Circor International Inc (CIR) 2017 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the CIRCOR International Third Quarter Fiscal Year 2017 Financial Results Conference Call. Today's call will be recorded. (Operator Instructions) I will now like to turn the call over to Mr. David Calusdian, from Sharon Merrill for opening remarks and instructions. Please go ahead.

Thank you, and good morning, everyone. On the call today is Scott Buckhout, CIRCOR's President and CEO; and Rajeev Bhalla, the company's Chief Financial Officer. The slides we'll be referring to today are available on CIRCOR's website at www.circor.com on the Webcasts & Presentations section of the Investors link. Please turn to Slide 2. Today's discussion contains forward-looking statements that identify future expectations. These expectations are subject to known and unknown risks, uncertainties and other factors. For a full discussion of these factors, the company advises you to review CIRCOR's Form 10-K, 10-Qs and other SEC filings.

The company's filings are available on its website at circor.com. Actual results could differ materially from those anticipated or implied by today's remarks. Any forward-looking statements only represent the company's views as of today, October 27, 2017. While CIRCOR may choose to update these forward-looking statements at a later date, the company specifically disclaims any duty to do so. On today's call, management will refer to adjusted operating income, adjusted operating margins, adjusted net income, adjusted EPS and free cash flow. These non-GAAP metrics exclude any special charges and recoveries. The reconciliation of CIRCOR's non-GAAP metrics to the comparable GAAP measures are available in the financial tables of the earnings press release on CIRCOR's website.

I'll now turn the call over to Mr. Buckhout. Please turn to Slide 3.

Thank you, David, and good morning, everyone. The CIRCOR team delivered third quarter results in line with expectations, posting revenue of $160 million and adjusted earnings per share of $0.43. Ongoing strong demand in our Distributed Valves business in North America and the addition of Critical Flow Solutions helped deliver a 62% increase in Energy segment orders. On an organic basis, Energy segment orders increased 26%. Demand for our shorter-cycle businesses remained relatively strong through the quarter. While we're seeing an increase in quoting activity, lower CapEx spending continued impact our longer-cycle project businesses, where decisions on project orders continue to be pushed out. Overall, the picture across our Energy end markets has slightly improved from last quarter with relative strength in our shorter-cycle businesses and early signs of improved order activity in our project businesses. We saw broad-based strength in our Advanced Flow Solutions segment with a 21% organic increase in orders. Each product line showed year-over-year order growth with Aerospace coming in strongest at 27%. Orders for the Predator UAV program as well as bookings for the Astute-class submarine for our U.K. Navy business contributed to the higher order levels over the prior year. AFS orders year-to-date are up 10% organically.

During the quarter, we announced an agreement to acquire the Fluid Handling business of Colfax. This deal significantly enhances our overall scale and ability to deliver severe service flow-control solutions across a complementary set of attractive end markets. The strategic fit is compelling, and our customers are equally enthusiastic about the transaction. Together, we'll have a more balanced portfolio of flow-control products, significant sourcing, manufacturing and engineering synergies, access to highly differentiated severe service technology and a robust aftermarket growth opportunity supported by a large and growing install base.

One of fluid handling's greatest strengths is its leading position in the severe service pump market and its associated strong brand reputation. The company has a history of innovation that has produced an impressive portfolio of products and patents, all delivered by an experienced group of engineers, well known for developing high-quality specialized solutions for customers.

In recent weeks, I've met with the fluid handling teams in Germany and the U.S., and we're excited about the cultural fit between our companies. We share a common focus on customers, innovation and accountability. Our integration team is in place and working well with the fluid handling leadership team. The antitrust regulatory approval request have been filed. We have a detailed action plan in place to get to closing, we're on track to close the acquisition by year-end and integration planning is underway. Technology innovation also represents an important part of CIRCOR's growth strategy. Let me give you a few examples of recent new product developments and intellectual property achievements. We have a patent pending on the breakthrough technology behind our new GYROLOK-XP product family designed for instrumentation and sampling customers. Launching this year under our HOKE brand, the GYROLOK product is consistent with our mission-critical severe service strategy. The GYROLOK-XP increases the system pressure capability by up to 80% over conventional tube fittings. This will allow our XP fittings to be used on tubing with higher pressure ranges, including exotic alloy tubing used in severe service applications. This increased capability replaces the more expensive options, such as welded tube fittings or the cone and thread approach. The GYROLOK-XP design dramatically simplifies the installation and ensures that the fitting cannot be overtightened, the most common installation error leading to leaks.

