阿美特克 (AME) 2020 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the Second Quarter 2020 AMETEK, Inc. Earnings Conference Call. (Operator Instructions) Please be advised that today's conference is being recorded. (Operator Instructions) It is now my pleasure to introduce Vice President of Investor Relations, Kevin Coleman.

Thank you, Andrew. Good morning, and thank you for joining us for AMETEK's Second Quarter 2020 Earnings Conference Call. With me today are Dave Zapico, Chairman and Chief Executive Officer; and Bill Burke, Executive Vice President and Chief Financial Officer. AMETEK's second quarter results were released earlier this morning and are available on market systems and in the Investors section of our website. This call is also being webcasted and can be accessed on our website. During the course of today's call, we will make forward-looking statements, which are subject to change based on various risk factors and uncertainties that may cause actual results to differ significantly from expectations. A detailed discussion of the risks and uncertainties that may affect our future results is contained in AMETEK's filings with the SEC, including in our 10-Q, which will be filed later today. AMETEK disclaims any intention or obligation to update or revise any forward-looking statements.

Any references made on this call to 2019 or 2020 results will be on an adjusted basis, excluding after tax, acquisition-related intangible amortization, and also excluding the gain from the sale of Reading Alloys in the first quarter of 2020 and the realignment charge taken in the first quarter of 2020. Reconciliations between GAAP and adjusted measures can be found in our press release and on the Investors section of our website.

We'll begin today with prepared remarks by Dave and Bill and then open it up for questions. I'll now turn the meeting over to Dave.

Thank you, Kevin, and good morning, everyone. Despite an economic environment that's challenging and uncertain as any we have ever faced at AMETEK, our businesses stood strong in the second quarter, delivering outstanding operating performance that exceeded expectations. I wanted to start by thanking all AMETEK colleagues, who are working tirelessly through this pandemic to provide our customers with great products and exceptional service. As our results attest, our employees are doing an amazing job.

The safety of our employees remains our highest priority. We continue to implement our Pandemic Response Plan, which provides a pandemic -- for our businesses to manage their facilities and workforce during this pandemic. We're following CDC and local health and safety guidelines, and are adjusting and enhancing our safety protocols as required to ensure a safe working environment for our employees.

Now let me turn to our results for the quarter. Sales in the second quarter were $1.01 billion, down 22% versus the second quarter of 2019. Organic sales were also down 22%, with recent acquisitions contributing 4%, the divestiture of Reading Alloys a 3-point headwind and foreign currency a 1-point headwind. Despite substantial demand weaknesses, our business delivered exceptional operating performance.

Our operating income in the quarter was $227 million and operating margins were very strong at 22.4%, while decremental margins were an impressive 25%. EBITDA in the second quarter was $289.7 million and EBITDA margins were a record 28.6%, up 160 basis points over last year's second quarter. This drove earnings of $0.84 per diluted share, down 20% versus the second quarter of 2019.

Our cash generation in the quarter was superb. Operating cash flow was up 28% year-over-year to $315 million. Free cash flow conversion was also exceptionally strong at 183% of net income. Our businesses are focused on controlling what they can. The operating performance in the quarter is validation of the strength and flexibility of our asset-light business model, the quality of our niche businesses and, most importantly, the talent and commitment of our workforce.

Next, I will provide some additional details at the operating group level. Second quarter sales for Electronic Instruments Group were $647.9 million, down 21% from the same period last year. Organic sales were down 26%, with the acquisitions of Gatan and IntelliPower contributing 5%. Despite the impact COVID-19 had on sales, our EIG businesses delivered excellent operating performance. EIG's operating income in the second quarter was $159.6 million and operating margins remained strong at 24.6%.

The Electromechanical Group also delivered excellent operating results, driven by better-than-expected organic sales and their Operational Excellence initiatives, which contributed to exceptional margin expansion. EMG sales were $364 million, down 22% versus the prior year's second quarter. Organic sales were down 16%, with the recent acquisition of PDT adding 3%, the divestiture of Reading Alloys was an 8-point headwind, and foreign currency was a 1-point headwind.

EMG's margin expansion was outstanding in the quarter. While operating income decreased to $84.3 million, operating margins expanded an impressive 170 basis points to a record 23.2%, driven by our proactive Operational Excellence initiatives. Truly exceptional work by our teams.

Now let me provide some color on the different end-market dynamics we are experiencing within our business. AMETEK serves a diverse set of end markets. And across these end markets, we are seeing very different levels of demand and COVID-19 impacts. So as I did last quarter, I'll group our businesses into 3 buckets based on the levels of demand we are experiencing and provide some commentary on each.

I'll start with the most challenged markets. Commercial aerospace and oil and gas, which, combined, account for approximately 15% of AMETEK sales. The weakness in commercial aerospace was largely as expected and driven by the impacts of COVID-19 on both our commercial OEM and aftermarket businesses. We expect these businesses to remain challenged for the balance of the year.

Along with the impacts from COVID-19, weakness in our oil and gas business was the result of difficult prior year comparison, given several large project shipments last year. As a result, we expect solid sequential improvements in this business during the third and fourth quarters. Combined, sales for aerospace -- commercial aerospace and oil and gas were down approximately 45% in the quarter. Excluding these 2 markets, AMETEK sales were down mid-teens on a percentage basis in the second quarter.

