Enerpac Tool Group Corp (EPAC) 2018 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to the Actuant Corporation's Second Quarter Earnings Conference Call. (Operator Instructions) As a reminder, this conference is being recorded, Wednesday, March 21, 2018.

I would now -- it is now my pleasure to turn the conference over to Karen Bauer, Communications and Investor Relations leader. Please go ahead, Ms. Bauer.

Thank you. Good morning, and welcome to Actuant's Second Quarter Earnings Conference Call. On the call with me today are Randy Baker, Actuant's CEO; and Rick Dillon, CFO. Our earnings release and the slide presentation for today's call are available in the Investor section of our website. During today's call, we will reference non-GAAP metrics such as adjusted profit margins or adjusted earnings per share. You can find a reconciliation of GAAP to non-GAAP metrics within the schedules attached to this morning's press release. I also want to remind everyone that any forward-looking statements made during this call are subject to risks and uncertainties, the most important of which are described in our press release and SEC filings. Finally, consistent with prior quarters, we'll utilize the one question, one follow-up rule in order to keep today's call to an hour.

Thank you in advance for following this practice. And with that, I'll turn the call over to Randy.

Thanks, Karen. Good morning, everybody, and thanks for joining our second quarter's earnings call. Before we start the second quarter results, I'd like to address today's press release appointing 3 new directors. Over the past month, we've had very constructive dialogue with Southeast Asset Management. As a result, we've entered into an agreement with Southeastern, which was filed as an 8-K resulting in the appointment of Palmer Clarkson and Sidney Simmons to the Board as Independent Directors. I'm really pleased that Palmer and Sidney are joining the Board, and I have no doubt that they'd be very helpful in driving our strategy. Secondly, as part of our succession plans, Alfredo Altavilla will be joining the Board as an Independent Director. Alfredo also has a great deal of industry experience and will provide valuable insights into our company. In summary, I'm very pleased to welcome these Board members to Actuant, and looking forward to working with the entire Board on the strategy of focusing on our most profitable businesses and improving the long-term shareholder value.

Now let's go to the second quarter. Starting over on Slide 3, I'm pleased to report that we delivered results within our guidance range for the second quarter. To summarize, sales at $275 million was at the high-end of the range, and I was particularly pleased with the core sales growth in Enerpac tools and engineered solutions. Adjusted diluted EPS was $0.13 a share in the middle of the range, with margins that, quite frankly, fell short of expectations. Year-to-date, we have grown the business by more than $40 million but we have not improved the profitability at an acceptable rate. Our cash flow was as expected with a bit of inventory and other working capital build to support the top line growth. The margin pressures are coming from multiple fronts in terms of contribution, heavy lifting project cost overruns and warranty issues were the biggest drivers. These factors, along with negative sales mix, growth in investments, inflation, resulted in disappointing incremental margins. The questions become, what are we going to do differently going forward. First, we need to rapidly finalize the remaining heavy lifting projects and the Energy segment restructuring. Secondly, we need to be more aggressive on the pricing front. We have accelerated our Industrial tool pricing and we are pursuing aggressive OEM price adjustments. We are driving cost efficiency and slowing our investments. We have clearly seen market share growth as a result of our investments, however, we need to absorb what we have in place and leverage the existing structure. Finally, we are increasing our focus on portfolio management outlined on our Investor Day, taking into account the relative strategic fit, in turn, concentrating on our resources on the most profitable businesses.

In summary, we are committed to driving the actions to achieve the targeted incremental profits in this robust sales environment. We're working to balance the priorities to meet strong demand, investing in the future and managing cost. To that end, I am confident that we can deliver on our priorities.

I'll turn the call over to Rick now to go through the details on the quarter, and then I'll come back with some updates, including guidance. Rick?

Thanks, Randy, and good morning, everyone. First, let's walk through the one-time items impacting this quarter that were excluded from our adjusted results as shown on Slide 4. Starting with taxes. We recorded a net charge of $8 million as our initial estimate of the impact of tax reform. The estimated $16 million impact on the repatriation of foreign earnings was partially offset by the revaluation of certain tax assets and liabilities to reflect the impact of reforms and the reduced U.S. tax rate. We also recorded approximately $1 million of tax expense as a result of new accounting rules that required a corporate tax triggered on the exercise of employee options to be reflected as a component of tax expense. During the second quarter, we had a significant exercise of stock options by a former Executive. Restructuring in the quarter totaled $4.3 million. You can see $3.5 million of this called out on the face of the income statement in the SAE section with the remainder included within cost of goods sold. With the closing of the Viking transaction on December 1, we recorded the final divestiture and impairment charges, which amounted to $12 million in the quarter.

Onto our adjusted second quarter, turning to Slide 5, let's start with the high-level recap. Fiscal 2018 second quarter sales increased 6%, core sales increased 3%, net of a 5% currency benefit and the 2% sales reduction resulting from the net impact of the Viking divestiture and Mirage acquisitions. Adjusted operating profit improved modestly with margins up 20 basis points. Our effective income tax rate was approximately 14% in line with our expectations. The adjusted EPS for the second quarter was $0.13 compared to $0.11 last year.