Second, one of our aerospace engineers was recently awarded a U.S. patent for miniature surface mount switch packaging. This packaging technology is designed specifically for Military applications. Its core function is to delay the arming of bombs or missiles, allowing them to be switch to armed status when they reach a certain acceleration or speed. This allows the missile to explode at the right time and safely away from the pilot who launched it. The breakthrough design simplifies and accelerates the installation and integration of the product at the customer site. And finally, we've applied for a patent on our pneumatic drone launcher. This launching system for smaller, unmanned aerial vehicles is powered by compressed air with no need for electrical power. It's portable for easy field deployment and provides improved reliability with multiple launches from a single charge. This technology replaces the use of slingshots or manual handheld launches. We'll continue to focus on introducing new product innovations to drive organic growth in all of our businesses, and you'll see the cadence of new CIRCOR products increasing over time.

Turning to simplification and operational excellence. We continue to shift production hours to our low-cost manufacturing centers of excellence in Mexico, Morocco and India. Since starting production in Q1, our facility in Mexico now accounts for approximately 20% of our distributed valve production hours. Additionally, our Morocco operations now represent about 1/3 of all production hours for our European Aerospace businesses. And we're in the process of expanding our India facility to manufacture CFS products to be sold globally. Finally, in our Distributed Valves business, the supply chain constraints that hampered shipments in recent quarters eased during Q3, and the focus shifted to ramping up production in Oklahoma City and Monterrey. Our current rate of production is in line with demand, but we still have a significant past due backlog to work through before the end of the year. While the production ramp-up in Q3 impacted profitability, working capital and cash flow in the quarter, we expect significantly better operating performance on all 3 dimensions in Q4.

With that, I'll turn it over to Rajeev to discuss the third quarter results in more detail, before I return to discuss our view on end markets.

Thanks, Scott. Let's review the segment results, starting with Energy on Slide 4. Energy sales of $93 million increased 34% year-over-year, driven by shipments from our North American Distributed Valves business as well as the contribution from the CFS acquisition. This was partly offset by lower volumes in our engineered valves projects business. While our engineered valves business continues to experience market weakness and intense pricing pressure, we are seeing a slight increase in project quoting activity that seems to indicate the market is gradually beginning to improve. Scott will discuss this in further detail later in the call.

Energy segment operating margin was 8%, a decrease of 180 basis points year-over-year. This decline primarily reflects losses in our engineered valves business, partially offset by higher sales and earnings in our Distributed Valves business. In the third quarter, margins were affected as we incurred incremental cost to ramp-up our Distributed Valves business in Oklahoma City, as well as additional costs related to the start-up of our Mexico factory, as we discussed previously. Despite closing our Houston-based operations for nearly a week, due to Hurricane Harvey, it did not have a significant financial impact in the quarter.

For Advanced Flow Solutions, please turn to Slide 5. Advanced Flow Solutions sales of $67 million were up 2% year-over-year. Our power and process and Aerospace businesses recorded good revenue growth, partly offset by a decline in industrial solutions. Advanced Flow Solutions segment operating margin was 14.2%, an increase of 210 basis points from the prior year. Our results continued to reflect the benefit from prior restructuring actions, increased productivity and better pricing. I should note that the AFS margins were adversely impacted by 30 basis points due to the impact of Hurricane Irma, which required a Tampa facility to be closed for about a week.

Turn to Slide 6 for selected P&L items. We recorded a $5 million charge for special and restructuring items. The components of this charge included $1.8 million in transaction fees associated with our acquisition of Colfax Fluid Handling, the noncash acquisition-related amortization expense of $2.7 million, and finally $500,000 of restructuring cost related to previously announced actions. We incurred $1.8 million or $0.08 per share of higher interest expense in this quarter compared with the prior year. In addition, the third quarter results reflect year-over-year FX headwind of approximately $0.02 per share.