Next, our strongest markets, defense and medical. Combining these markets account for over 20% of our sales, and we have been experiencing solid internal growth, while also strategically expanding our portfolio in these areas through acquisitions. In the second quarter, sales were up low single digits for these businesses, and we expect this strength to continue in the third and fourth quarters.

And for the balance of our markets, which include power, industrial, automation, metals, food and beverage and research, we were seeing demand levels somewhere in between those other 2 extremes. We expect to see sequential improvements through the balance of the year for these businesses also.

To offset these COVID-19-driven demand challenges, we remain focused on actively managing our cost structure through a mix of structural and temporary cost actions. Our executive office meets regularly with each of our businesses to review current market conditions, their demand outlook for the coming months and their operational plans. It is critical that each of our businesses develop an operating plan customized for their business, and that this operating plan be adjusted if conditions change.

This flexibility is key in our asset-light operating model, where costs can be quickly variabilized. This approach allows us to best align our cost structure with the demand levels we are experiencing by market and by business. We have the flexibility to expand cost-savings initiatives or, as demand continues -- demand conditions improve, we can add back costs as required.

In the second quarter, we generated $85 million in total cost savings, with $35 million of structural savings and $50 million in temporary cost savings. This level of savings was above our initial estimate of $80 million in total cost savings in the quarter.

As we look ahead to the third quarter, we expect approximately $65 million of total cost savings, with $35 million to $40 million of structural and $25 million to $30 million in temporary savings. And for the full year, we now expect structural savings of $135 million and will flex our temporary cost savings either up or down based on volume levels in the fourth quarter.

The spread of the coronavirus has oddly forced companies to adapt and adjust how they do business. Work-from-home requirements and travel restrictions have changed how companies interact and engage with customers. Our businesses have been proactive in developing and utilize digital capabilities to help them stay engaged with our customers.

Our sales and engineering teams are working side-by-side with our customers through digital channels to cultivate and build relationships. These initiatives have included virtual events through newly implemented digital platforms to provide product demos webinars and collaborative business meetings.

Finally, some of our teams are finding innovative ways to help provide aftermarket services for our customers through interactive technologies. I commend our teams for quickly adapting to the new reality and for embracing these new ways of doing business. We remain committed to investing in additional technologies to support our customer experience.

Despite the global demand challenges, AMETEK continues to invest meaningfully in new product development initiatives. We are seeing great success from these investments as our businesses are introducing many new innovative solutions to help solve our customers' greatest challenges.

Our Vitality Index, which measures the amount of sales generated from new products introduced during the last 3 years, was very strong at 26%. And here are just a few of the recent examples of new product introductions.

AMETEK Land, a leading manufacturer of noncontact temperature measurement solutions, saw robust demand in the second quarter for their new VIRALERT 3. This newly developed, noncontact temperature measurement solution, is used to rapidly detect elevated skin temperature, while allowing users to adhere to social distancing requirements.

This safe, noncontact, easy-to-use and highly accurate temperature solution is being used in entry points of offices, warehouses, hospitals, schools and recreational facilities. Given the product's ability to complete accurate temperature screenings of scale, the VIRALERT 3 is playing a role in reopening key facilities around the world.

Creaform, a leader in 3D measurement technologies, released the latest solution in their MetraSCAN 3D lineup. The MetraSCAN BLACK is the fastest and most accurate 3D scanner in the world, with 4x the speed and resolution of its predecessor.

The MetraSCAN BLACK can withstand harsh production environments and is utilized in the most complex quality control and quality assurance applications. This incredibly versatile instrument can be used to scan various part sizes and service finishes in real-time, all with the same device.

And additionally, MOCON, a leading global provider of food package testing instruments, released their latest version of the Dansensor CheckPoint. This new portable headspace gas analyzer provides quality control managers a more precise, faster and more stable solution for measuring gases and specific food applications using modified atmosphere packaging, or MAP. MAPs are used to extend the shelf life for packaged foods and pharmaceutical products requiring specialized packaging.

Congratulations to the Land, Creaform and MOCON teams on these impressive new product developments.

Now shifting to acquisitions. The overall M&A market remains relatively quiet, given the high levels of uncertainty around the coronavirus and its impact on the economy. That being said, our M&A teams remain very active, and we are managing several opportunities.

We have a very strong balance sheet and liquidity position and the ability to deploy meaningful amounts of capital on acquisitions. Our preference remains deploying that capital on strategic acquisitions that provide us the ability to add high-quality companies to our portfolio and drive excellent returns for our shareholders.

Now turning to the outlook for the remainder of the year. High levels of uncertainty remain, given the continuing spread of the coronavirus, especially throughout parts of the U.S. While visibility has improved from this point last quarter, it is still limited as customers remain cautious.

As a result, we will not be providing guidance for the third quarter or the full year. We will issue guidance as conditions stabilize and visibility improves. However, I did want to provide some high-level comments around the third quarter and the balance of the year, given what we know now.

