub to be about 40 basis points of segment income margin. We now anticipate this impact to be approximately 50 to 60 basis points for the full year.
In summary, our year-to-date performance positions us to achieve our adjusted EPS guidance for 2018. Our HVAC and Detection & Measurement segments are primary growth engines, now account for more than 80% of our company's segment income. Our strong balance sheet, cash flow and liquidity position provide us with considerable financial flexibility to invest in organic and inorganic growth initiatives. And with multiple prospects in our target pipeline, we feel good about our opportunity to execute on value accretive transactions. Ultimately, we will weigh these opportunities against other capital allocation options and focus on those that maximize shareholder value.
And now, I'll turn the call back over to Paul.
Thanks, Gene. Kenzie, we are ready to go to questions.
[Operator Instructions] Your first question comes from the line of Damian Karas from UBS. Your line is open.
Hey, good evening, everyone.
Hey, Damian.
Hi, Damian.
So I just wanted to dig a little bit deeper into the - some of the external headwinds that you guys are experiencing. And, Gene, you talked about sort of the 50 to 60 basis points of full year impact of cost inflation versus the prior 40. But just for the quarter itself, could you kind of help parse out for the entire business what that higher cost impact was as well as the overall Hurricane Florence production impact just in 3Q?
Hey, Damian, this is Scott. Yeah, so for the full company in Q3, it was about 30 basis points of headwind for price cost, which was probably less than half of what it was, what we experienced in Q2 and that's Gene was talking about. We made some good progress here, and we expect even better progress as we look into Q4. A lot of that has to do with the initiatives that we put in price and the additional pricing that we have put in place. And then, as far as the hurricane, we've said, it's about 100 basis point impact year-over-year to Engineered Solutions, do the math, it's about $1.5 million.
Okay. And I guess, specifically on HVAC, you talked a little bit about just the price offset not been quite what you had anticipated. Any reasons why that is? And what gives you a little bit more confidence that you can overcome that?
Sure. So it was really driven by the execution on the backlog, and we're able to get there. And we talk about the impact here. It's both material and freight. So it's just more of the ability to actually reprice some of that backlog than anything else. So we feel good about what we're doing now in the orders that are being booked and the pricing level though is going into Q4.
Okay. And then, one last one here. Gene, you mentioned that you've seen some strong frontlog in Detection & Measurement on the project side of things, and you feel like you're pretty close to winning some awards here. Just could you give us a sense on timing? Is this something that's more likely to 2019 and it looks like from your guidance you kind of still expect Detection & Measurement to kind of the Core business to be down in the fourth quarter?
Yeah, let me take a crack at that, Damian, and then maybe Scott can help out a little bit. I think, if I look at Detection & Measurement, we're very pleased with Detection & Measurement this year. We have very significant margin expansion in the Core business, very significant. And obviously, the two bolt-ons, Schonstedt and CUES, which we think actually improves our growth profile as well as our competitive position there.
But with regards to the projects, as a reminder, those are predominantly focused in our comm-tech business and in our fare collection business. What we - what the comments in the script highlighted is that we see a very nice conversion rate of both orders that we have in our frontlogs that we're converting. And that's why, we have - we feel very good about Q4, and we feel very good about our year.
We've talked about many times about Detection & Measurement. It's a tough business to look at sequentially quarter-over-quarter, year-over-year, quarter-over-quarter. But if you look at it year-over-year, you can generally be very good about the improvement, and we feel very good about the improvement year-over-year and then also feel very confident in our ability to deliver Q4. And I think, we're just feeling good about the end markets as we look to 2019. And Scott, obviously, you have any other color, you'd like to add?
A couple of things to add. So as far as the orders go for the Q4, where we sit today as far as the projects go, we have all of them committed to and many have already shipped early in the quarter or so in October. So we feel really good there around that activity. And then the broader activity is maintaining a robust view. And specific to Q4, just a reminder, last year, we were in Genfare, we were executing on the San Francisco project.