Our adjusted tax rate for the quarter is 17%. The tax rate in the quarter benefited from certain discrete adjustments relating to previously established tax reserves. The 2017 tax rate is much higher than the 2016 rate. In Q3 last year, we recorded a significant tax benefit from the repatriation of foreign cash.

Turn to our cash flow and debt position on Slide 7. Our cash flow performance in the third quarter was driven primarily by higher working capital, especially inventory, as we ramped up our Distributed Valves business to work through the past due backlog. We're anticipating a much stronger quarter from a cash flow perspective in Q4, with the expectation that our free cash flow will exceed net income for the full year.

This brings us to our guidance for the fourth quarter. Please turn to Slide 8. Overall, for Q4, we expect revenue in the range of $155 million to $175 million, and adjusted EPS in the range of $0.35 to $0.55 per share. This guidance does not include the pending fluid handling transaction. Overall, for Energy, this guidance assumes sequential improvements in orders and revenue in Distributed Valves, CFS and instrumentation and sampling, offset in part by ongoing weakness in our engineered valves project business. We expect sequential sales growth in our AFS businesses, primarily in Aerospace & Defense. AFS sales are expected to grow year-over-year, despite the divestiture of the French build-to-print business we completed last quarter. Scott will cover our market expectation in detail in a moment.

Regarding special and restructuring charges for the fourth quarter of 2017, we anticipate charges to be about $4 million or $0.15 per share. Although, we expect to incur transaction-related cost for the fluid handling deal in Q4, this guidance range excludes any such costs. We expect our fourth quarter adjusted tax rate to be approximately 28%.

With that, let me turn it back over to Scott.

Thank you, Rajeev. Let me provide you with an overview of the trends in our end markets, starting first with Energy. Energy segment orders increased 62% year-over-year in the third quarter, led by strong demand in our Distributed Valves business and the contribution of CFS, which we acquired a year ago. Organically, orders were up 26%. Orders in our engineered valves business rose slightly in the quarter off of a relatively low comparison last year. Instrumentation and sampling orders increased modestly and in line with expectations. In our Distributed Valves business, we ramped up production in the third quarter to meet strong demand. The production run rate we saw in September sets the stage for a strong fourth quarter. Most of the activity remains in the Permian Basin, although, we're seeing higher activity in Eagle Ford and Marcellus regions.

North American rig count was up slightly sequentially in Q3, but has moderated a bit in recent weeks. We do not expect a significant change in rig count looking ahead. Drillers are emphasizing efficiency and return on investment over growth. After largely resolving our supply chain issues and ramping up production in Q3, we're focused on burning down our past due backlog and improving our on-time delivery in Q4. Our efforts to penetrate the midstream market continue to gain traction. And finally, we're increasing prices in response to the strong demand environment and are improving delivery performance.

Within our instrumentation and sampling business, the market remained stable with Q3 bookings in line with seasonal expectations and up modestly year-over-year. We expect to see some growth for upstream projects, especially in Asia. The downstream market for our sampling products is growing. Overall, we expect a gradual improvement in Q4 with a positive outlook for 2018.

Orders in our engineered valves project business were up slightly in the third quarter with an uptick in quote volume, primarily for midstream projects. This market remains challenging, although, we're seeing a shift from budgetary quotes to specific project quotes for a handful of midstream projects. Most of the activity continues to be in the Middle East, with some new projects launching in Asia. Pricing pressure remains intense, and we're managing the cost structure of the business in response to this difficult market environment. In our Critical Flow Solutions business, recent trends remain unchanged. In the quarter, we continued to see order strength for the TapcoEnpro capital and aftermarket business, while DeltaValve orders performance was mixed. The outlook for TapcoEnpro capital projects remains positive, despite an anticipated dip in project orders in Q4. We expect ongoing strength in the aftermarket. DeltaValve capital project decisions continue to be deferred as refineries manage the scope and timing of their capital expenditures. Our historic win rate remains unchanged, while the list of projects quoted and awaiting decision continued to grow in the quarter.