First, we expect to see sequential improvements in the third and fourth quarters, with commercial aerospace being the only business not expected to see sequential improvements. Second, we still expect very strong decremental margins at approximately 30% in the third quarter. And lastly, we now expect full year decremental margins in the 25% range versus our previous estimate of 25% to 30% decrementals.

In summary, AMETEK managed well through what's an extraordinarily challenging environment during the second quarter. The strength of the AMETEK growth model was evident in our second quarter performance, and we will continue to allow us to operate at a high level through these dynamic market conditions.

We are taking responsible cost actions and continuing to invest our businesses to ensure they are poised to generate strong growth coming out of the downturn. We also have a robust balance sheet and liquidity position to allow us to capitalize on what we believe will be an opportunistic period for acquisitions.

Finally, we're confident that AMETEK will emerge from these challenges a stronger organization, given the growth profiles of our differentiated businesses, the company's financial strength and, most importantly, the impressive level of talent within our world-class workforce. I will now turn it over to Bill Burke, who will cover some of the financial details of the quarter, then we'd be glad to take your questions. Bill?

Thank you, Dave. I'd like to echo Dave's comments on the outstanding efforts of our employees around the world. They continue to deliver exceptional performance during these challenging times. Let me provide some additional financial highlights for the quarter.

Second quarter general and administrative expenses were down $1.7 million compared to the same period in 2019 due to lower compensation costs and other discretionary spending cuts. The effective tax rate in the quarter was 19.5%, down from 20.4% in the same period last year. The lower rate in the quarter was due to tax planning initiatives.

For 2020, we now expect our effective tax rate to be approximately 19.5%. And as we've stated in the past, actual quarterly tax rates can differ dramatically, either positively or negatively, from this full year estimated rate. Working capital in the quarter was 19.6% versus 18.3% in last year's second quarter.

Capital expenditures in the second quarter were $10 million. We continue to expect full year capital expenditures to be approximately $75 million, down from our initial expectations to start the year of $100 million.

Depreciation and amortization expense in the quarter was $61 million. For the full year, we expect depreciation and amortization to be approximately $260 million, which includes after-tax, acquisition-related intangible amortization of approximately $117 million or $0.51 per diluted share.

Our businesses continue to generate high levels of cash. Operating cash flow in the quarter was excellent at $315 million, up 28% over last year's comparable quarter. Free cash flow was also outstanding at $305 million, up 36% over the same period last year. And free cash flow conversion was superb at 183% of net income.

Total debt at the end of the quarter was $2.87 billion, up modestly from $2.77 billion at the end of 2019 and down $383 million from the end of the first quarter, as we repaid a portion of the borrowings under our revolving credit facility. Offsetting this debt is cash and cash equivalents of $1.13 billion.

Our gross debt-to-EBITDA ratio at the end of the second quarter was 2.1x as we are intentionally holding higher-than-normal cash balances. This ratio was comfortably below our debt covenants of 3.5x. Our net debt-to-EBITDA ratio was 1.3x at quarter end. And both our gross and net debt-to-EBITDA ratios improved by 0.1 turns in the quarter.

AMETEK remains well positioned to manage this economic downturn, with approximately $2.1 billion in liquidity to support our operations and growth initiatives. This includes over $950 million in available revolver capacity. As we highlighted on our last call, AMETEK has a robust balance sheet, with no material debt maturities due until 2023.

To conclude, our ability to deliver solid results with outstanding cash generation, despite these unprecedented challenges, is a testament to the strength of our businesses and the dedication of our world-class workforce. The AMETEK growth model and our financial strength firmly position us to manage this economic environment and invest in future growth to deliver long-term success. Kevin?

Thank you, Bill. Andrew, could we please open the line for questions?

(Operator Instructions) And our first question comes from the line of Matt Summerville with D.A. Davidson.

A couple of questions. First, Dave, can you talk about what you saw from an organic order standpoint in the quarter, and maybe provide some color on kind of what the monthly year-over-year cadence may have looked like from April into July?

Right. Our overall orders were down negative 22%, and organic was down about the same. So really aligned with our sales. Both of our groups were down and really followed sales, and we ended up with a book-to-bill of about 0.99. And for orders, the -- April was a low point in the quarter. It grew nicely in May and then again in June, so it followed a similar trend for sales.

And then can you talk about your expectation for second half decrementals? You indicated in Q3 maybe expecting something a little worse than what you had in Q2. So maybe what's driving that? And then maybe put that into context of the sustainability you see for the record EMG margin performance you generated in the quarter?

Yes. The first point is the -- the second point -- I'll answer your second question first. The EMG margins were exceptional, and they were driven by strong operating performance. We had positive mix in our defense businesses. And we also had the divestiture of Reading Alloys that contributed 50 basis points at the EMG level. So EMG had a great quarter. And the majority of that margin expansion was driven by excellent operating capability.

In terms of the decrementals, I mean, we had good decrementals in both parts of the business. We had 16% decrementals in EMG and 31% in EIG, and those are really good. And in terms of the guidance of 30% decrementals for Q3, we're going to -- we're adding back some costs, and we're really preparing for a larger fourth quarter. So -- and still for the full year, we've increased our decrementals from 30% to 25%. So that's what we're doing.