So that was - had some heavyweight into Q4, so that create some of that. There are more opportunities out there. And if you look at the kind of what could drive the difference in the top or bottom end of our guidance range, really a lot of it will be around project activity that could possibly come - still come through and ship, beyond our guidance - what we're expecting in the guidance. And weather is, obviously, other one that could impact us more. More towards, we don't want to account in cold weather in HVAC, but that's the other piece that if there is a cold winter, that could positively benefit us.
Okay. That's helpful. Thanks. I'll pass it on.
Thanks.
Your next question comes from the line of Brett Linzey from Vertical Research Partners. Your line is open.
Hi, good evening, all.
Good evening.
Hi, Brett.
Hey, just wanted to come back to comm-tech. Could you maybe just put a finer point on the push-out in the quarter? How large was it? Is this an isolated customer or more broad based? And how you're thinking about the timing of those projects or project as you look forward? Is it a Q4 vector? Is that moving to 2019? Thanks.
Yeah, this is Scott. So there really wasn't a push-out in the quarter itself as we've said about the - some of these projects that are hard to time. There were - those are actually some that shipped here in October that could have shipped. I mean, we're talking about a matter of weeks, the difference between the quarters. So we do really think about as on an annual basis, as Gene mentioned. So we feel good about all those - all the orders are from a project nature and a steady run rate order track that we're seeing in comm-tech and across the business and have all those orders kind of in-house already and executing on them.
Yeah, and I would say, that's almost little bit atypical where we've had the orders in hand, and have shipped a large majority of them at this material portion over this point in time. So we feel good about that.
Okay, great. And then, just the guide for D&M in Q4, I mean, it's a pretty big step-up sequentially. I mean, still negative against the very tough comp. But what bridges is there? Is it the comm-tech stuff that's pushed out? Or how you're thinking about maybe the divisional performance in Q4 in D&M?
It's the - you're looking at Q3, Q4 sequentially or year-over-year, just clarify?
Well, yeah, so the year-over-year performance. So the full-year guide would imply kind of low-single-digit decline for Q4, which is a big step-up from the negative 13% in Q3. So I'm just wondering from a year-over-year standpoint.
Yeah, that's just the - you're talking about on the organic side. That's just really the timing of when some of these order activities are happening on a quarterly basis. And why it's hard to give quarterly numbers because of the timing there. And really sequential and year-over-year quarterly analysis is less meaningful than looking at it in the full year. But I'll say is, specifically - just reiterate is, we feel very good about where we are for the quarter and delivering on the full-year commitments and forecasts for Detection & Measurement, and all the segments.
Okay, right. And maybe just one follow-up, just on the price cost, I know you said 50 to 60 bps headwind for the full year. Could you just level set me, what does that imply for Q4? Is it still negative or do we reach parity in Q4 on price cost? And I saw you did put out a price increase a couple of days ago. But what are your early expectations for 2019 as well?
No, we're not expecting to get back to parity. There'll be a minor decline or net headwind for the quarter. I said, about 30 bps for Q3. It'll be less than that for Q4.
Okay. And do you think you'd probably reach parity in Q1 if all the price actions stick, Q1 of 2019?
I think we're feeling good about the sequential improvements that we're making across the business. So I think we got our arms around that, absent any other further broad quick changes in the market.
Sure. Okay, great. Thanks, guys.
Thanks, Brett.
Your next question comes from the line of Robert Barry from Buckingham. Your line is open.
Hey, guys, good evening.
Hey, Robert.
Hey, Robert.
Maybe I'll just pick up there on the price cost. I just wanted to clarify, is there some reason you're seeing weaker price realization or is it just the inflation is tracked higher and it's just higher than the price hikes you had put in, had contemplated?
Yeah, the impact was more around, as I said, in - it's really around Q3. And it's around the impacts and the assumptions we made around being able to capture some pricing, and things that are already in backlog and executed.