Looking forward, we expect capital project bookings to improve as detailed project activity has increased on smaller projects, primarily in the U.S., Europe and India. DeltaValve aftermarket orders were strong in the quarter and supported the fall of 2017 and spring 2018 turnaround seasons. Finally, we don't expect a significant order impact, either positive or negative, from Hurricane Harvey. Overall, for Q4, we expect Energy to deliver year-over-year revenue growth and margins in line with the prior year, as productivity and growth in our short-cycle businesses offset market weakness in our project businesses.

Turning to Advanced Flow Solutions, which serves the aerospace, power and process, and industrial end markets, revenues remain strong and we're seeing broad-based order strength across each of the 3 end markets.

Looking forward, CIRCOR's participation on growing aerospace platforms, such as the Joint Strike Fighter and the A350, combined with an increased focus on the aftermarket, should generate increased orders compared to the prior year as well as revenue growth. Commercial and Military aircraft build rates continue to increase, providing a strong platform for growth and margin expansion. In our power and process business, we're expecting flat order intake sequentially with headwind in Europe, especially Germany, offset by increased activity in North America and China. We're also expanding the scope of our key channel partners in the U.S. to sell our RTK and Schroedahl products, along with our Leslie and Spence products. Orders for our industrial solutions business, which serves end markets, including HVAC, maritime and industrial, are expected to be up sequentially and year-over-year, driven by HVAC orders in the residential market and MRO orders from the U.S. Navy. Overall, for Q4, we expect AFS to deliver year-over-year revenue growth and strong margin expansion.

In summary, for Q4, the overall orders outlook for both the Energy and AFS businesses remains positive with the exception of our energy projects businesses. We expect strong demand in our Distributed Valves business, as we focus on maintaining current production levels and burning down our past due backlog. We anticipate a stable environment in our instrumentation and sampling product line, and a slight improvement in CFS and engineered valves. In AFS, all 3 product lines are well positioned to grow. We continue to focus on what we control, executing on our growth initiatives, simplifying the company, increasing the importance of our low-cost manufacturing plants and driving operational excellence. We remain focused on delivering long-term value for our shareholders by investing in growth, expanding margins, generating strong free cash flow and being disciplined with capital deployment.

With that, Rajeev and I are available to take your questions.

(Operator Instructions) Our first question comes from the line of Nathan Jones with Stifel.

I'm going to start in Energy here and the margin level, which was a little lower than we were anticipating. And it sounds like you've got some things moving in one direction and some moving in the other. So -- and I think you stated there was actually negative margin in the engineered valve business this quarter. I wonder if you could talk about the way the margins are trending in the different pieces of the business in there? Where the challenges are? What the solutions are? And how are you going about getting these margins going back in the right direction?

Sure, Nathan. Let me help out there. And you're right, you heard correctly. There are a number of moving pieces here. The engineered valves business, we did book a loss for the quarter in that. Now just recognize that we are not taking on negative margin contracts, so they are profitable from a gross margin standpoint. But as you look at the whole business, there was a loss and that put pressure on the margins. Going the other way, with the Distributed Valves, which was good growth in margins, tempered somewhat by this ramp-up cost and -- that we incurred during the quarter. And then the other 2 pieces that you should recognize or 3 pieces is, obviously, Critical Flow Solutions was positive and accretive. We did get benefit from restructuring and cost reduction actions to the tune of about 200 basis points, offset in part by the Mexico start-up cost that we had signaled at the end of the second quarter call of about 40 basis points. So those are the pieces that make up the margin there. Relative to the trend, we do expect sequential improvement, as we continue to manage not only the engineered valves, but also the Distributed Valves as we get kind of over the hump of the ramp-up here. And good growth also on the top line. So that's the trend. In terms of the challenges, I will turn it over to Scott, who can talk to you a little bit about the market challenges we're seeing there.