We're managing the business, looking at -- focused on cash, focused on managing the decrementals and focused on driving key growth opportunities. And we're doing an excellent job of managing the decrementals and really kept our net income, our cash EPS, down at the same level of sales drop, which is pretty amazing when you consider their profitability level of the company. So we're pretty pleased with that.

And our next question comes from the line of Allison Poliniak with Wells Fargo.

Dave, could you talk a little -- I know you mentioned the structural versus cyclical costs. But could you just give a little bit more color on the structural cost savings that you're doing? Is it widespread across the verticals? Or is it focused specific on the more challenged ones, say, like aerospace?

Yes. I would say the structural costs are more focused on the more challenged markets. And they're resizing those businesses to the new demand level that we have. Those businesses are profitable. They'll remain profitable on the way down. And the way we're looking at it, as the businesses start to grow from the bottom, it'll be very profitable on the way up.

So there's a quick change in revenue. And the team has done an excellent job of adjusting to the new demand level. Also, there's an element of those structural savings that are pulled forward from projects in our strategic plans. So we look forward to -- out every 3 years. And if we got a time like this, we pull forward some projects that are some efficiencies, some plant consolidations. But mainly, the structural costs, they're -- while across the board, they were mainly targeted at the commercial aerospace and the oil and gas business.

Great. And then just turning to the M&A market, obviously, still challenged there. But could you give us a little color on your pipeline in terms of size? Have you pivoted to a specific end-market vertical, and I guess, even just comfort level, just given the uncertainty relative to the size of potential deals that you're likely looking at?

Yes. Great question. I mean, as you know, Allison, M&A remains our first priority, and we feel there's going to be a substantial opportunity for us as we get through this crisis because there's going to be pent-up demand on deals. And we have the balance sheet and the cash flow-generating capability to execute on the opportunity.

And while the broader deal activity is subdued right now, we're very active in pipeline development, and we actually have a couple of deals we're looking at right now. So we're actually in diligence. And those are deals that have been working through our pipeline. There are larger deals and there are smaller deals.

So I'm quite optimistic on the pipeline. But you still have the situation, where, to get to the end of a deal, buyers and sellers have to agree on new pricing expectations based on the cash flow visibility, and that impacts the valuation process. And we're adjusting our process because we have the inability to perform the face-to-face diligence that we used to take for granted. And we still need to have some of that to feel rather comfortable with what we're buying.

So we still think it's going to be late 2020 before the market returns to some kind of normal. But we are active on some properties right now. So I'm pretty pleased with how hard the team is driving the pipeline and some good candidates in our pipeline.

Your next question comes from the line of Josh Pokrzywinski with Morgan Stanley.

Dave, can you just remind us, with all of the structural and temporary costs elements coming in, and I know you're still kind of leaving it open on the fourth quarter based on demand, how should we all in think about incremental margins for next year? Because, obviously, there's a lot of torque in the business. Gross margins are high. So volume recovery would feel pretty good. But if I had to cross-check that against maybe some of the temporary costs that come out, is it still fair to say that incrementals can start with the 3 next year? Or should we think about that differently or maybe more specifically, knowing what we know about the temporary side?

Right. That's a great question. And I don't think there's any doubt that incrementals was -- you can start with a 3. If you look at past downturns, AMETEK's really driven margin expansion as we come out of the downturns. And the temporary costs, we're going to put back in as we progress throughout the year, but that's not stopping us from putting up positive incrementals.

So I think, largely, we're going to end up with contribution margins in 2021 in that kind of range, and I'm optimistic about that. Because the other thing you have to factor in is our pricing. Our pricing was very strong in the quarter, and it's holding up well. And I'm very pleased with them.

Got it. That's helpful. And then kind of a 2-part second question. First, anything on July. I think Matt Summerville asked about it, but I don't know if there was anything specific. And maybe talk around the role of backlog and some of the momentum. Are you feeling like you're living hand-to-mouth in most of the businesses? Or was backlog maybe kind of distorting 2Q, where there's still some longer-cycle businesses that need to run off?

Yes. No, our backlog is pretty flat at $1.7 billion. And as you know, we went through our guidance. But what you and what Matt were asking is a sense of where the business is going forward, and we can give you that. I mean, if you start with Q2 or sales, April was the worst and improved in May and further improvement in June. And if you look at that improvement trend, and you look at July, which is supportive of it, we think that we'll be down roughly 15% in the third quarter. But that's an estimate based on what we know, and there are many uncertainties. But that's kind of what we're tracking to right now. And it kind of linked -- yes. Okay.

And our next question comes from the line of Nigel Coe with Wolfe Research.

So you mentioned research. I'm just curious kind of how your research end markets performed. I can't imagine the stay-at-home, work-from-home trend is really helpful there. So just curious what you're seeing next? I know that's more of an ERG kind of exposure?

Yes. I think the -- I'll break the research market into a couple of different areas. In the material science area of research, both university and corporate R&D, it was weak. Those projects have been pushed to the right. But in the life sciences area, the market is holding up very well.