Yeah, I'd say, on the new business, on the run rate business, we feel very good. And we're actually seeing very good performance there, had some of the - working through some of the backlog. And that keeps going down, and that's why each quarter, we're getting very nice sequential improvement.
Yeah. When we look at it in total, it's really the HVAC and Engineered Solutions segments that are fueling the impact on a year-over-year basis. Engineered Solutions, you're actually seeing decremental margins for the whole segment. That's a big part of it. And they are - being our longest backlog business, particularly transformers, it makes sense. And that we really saw that in the first-half of the year. And we're seeing that moderate significantly here in Q3 and the second-half.
And then, on HVAC, again, we are impacted mostly in the first-half of the year. And we're seeing significant improvement here in the second-half. But even on HVAC with the headwinds from the price costs, we are still expanding margins on an absolute basis for the year. So we're feeling good about what we're being able to do in light of a negative impact from price and cost.
Yeah, I mean, the price/cost clearly has been a headwind for us. But if you look at the HVAC business today, 11%, 12% growth, 50 basis points margin expansion, we want more and we expect more and we're going to push for more. And I actually think our product portfolio and our team there really position us well. And we think we feel good about working through the price cost and we like the general momentum of that business.
Got it, got it. Actually, I wanted to ask about the momentum there. It sounds very good. I think it's been tracking a lot stronger than you had anticipated. Just kind of thinking a little bit further ahead, I mean, are we setting ourselves up for facing some really tough comps for HVAC as we think about next year or is this kind of a sign that stepped-up momentum in this segment is really just starting on the back of all these product launches?
Yes. When we look at it from that this is the new rate, right, I mean, I think we're sticking with our long-term expectations of 2% to 4% around - in the segment. We do have benefiting us this year the cold winter in Q1 that we talked about earlier. So we don't plan for cold winters. So that will be a little bit of a headwind, if you will. But overall, we're still feeling without getting into 2019 guidance, which we'll obviously do in our Q4 call. But we are still feeling good about prospects for growth off of 2018 for 2019.
Yeah, and I think that's a function of - there is a broader product line, both in the heating and then in cooling. The business has been taking some share. And, yes, I think, our focus would be to move that growth rate up over time. And that's really our focus is to have organic initiatives that can continue to move us in the positive direction.
But, yeah, the 11%, 12%, that was - this year is an exceptional year for growth. But this is a good business, it's well positioned. We like it.
Right, right. Yeah, I just wanted to just see if we should be thinking about the low-end or kind of a flattish 2019, just given it's been so strong this year. But it sounds like you think you could still be in the 3% to 4%.
Yeah, I think we are still - we're expecting growth into 2019. And we'll get into, obviously, more details on the Q4 earnings call, when we provide our 2019 guidance.
Yeah. Maybe just lastly for me, looking at Engineered in the fourth quarter, that margin implied, I think it's about 10%. Is that fair to get to the 7%, which would...
I'm sorry, I didn't hear the question. Did you…
Yeah, I was just looking at the margin implied for Engineered Solutions in the fourth quarter to get to your 7% for the year, which I think would be low-double, maybe around 10%. Just curious about your line of sight to that and…
Yeah, I think it's a little bit below that, but it's a significant step-up from where we were in Q3. Now, Q3 is always our lowest quarter for Engineered. It's when we do our planned shutdowns in transformers. And then, we obviously had the impact, we said about the hurricane this year. So we're - that is really largely backlog. We feel good about where the backlog is.
We feel good about the price/cost, impact of the mix there. And we did identify that we had some inefficiencies in production in our Wisconsin plant. We feel good about where we are from those issues coming into Q4. So I would say we feel pretty bullish about being able to achieve our outlook expectation there.
All right, thanks a lot guys. Have a good day.
Okay. Thanks.
I am showing no further questions at this time. I would now like to turn the conference back to Paul Clegg.
Thank you, Kenzie. I thank all of you for joining us on the call this evening. We look forward to talking to you next quarter.
Ladies and gentlemen, this concludes today's conference. Thank you for your participation and have a wonderful day. You may all disconnect.