So just to add to what Rajeev said on the margin piece, the -- well, DV did help sequentially with revenue and margin from Q2 to Q3, it was not nearly the margins that we get in that business in -- at a normal run rate scale operation. So because of the ramp-up, we had extraordinary costs in the quarter that we don't anticipate will remain in the business as we go into Q4. So if you look at our performance in September, as we exited the quarter going into Q4, we feel a lot better about the performance that DV will deliver in the fourth quarter. So we expect good margin expansion out of that piece of the business in Q4. On engineered valves, with respect to your question on challenges, Nathan, it's a -- the engineers are the core part of that business. We've taken a lot of cost out from last year. We are in the process of taking more cost out as we go into Q4. We don't expect to be at breakeven in Q4. We expect a small loss in Q4, although, smaller than Q3. But you should know that we are in process of taking more cost out. We're somewhat limited in our ability to take out more headcount, because they're largely engineers. They are the core of the business. When the market does come back, we need to have the engineers. They're seasoned, experienced, talented people that we need to have to run that business long term. Having said that, we're spending a lot of time on value engineering. We're in the process of transferring work from our factory in Milan to India. There's a decent scope of business going forward that would be produced out of India. So there's a lot of different dimensions to addressing the cost structure there that we're executing on, but that was clearly one of the challenges we had in Q3. As far as -- I'll stop there. The last thing I'll say is, instrumentation and sampling continues to execute well and manage margins well and deliver more or less in line with expectations.

Okay. A couple of follow-ups to that. Can you quantify what impact it had to margin from the start-up costs in Mexico and the ramp-up in OKC? And you said that you don't expect those to repeat in 4Q, correct?

Correct. So for the ramp-up is about 80 basis points of margin impact. The Mexico start-up was about 40 basis points. We will have some start-up still, but it'll be less than Q3. So sequential comes down, but it does not go to 0.

Okay. And then I think, Scott, at this point last year, you gave us an indication of what you were thinking about for the growth rate in engineered valves in the first half of '17. Are you in a position where you can outline what your expectation is for that business in the first half of '18?

For -- I'm sorry, for engineered valves?

For engineered valves, yes.

Yes. So I think that the guidance that I've given the last couple of quarters hasn't changed much. What we're hearing from customers and what we're actually seeing now is gradual improvement in the market. So if you break it down a little bit, we're still seeing good activity in the Middle East, largely around midstream. And when I say good, it's -- I mean, improving, some improving activity. So where we were seeing 6 months ago a lot of budgetary quotations, we're now seeing more specific purchasing quotations in midstream, largely in the Middle East, but also some in Asia. For upstream, which historically has been the strongest part of our business, we're still seeing budgetary quotations. But I would say, more budgetary quotations than we have in the past. Those tend to have a 6- to 9-month lead time before you start getting more specific purchasing quotations. So it seems that the gradual improvement with '17 activity being better than '16, and '18 activity being better than '17 seems to be playing out, but it's not a dramatic recovery that we're seeing, it's a gradual increase in activity over time.

Our next question comes from the line of John Franzreb with Sidoti & Company.

Just [summing] on your comments on the Distributed Valve business, Scott. Last quarter, its sounds to me like you told us kind of flattening out your order trends and everything was in equilibrium. But it seems to me that third quarter was -- might have been a little bit better than expected and you're signaling that Q4 will be better than Q3. Can you just talk to what's going on there? Are you taking share? Was demand a little bit better than expected maybe a quarter ago?

So -- and this is with respect to Distributed Valves. The way I would characterize the market is as stronger than we've seen last year, relative -- but staying at current levels. So if you look at our order intake in Q3, it was better than Q2, a little worse than Q1. And as we look at Q4, it's more or less in line with what we expect in Q4 is more or less in line with what we saw in Q3 at an order intake level. So we see rig count flattening out a little bit here at the current level. So this is a relatively strong activity level from where we've been the last couple of years that we expect to hold as we go into 2018. When I talk about our business and how we did in Q3, we had challenges. So we did resolve all of the supply chain issues that we had earlier in the year. So material supply was not -- as we exit the quarter, is not an issue any more. The challenge we had in the quarter was ramping up production, and we had a dramatic ramp-up from month 1 to month 2 to month 3 of production in the quarter. But of course, that's not the most efficient way to run a business. So we had higher freight and expediting costs, we had employee turnover, we had to do a lot of training, of course, as we're ramping up. So we've got a lot of that behind us in Q3 and a lot of the cost associated with that fell through in the quarter. And so when you look at our run rate going into Q4, we're expecting to burn down our backlog almost completely by the end of Q4, and we're running at a much more efficient rate without all the expedite and freight cost that we had in Q3 as well. So we feel much better about the profitability. And you'll see improved revenue in Q4 and significantly improved margin in Q4 out of Distributed Valves.