And as shown by our Gatan business, the business that we acquired last year, they had performed very well, slightly ahead of our expectations, and actually had flat revenue year-over-year in the second quarter. So their top line went well, and that was driven by the life sciences market.

And the Gatan products have been influential in the fight against COVID. In fact, the researchers at the University of Texas used a Gatan K3 camera. They were the first people to structurally image the spike protein on the coronavirus. So that's driven a lot of excitement and demand around the demand tools. In fact, the Gatan K3 was the first person to structure the coronavirus, and the next 2 people that did it used the K2, which is slower. And the speed of the cameras, the K3 is faster, allowed the researchers to get done quicker.

So good demand drivers on that business. And it really points to, again, our research market. There are some areas that are doing very well, some areas that aren't. And in certain parts of the world, those research institutions have not really opened up. They're still closed. So we're hanging in there, but it's a complex story.

Okay. So on balance doesn't feel like it's any worse than the average. And then maybe just a little bit of context on the geo markets. If you could give us how U.S., Europe China, et cetera, are performing versus -- and then just on the export exposure, has that changed materially over the last several years? And I'm just curious how the U.S. dollar weakness maybe benefits you going forward.

Yes. Yes. As you know, we're naturally hedged at the top line and the bottom line based on currency. So the currency swing doesn't really impact our profitability. But when the dollar weakens, we do get more competitive. So it's something that we're looking at. So it's a good thing for us because we export over $1 billion.

And in terms of the geographical storyline, we really have broad-based weakness. And Europe and the U.S. were most challenged. Europe was down 29% on broad weakness, and it also had a difficult comp because there was some Middle East project business for our oil and gas business. The U.S. was down about 20%, but it's pretty broad-based.

And Asia was the best of the markets. That was down mid-teens and had notable strength in Asia and our automation business. China improved for us. China was actually up 3%. So it was a positive rebound in China, driven by our automation and CAMECA business. So that's the story, broad-based weakness, and Asia was the best and driven by China.

And our next question comes from the line of Deane Dray with RBC Capital Markets.

I did notice that you guys put free cash flow in your release for the first time. So we really do appreciate that.

I'll let Kevin know that. Kevin has got a smile on his face.

I'm sure he does because I've pestered him about that for quite a while, but we really do appreciate it. But now I feel obligated to ask a free cash flow question. So here it is. Did you benefit at all from the timing of tax payments? We've seen other companies that have had upside on the free cash flow. So was that a factor?

Yes. Not a huge factor, Deane. It was probably about $18 million or so. So that $183 million would still be a pretty strong number, probably in the mid-160s to $170 million kind of a place.

Good. And I really like how you segment the business into those 3 buckets, just to kind of give us the color real-time as to the COVID impact. And last quarter, I'm pretty sure you included defense in the better bucket, better performing. And it got called out as a positive mix this quarter as well for EMG. Can you comment on defense? And should it be in that bucket?

Yes. Defense was in the good markets in both last quarter and this quarter. So defense -- the buckets haven't changed and defense and medical were positive in Q2, and they were also positive in Q3. And as you recall, our defense business is about 5% of the company, and it's doing extremely well. It was up low double digits in the quarter. So while the commercial market was challenged, the defense market was strong.

Great. And then, on Gatan, really like that -- the update there and especially on the imaging of the spore. When is the next-generation due to be released? Would that be the K4?

It is. There's a K3-plus and a K4, and we're working on them both. And we haven't announced when the next one will come to market.

Terrific. All right. Last question on CapEx. So you had cut $25 million out just for cash preservation. When might that come back? And just share with us a bit of your decision-making as to what would you trim and why. And when you bring -- what types of projects do you bring back on?

Yes. Yes, the important point for us is our RD&E spending is roughly flat with 2019. So we thought that was going to be upcoming into the year, and we trimmed that back to flat, but we're really investing in RD&E. And the types of things we've delayed are expansions in regions of the world where we're trying to put extra capacity in place, and a new region in the world that we're putting some capacity in. And so those kind of projects got delayed.

Quite honestly, we have decentralized the entrepreneurial team, and they understand the situation. So they make natural decisions, and we really don't have to push that number. That's what comes up to us. That's what our business leaders want to spend. And I can see, as we get later in the year, start evaluating, turning on some of those expansion projects we have in the various geographies of the world that we put on hold, but it's very difficult to complete those.

Next question comes from the line of Rob Wertheimer with Melius Research.

Congratulations on the book.

Thank you so much. That's kind. So I just had 2 questions on the temporary side, if I can. I think last quarter, you talked about delays and difficulties in getting the customer sites or whatever, pushing out a little bit of revenue. Is that still ongoing? And does that come back at any point? That's the first.

Yes. That certainly was with us throughout all of Q2. And it's still a bit of an issue, especially now traveling in the U.S. -- and really, what it comes to, you can travel, but you're quarantined. And that was a big issue in China. Now that's abated, and it's -- but that's a spotty issue around the world, and it was a big factor in Q2. It will be a diminishing factor in Q3.

And then does that -- is there a few points of revenue that kind of come back to you in 4Q or whatever? Or is there risk that it cancels? Or is it too small to matter?