Did you bring on the suppliers?

We have. So -- and we started working on that last year and early this year. So we have qualified new suppliers in situations where we had one supplier that was constrained, we now have 2 suppliers. So we've done a lot of that work earlier this year.

And regarding the segment operating margin, I just don't recall, was engineered valves running at a loss in Q2?

It was breakeven, John.

Okay, okay. And I guess, one last question, and I'll get back into queue. You mentioned pricing in your commentary. It sounds like you're not only getting pricing inflow, but you're also getting pricing in Energy. Is that the case? And could you just walk on how you stand as far as raising prices within both segments?

Sure. So it depends which side. Okay. So in AFS, Aerospace & Defense, we're getting a pretty significant price increases this year, okay? And we -- and if you look at power and process and industrial solutions, I'd say, pricing is stable. If you go to the Energy side of the business, engineered valves and CFS, pricing is stable. On the engineered valve side, we've talked about how competitive that is. It's really difficult pricing on the engineered valve side. CFS, I'd say, stable pricing. In instrumentation and sampling and Distributed Valves, our shorter-cycle businesses, both of those businesses we're raising prices right now.

Our next question comes from the line of Charlie Brady with SunTrust Robinson Humphrey.

How much of backlog is Distributed Valves right now?

Yes. We don't actually punch that out, as you would expect, by product line. But there's a substantial amount of past due backlog as well as backlog that gets delivered beyond the quarter here. So a good portion. I would say, a good portion of the Energy backlog of about 100 -- the Energy backlog is $143 million, a significant portion of that is Distributed Valves.

Okay. And did I hear, Scott, correctly that you expect to burn the DV -- valve backlog off by the end of 4Q?

Yes, I'm sorry. Let me -- I meant to say past due backlog. So if I said backlog, that's not right. The past due backlog is substantial as we come into Q4, and we expect to largely burn off the past due portion of the backlog. Sorry about that.

I may have heard you incorrectly, so thanks for clarifying that. On your commentary on AFS margin being up sequentially, and I guess, on a year-over-year basis -- and by the way, I just want to make sure I heard that correctly, you're looking for sequential improvement in margin in Q4, correct?

Correct.

Yes, that's correct.

And then on Energy, you said, up year-on-year. And just to clarify, there's a reported margin of 10.4%, and as you adjust it, of 14%, you're referring to the adjusted or the reported margin?

For the last -- for the prior year, the margins were 10.4%, is that what you're asking?

For Energy business?

Yes.

Yes, because there were some adjustments in there too, but I just wanted to clarify which number was being referred to.

It's a 10.4%. And just to be clear, what we are saying is that it's essentially flat to the prior year for Energy in Q4.

Got you. Can -- Scott, can you just talk a little bit more about what you're seeing in midstream, you touched on it a little bit in your prepared remarks. But you guys have been making some traction there and getting certified by a number of customers. Can you just -- maybe a little more update on what's going on in midstream?

Sure, sure. We now are on the approved vendor list for 11 midstream customers. We have a target list that's about 30, that we're working on. As you probably know, there's a decent amount of work that goes into getting on an approved list. So we're methodically going through the list and having some success. The -- if you look at the order intake, it's off a very small base. As you probably know, we weren't very present in this market last year, but we're seeing significant growth in order intake this year, and we're expecting that trend to continue next year.

Our next question comes from the line of Matt Summerville from Alembic Global Advisors.

I have one follow-up in aerospace, so I apologize if this has been asked. But what is the magnitude of pricing that you're able to get in Advanced Flow? And given that's on the Aerospace Defense (sic) [Aerospace & Defense] side, I guess, I'm a little surprised to maybe be hearing that now. So can you talk about how the contractual relationships are structured that is sort of enabling you to get price in that business?

Sure, Charlie. The -- I'm sorry, Matt. The pricing -- there is 2 aspects to the pricing. So the part that we deal with on the aftermarket standpoint, and that we, obviously, largely control. And then with respect to the OEM standpoint, contractually, we do often have escalation clauses built into the contract. And based on what's going on with inflation, specific to the products that we're manufacturing, you're able to drive some incremental pricing. With that said, in other cases, we do own the intellectual property and that allows us to also manage -- appropriately manage the pricing there. So you can get anywhere from 80 to 150 basis points in a particular year.

And that's about the magnitude that we're in right now for 2017 in aerospace.

And then how much of the backlog in Energy is attributable to sort of the past due portion of Distributed Valves? And when you look at, I guess, Scott, the runway that you have in the Distributed Valve business, can you talk about that in the context of where the U.S. or North America is with all the DUCs out there right now?

Sure. And let me take the question on the backlog, and then -- and Scott can talk about the market and the uncompleted wells. The DV past due backlog is probably around 10-ish percent of the total Energy backlog, Matt. So that's a key point there. And as you know from the drilled, but uncompleted wells, that inventory level has gone up substantially in the third quarter, off of the second quarter and actually higher than even the first quarter, as you probably know. So it's over 7,000 wells at this point. And that bodes well for us, because as those wells get completed, we're able to sell product. So a significant portion of those uncompleted wells are in Permian and Eagle Ford, and no surprise there. And so it -- it's another indicator of positive strength in that market.

Our next question comes from the line of James Picariello with KeyBanc Capital Markets.

So just on the fourth quarter guide. Pretty wide range there. What are the big swing factors within the businesses that warrants such a wide range?

Yes. Sure, James. The -- there are a number of factors that come into play, as you would expect, when we set the guidance and we take a look at our forecast and the plusses and minuses there. There's really 2 -- it boils down to 2 major factors. There is the execution aspect, where we might have the timing of shipments come into play. If there are shipments that are scheduled towards the end of the year and they flop into the subsequent quarter, obviously, that would come into play. So the timing of shipments is one. And the second is with respect to our project business. Our project businesses have some risk around them relative to delivery, relative to orders. And so that is another factor that we take into account when we build the range there.

So I'd just add to that. On the timing of shipments, it's not only us in control, often we're waiting for customer approval to ship, our customer inspection has to come on site and approve the shipment. And so there is sometimes situations that towards the end of the quarter where we're sitting on large shipments waiting for a customer to come in and inspect the product before they allow us to ship. And that doesn't always work out in our favor. The other piece is orders on large projects. So depending on the timing of the orders in the quarter, it can have an impact on our revenue and earnings in the quarter as well.

Got it. And just back on the Energy margins conversation. Did you quantify exactly what the past due backlog, what all those fees amount to in terms the basis point impact on margins. And then if we just take a step back, you guys basically cut your supplier base in half over the last 3 years, as part of your business system initiatives. Can you remind us again what exactly this supplier issue was at the start of the year? Did your consolidation efforts there have any role in that? And how should we think about standard incrementals for 2018, given engineered valves trending towards neutral breakeven by year-end possibly, and the Distributed Valves price increases, et cetera?

Sure. Let me start with that, James. The -- on the Energy, the Distributed Valves past due backlog -- just recognize, we're not paying any fees on them. This is just the cost that we're incurring to ramp-up and to get material in and out the door here. We did quantify it earlier in the call here, it's about 80 basis points of margin impact in the quarter. And with respect to the kind of supplier base and how we've been managing that, I know Scott can chime in. But we're very careful and deliberate in terms of how we rationalize the supplier base. And as you know, we've been doing this for a number of years.

So I think on that piece, I just want to point out that we and our competitors have been -- had struggled with the supply base in the first half of this year in terms of getting material and trying to meet the ramp-up and demand. So we benefited in the sense that -- thankfully, we weren't the only one, because clearly, we would have lost share through that situation. So -- but having said that, did the supplier consolidation initiative that we have played a role year? I may reiterate what Rajeev said, we're pretty careful about the way we consolidate suppliers. The critical suppliers are casting suppliers, the ones that really caused us the biggest problem in the ramp-up here in North America. They're casting suppliers in China. We've now dual-sourced those suppliers, so we do have alternatives. I'm not entirely sure how helpful that would have been during the ramp-up given the whole supply chain was constrained, including the dual-source options that we brought into our network now. So I don't know that our consolidation initiative really played much of a role here. Maybe you could argue that we were spending more time consolidating and should have been looking at having multiple sources of supply for some of these key suppliers in hindsight 2020, perhaps we could have done a better job there. But I wouldn't look at the supplier consolidation initiative and point to that as the root cause. I think there was a much broader issue here that we were a part of.