No. No. That's -- that will come back. And they've been rescheduled and pushing things out, but it will definitely come back.

Perfect. And then on cost side, if I may. Can you kind of roll the temporary cost indefinitely? The way you described it, it's obvious that commercial aero may be in trouble or oil and gas for a bit, and so maybe more permanent restructuring is appropriate there. But for the other markets that are just depressed during COVID, and we don't know when it comes back, can you roll that indefinitely? Or does there come a point where costs have to sort of come back in the system when things don't stop?

Yes. Yes. That's a good question, Rob. And we did a restructuring early on, you'll recall, and we think we got the balance correct, but -- and we'll bring back those temporary costs. But if it gets to the point where there's diminished long-term viewpoint on revenue, then it doesn't -- we can't run with the temporary costs forever. So it's a -- I view those temporary costs as coming out -- coming back during the course of the year. And if demand doesn't come back, then we may have to do something extra on the cost side. But we're certainly not looking at that as a long-term situation.

And our next question comes from the line of Christopher Glynn with Oppenheimer.

Dave, you mentioned some different adaptations around delivering, administering some of your aftermarket services operation. I'm wondering if you're revealing any -- or any businesses coming up with delivery models that might -- may actually be productivity levers and kind of remain post COVID?

That's really the case. The accelerated adoption of digital capabilities is really opening our eyes. And it's obviously in the digital marketing area and the way we interact with our customers. The one thing I'd point to is in the -- we have complex systems that are installed and calibrated, and they need commissions. And we have some service teams that are using augmented reality to remotely service and install our products and really interesting tools right now. So I think some of those will be long-lasting, and we're certainly adapting our business and learning as we move through this pandemic.

Okay. And then in terms of the third quarter outlook for kind of everything getting a little better versus other than commercial aerospace, any -- some areas maybe you could call out where you're seeing the sharpest kind of rebounds? And in particular, anything just getting back to normal?

Yes. Our automation business is -- kind of led us back. That's doing well. Our oil and gas business is going to recover, but that's because of a lack of a comp, as much as anything. So those 2 businesses are ones that will recover. And I think our defense business will be strong.

And the other thing we see is in the medical space, we saw really good demand on the COVID-related products, like COVID testing and COVID breathing apparatus, but we saw the elective surgeries tail off. And in the second half of the year, what our med tech customers are telling us is the elective surgeries are going to rebound. So that's the kind of things I'd point you to.

And our next question comes from the line of Scott Graham with Rosenblatt Securities.

So I wanted to understand a little bit more on the cost side, where you talked about third quarter, your cost reductions are going to be $65 million. If my calculations here are right, that you were a little bit below what the annualized number would be for structural in the quarter. And that should pick up in the second half of the year, which would suggest a pretty significant reduction in your temporary in the third quarter, yet you're not providing full year EPS guidance. So I guess I'm trying to maybe connect those dots there. If you're dropping down on the temporary, why don't you feel more comfortable with giving guide?

Yes. There are too many variables and uncertainties to give guidance with our typical precision. And I do appreciate your question, and I understand why you're asking for that information. In normal times, we'd give you that type of information, but these aren't normal times. And we withdrew our guidance, and we just don't feel comfortable putting it back in place yet because of COVID and the lack of visibility and with the typical precision that we have.

Can I maybe take a stab at one of them? Would it be that you're unable to predict what your second half mix will be? Is that part of it?

No. I don't think that's -- I mean, I was pleased that the mix held up, the pricing held up. That's -- that isn't a concern. It's really, if you think about it, we're in a pandemic. And we don't -- we can have hotspots show up in places, and we're constantly managing things. So there's a lot of uncertainty now, and we just don't feel we can give guidance with a typical precision.

Understood. A couple of others, if you could. Typically, you give that by-business unit stuff. Maybe you can just kind of call out specifically what you saw in the quarter in automation, power, research, specifically? And maybe if you could split for us commercial aerospace OE versus aftermarket?

Right. I'll take you through the market segment commentary because that covers a lot of ground, and I think we'll be able to answer your questions there. In our process business, overall sales were down high teens in the quarter. And we had the contributions from Gatan, offset by organic sales declines, in line with AMETEK's organic sales decline. And we talked about widespread travel restrictions. And in addition to project pushouts and delays and our ability to provide service. So that impacted process significantly.

And the largest weakness in process was our oil and gas business. Our medical businesses performed well in the quarter, as did our Zygo business. Zygo is seeing solid growth, driven by some semiconductor, fabrication work and extreme UV, EUV. And while the end markets remain challenged and visibility is limited, we do expect to see sequential improvements in the third and fourth quarters across our process businesses, including oil and gas.

In aerospace, we've talked about that. We were -- the defense business was up low double digits. The commercial business was down in the high 40s. We -- in the commercial business, the aftermarket was a little worse, and the OE was a little better. We expect our defense businesses to stay strong in the third and fourth quarter. And the commercial aerospace business, it's bouncing around bottom, and we may have some shifts between aftermarket and OE, but we're not calling that one out as improving. We may be conservative on that, but that's where we are.