Okay. And your best guess on incrementals for next year?

Yes, so -- yes, sure. So Energy, we do expect improvement there. Again, you're going to question me about what the market's going to do and how does that factor in. We do expect improvement, maybe gradual in some parts and maybe pretty strong in others. So as I look into 2018, we do expect margin expansion. And you had a question about DV pricing, but I wasn't sure what that was if you want to repeat that, James?

Well, I was just trying to run through the businesses and puts and takes. You'd called out distributed pricing, the price increase there. So, yes, not a specific question. Just one follow-up, maybe I missed it. The tax rate, what drove the lower tax rate in the quarter?

Yes. So we were able to get through some risk that we had setup some reserves for and get that favorably resolved, such that we were able to take back previously established reserve in the quarter to the tune of about $0.05 a share, about $1 million was the net impact.

Our next question comes from the line of Brett Kearney with Gabelli & Company.

So you guys have provided a lot of great color in your discussion on pricing. I was -- just want to ask kind of what you guys are seeing and what you expect in terms of raw material and component cost from here?

Yes. We don't see a significant impact with respect to any sort of raw material or commodity fluctuation in pricing and the impact on us. We've -- the type of material that we buy, where we buy it from, the contracts that we have with our suppliers, really help manage and mitigate any significant volatility with that, Brett.

Brett, in a normal year, which we look at this year being normal, we would generate net productivity on material. So net of any inflation, the savings would offset inflation and that's what we're seeing this year as well. So we're not experiencing a material inflation that we're passing through or absorbing in our margin. It's quite -- it's actually the opposite. We're seeing savings on supply chain right now.

Our next question comes from the line of Nathan Jones with Stifel.

Free cash flow. It was minus $19 million in the quarter versus plus $17.5 million last year. It's been very unusual for CIRCOR to generate a negative free cash flow number over the last several years. Can you talk about the puts and takes that drove that there? And also maybe a comment on the inventory build in the quarter?

So the inventory build and the negative cash flow are directly linked. And it's really not -- it's not a complicated story to explain and not a lot of puts and takes. The big issue that we had in the quarter was -- with respect to cash flow, was the ramp-up of production in Oklahoma City and Monterrey in our Distributed Valve business. So as part of that, we received a lot of material in the quarter. We ramped up production in the quarter dramatically through -- into September. But at the end of the quarter, we still had a lot of raw material and a lot of work in process, and we shipped a lot of product at the very end of the quarter, a product that we did not collect cash on. So that dynamic of ramping up with material and production and shipping -- the majority of our shipments went out in September, where we didn't capture the cash in the quarter led to the situation that we're in, in the quarter. So we don't expect that to repeat, Nathan, in Q4. We expect to run at current production levels through Q4, and we expect to pull the inventory down. So we expect the cash flow and working capital to get better in Q4.

Would you expect to then regain this all in Q4? Or maybe do -- takes you into Q4 to get all the shipments out, Q1 to collect all the cash on that?

Yes. So, Nathan, there will be a little bit of a flopover into Q1 as you would expect based on the receivable collection standpoint. But it should be substantially better in Q4 versus Q3.

(Operator Instructions) Our next question comes from the line of John Franzreb with Sidoti & Company.

Yes. Just quickly, you increased your amount of restructuring savings from $13 million to $14 million last quarter to this quarter. Is the extra million dollars -- is that attributed to the, like you talked about, actions you're taking in the engineered valves business? Or is there something else going on there?

No, that's the closure of the and sale of the French build-to-print facility, John, that we did -- that we announced at the second quarter.

Yes. But in the second quarter the actions -- the total actions were $17 million [to] $13 million, and you've raised it to $14 million. So I figured that was already in there.

I think that's the bulk of it. There -- the action that we're taking in our engineered valves business, the bulk of the major program has been done. But the -- in the past, there'll be an incremental action probably in the near term here. But I think it's additional savings on that French action.

There are no further questions at this time. Thank you for joining us today. This does conclude our conference call. You may now disconnect your lines, and have a wonderful day.