In our power and industrial business, they were down in the high 20 range. A lot of similar dynamics to our process business, demand impacted by the global shutdowns and travel restrictions. And we're looking to -- the orders in our power business were stronger. And we're looking to the second half, where we expect conditions to improve modestly, with sequential growth in both our power and industrial businesses.

And finally, our automation and engineered solutions business, they were down mid-teens on a percentage basis. And we're seeing automation trends improve across Asia, within China. And health care is the other big driver for our automation business. So we're seeing good sequential improvements there, and we expect that to continue in the second half.

Your next question comes from the line of Ivana Delevska with Gordon Haskett.

So I just wanted to ask about the structural cost opportunities as we get into next year. I know there was some volume-related benefits that you were originally expecting to get this year that may get pushed out to next year. So could you just give us a sense of like how do you see next year shaping up? And what will be the different buckets?

Sure. We haven't done a lot of thinking about next year at this point. But the one thing that we do know, we'll probably have about $50 million -- $45 million or $50 million flowing over into next year from the structural reductions that we did in 2020.

So we'll have a good head start on whatever cost reduction plans that we put together, and we'll couple that with a traditional material cost-outs and the other projects that we'll put together. And we typically have a pretty healthy project list, and we decide on that list during our budgeting process. So I haven't really done much planning, but we have a good head start with the structural flow over from the things we've done in 2020.

And how much was the volume, like sourcing expected to help this year, that didn't materialize because of the environment?

Yes, I -- yes. Sourcing was a big driver, and I'm just going from memory now, and Kevin -- you can check this with Kevin before that. But we probably lost about $10 million or $20 million of sourcing savings that -- because the volume isn't there, and we had to make that up with the other structural savings.

Perfect. And just one more question in terms of synergy realization. Could you compare next year to this year in terms of how much synergies do you expect from the different deals and the timing?

Yes. The way I can answer that is we're on track with all of our deals. I mentioned Gatan. That's the biggest deal that we did last year, and we just did a review of that business. And we're actually slightly ahead of our acquisition model.

So when we combine that business with our EDAX business, is another business within our portfolio, and they're in the same market. So that combination is driving good synergy and because they have the same customer base.

And all of our acquisitions are progressing, and we're certainly focused on the synergy. And some of the top line may not be there, but we're focused on the synergy. And that's pretty hard to tell you right now, in 2021, what that's going to be. We'll typically tell you that in the beginning of 2021, when we go through everything and understand at a granular level, what actually is going to happen and what we're going to do.

And our next question comes from the line of Andrew Obin with Bank of America.

I'm going to try a first question. So one of sort of companies that I covered today sort of took a stab at when they thought revenues were going to turn flat year-over-year. Would you guys care to guess if and when that happens? Hopefully when.

I'm not going to guess at that.

Okay. I figured that much. You guys highlighted automation doing well. Could you talk -- are you seeing any of your customers sort of moving their supply chains around the globe? And what are the sources outside of China of automation doing well?

Yes, that's a good question. And we are seeing that. It's -- supply chains are regionalizing. So there was a point of time where there was some overdependence on China. And I think a lot of companies are reconfiguring their supply chains, and there's some reshoring activities going on. And that's going to help us because our process businesses help businesses manufacture things efficiently and at lower cost. And it's happening. The seeds of that are just beginning now, but that's going to be a good long-term driver for us.

And what industries -- do you care -- what industries are you seeing reshoring in, particularly in North America?

Yes. It's just the beginnings. And -- but there's definitely plans in place for a lot of companies to make their supply chains more durable. And we're seeing volume intake, potential volume upticks in places like the U.S. and Europe for reshoring activities. But this is really on the early edges of it. And -- but it's -- fundamentally, people want regionalized supply chains and want to reduce their dependence on parts of the world.

And then on M&A front, you sort of highlighted that you're engaged in some due diligence, some of these are smaller deals. So how do you look at your sort of firepower in terms of how much can be spent on M&A over the next couple of years? And how big a deal can you guys get to?

Yes. I mean, I look at it like we certainly can look at our free cash flow, look at our operating cash flow. It's $1 billion-plus year type thing. And then we have current liquidity of about $2.1 billion. So very clearly, our balance sheet is strong. I think Bill mentioned that it delevered during the second quarter. So in a pandemic, when our top line was down 22%, our balance sheet delevers. That's a testament. I don't know if you want to comment on that, Bill?

Well, no, I think we certainly -- Dave, you mentioned the $2 billion. We could do more than that and still remain below our covenants. But as we've always said, the -- this is not a capital-constrained strategy. This is more about finding the right businesses that will move the portfolio in the right direction and drive the returns that we're looking for. But the strength of the balance sheet can certainly support the several -- a couple of billion dollars' worth of deals.

And more appetite for larger deals going forward?

We're looking at some larger deals. Gatan, we spent close to $1 billion on. And we have some businesses that are in our pipeline right now that are of that size.

Your next question comes from the line of Andrew Buscaglia with Berenberg.

Can you -- forgive me if I missed this, did you -- can you comment on the price versus cost in the quarter?

Yes. You didn't miss it. We talked about it, but we didn't give the numbers. And very pleased to see our pricing held up well. Q2 was similar to Q1. We achieved about 1.5 points of price across the entire business. And total inflation and the impact of tariffs was a little less than 1%. So we had a good positive spread out at the margins, and that drove some of the margin and performance in the quarter.

Okay. And David, you've been around the block a few times. Given you've had a few more months to kind of digest what's going on in the situation with aerospace. Last quarter, it's -- everything was so fresh. Do you have any updated commentary about what you're seeing, what you're hearing from customers? And how you expect that market to go over the next couple of years?

It's going to take several years to get passengers back to the same volume in 2019. There's no doubt about that. And the base -- our base model for aerospace assumes that there's a medical solution to the virus, whether it's a vaccine or a therapeutic. And people have to be comfortable flying again, and that's going to take some time. But we're balanced in our aerospace, and our military business is doing extremely well.

And we're very pleased with our portfolio. It's a high-quality set of businesses, and our strategy is to focus on a diverse set of markets. So we think we're well positioned with our leadership positions to recover with the market and recover profitably. But that's one market that we're going to have to -- it's going to depend on the government funding. It's going to depend on capacity decisions of many airlines. It's going to -- depends on the confidence of the flying public. So there's still some uncertainties associated with that.

So we just manage what we know, and we can resize the business. And I was running our aerospace business back on 9/11. So been through a similar type of hit. And if you look at what our aerospace has done since then, we resized it. And it's been a tremendous contributor to AMETEK over that time, and we're doing the same thing right now. So we have a great team in aerospace and leadership positions in many areas, excellent positions with wide moats. And we're controlling what we can control right now, and -- but it's certainly going to be an extended recovery.

Your next question comes from the line of Richard Eastman with R.W. Baird.

Yes. Dave, just to expand on your last answer there, could you just recalibrate us on maybe the percentage of the business at AMETEK that is aerospace? And also how the 4 businesses maybe -- will perform or the 4 segments will perform for '20?

Yes. I mean the aerospace presence is 15% of sales. And that's 5% of that 15% is in the military market. And 10% of that 15% is in the commercial market. And that commercial market includes our OE market, it includes our business gen market and it includes our third-party aftermarket. And that's the business that we're saying -- it's a small part of our company, about 10%, but we're saying that we're not seeing as clearly a recovery path during the second half of the year. I think we got a little better in Q2 so we call that at maybe 45% for the balance of the year. But it's pretty difficult to get too granular on that market right now because you don't know what -- many variables that you don't control are happening, and we're just managing what we can control.

In terms of the process business, we're saying we're going to grow in Q3 and Q4, and that includes our oil and gas business. In terms of power and industrial, we're saying we're going to grow in Q3 and Q4. And in terms of our automation and engineered solutions, we're going to grow in Q3 and Q4. So we think that sequential improvement that we're seeing will continue as the economy gets back to normal.

Okay. Okay. And then just one question on the gross margin. Bill, the gross margin declined maybe 110 basis points, I guess, year-over-year. Could you just break that out a little bit? It sounds like you had a positive contribution from price, maybe only 30 basis points or something. But could you just give us a little bit of a walk up there or walk down on the 110?

Yes. I think the -- I think you've got the positive there in terms of the price versus cost. But what you're really dealing with is just the reduction in the sales levels, yours getting the decremental margins on the fixed cost. So I don't think there's anything more interesting.

Okay. All right. And mix here -- was mix much of an issue here between EMG? Again, I guess you favor EMG a little bit, with less of a decline versus EIG. So mix was negative there?

I think the military market and the health care market held up well for EMG. And in EIG, we have a good part of commercial aerospace. And you also have the oil and gas business.

And our next question comes from the line of Joe Giordano with Cowen.

Correct me if I'm wrong, but I thought that you, last quarter, from an organic standpoint, was that EIG probably does a little bit better than EMG. So curious as to like what kind of shifted during the quarter from a market standpoint that would have kind of flipped that around?

Yes. Everybody here are shaking their heads. We didn't signal EIG would be better than EMG.

Okay.

We talked about the automation business getting stronger. We talked about the military business and commercial aerospace.

Commercial aerospace was going to be weak and oil and gas is going to be weak, and those are predominantly in EIG. So it kind of paid out like we thought.

Okay. Fair enough. And then, on R&D side, you talked about some of the advancements in some of your businesses made during the quarter and new launches. Can you just kind of talk to us about how -- I mean, R&D is so critical to what you guys do, and how are you guys doing it in this environment with social distancing in this? And what has had to change in where to allow R&D to progress at this stage?

Yes. That's a great question. Great question, Joe. And I've been pleasantly surprised at the quality and effectiveness, and we're getting the work done. But for R&D, it's not ideal. I mean, we have to have technicians interact with engineers, and they have to find a way to get together. And there's a certain spontaneity and productivity that comes with people getting together.

So we're still learning. But and -- but we're using the tools and doing things safely, and we're making good progress. But it's certainly an issue that we specifically have worked on, and then holds us back, certainly. And -- but the digital tools are helping mitigate the problems.

Thank you. Ladies and gentlemen, this concludes today's conference call. Thank you for participating, and you may now disconnect.