Turning to Slide 6. Our core sales were at the top of our guidance range of 1% to 3%. Total Industrial segment sales were generally in line with expectations as strong tool sales more than offset mid-teen declines in both heavy lifting and concrete tensioning. Engineered Solutions exceeded expectations with strong demand across substantially all product lines, despite weakening China truck volumes and more difficult comparisons. While still negative, energy core sales were a little bit better than our latest outlook on strong Cortland rope and cable demand.

On Slide 7, you can see the modest increase in year-over-year margins. Randy walked through the incremental margin pressures at a high level, and I will provide more details as I discuss the segment results. First, let me address briefly the steel and aluminum tariffs. While we are still digesting the new rules and in active discussions regarding the exemption of certain specialty steel categories not available in the U.S., our current estimate of the impact upon cost is approximately $5 million on an annualized basis. This is our estimate of the impact of both the tariffs and the expected U.S. supplier increases -- price increases on higher demand. This would largely hit our concrete tensioning and agriculture businesses and industrial tools to a much lesser extent. Like others, we expect to implement pricing surcharges to customers to cover any increased costs.

Now let's get into the segment detail, starting with the Industrial segment on Slide 8. Core sales for Industrial increased by 4% over the prior year. Industrial tools sales remained robust despite tougher comps, up low double digits, which accelerated a few points from the first quarter growth rate. Global Industrial activity levels remained strong, and we continue to see this across the vast array of end markets we touch. This strong macro environment, combined with our commercial effectiveness actions and new product launches have all contributed to the sales performance. On the other end of the spectrum, we experienced mid-teen declines in sales for both the heavy lifting business as well as the concrete tensioning product category. The former due to the lumpy nature of that business and the latter resulting from poor delivery. From a profitability standpoint, Industrial's margins were down 210 basis points year-over-year. Obviously, this was disappointing and we will try to provide further granularity here. Our standard industrial tools portion of the business had incremental margins in the 20% range. This was lower than expected and largely associated with an incremental $2 million investment in commercial effectiveness, including sales and engineering along with modest inflation. As Randy noted, we are decelerating the investment in the back half of the year and accelerating price increases to right size the cost structure. Within heavy lifting, the custom solutions portion of our business continue to incur significant cost overruns largely associated with 2 international projects. This resulted in losses for HLT of approximately $2 million in the quarter and a swing of a similar amount on a year-over-year basis. As we discussed last quarter, these customized fit-for-purpose projects will wind down as part of the HLT offering on a go-forward basis, we expect to continue to experience margin pressure from these projects for the balance of the year, but at a less severe rate. We're in the process of executing restructuring actions in our European operations to reflect reduced custom activity going forward. However, these won't be completed until the fourth quarter as we work through certain regulatory requirements and must be managed closely as we wind down our contractual obligations. The operating efficiencies continued for our concrete tensioning business, but are sequentially improving. Unfortunately, our production issues and inability to meet service levels have resulted in lost share. In total, this accounted for about $1 million in year-over-year profit degradation. While the facilities have been consolidated and machines are up and running, the market share loss is expected to continue to impact the second half of the year.

Now let's turn to the Energy segment on Slide 9. Overall, core sales declined 8%, but sequentially improved from the minus 12% last quarter. Hydratight's core sales rate of change was a bit less worse down low double-digits versus mid-teens last quarter. Customers across our various served markets and regions continued their trend of maintenance deferrals, pushouts and scope reductions, despite stable to improving oil prices. As we noted last quarter, the Middle East continues to have the most stability in terms of maintenance activity levels and Asia Pacific remains the most challenged. Cortland delivered mid-single digit core sales growth in the quarter on improved -- on improvements in both oil and gas as well as the medical markets. Encouragingly, quoting activity in offshore energy is picking up, notably in the seismic area, which is obviously extremely front end. Adjusted operating profit margins improved 200 basis points largely due to the elimination of Viking losses, which was partially offset by the lower Hydratight volume levels. We continue our restructuring efforts within the Energy segment with actions impacting both Hydratight and Cortland, we are closing ancillary operating locations, streamlining regional structures and refocusing resources on the most profitable product lines. While these actions are difficult and take time, they are beginning to provide savings.

Turning to Engineered Solutions on Slide 10. We saw strong performance again from a top line standpoint, delivering 10% core sales growth despite more difficult year-over-year comparisons. Our customers are experiencing solid end-market demand and are reestablishing inventory in the channels, which is being reflected in our robust production rates. The sales growth continues to be broad-based across off-highway markets, including agriculture, construction, forestry and mining, among others. Europe truck production levels remained solid, but as expected, China truck build declined year-over-year with our sales down approximately 25%. Profit margins in Engineered Solutions declined 130 basis points year-over-year as the higher volumes were offset by warranty costs, higher material and wage costs and unfavorable sales mix with the lower China volumes, along with preproduction engineering support for new product launches in that order. The warranty issues are behind us and we have initiated pricing discussions with many of our customers. While these will likely layer in over time, we expect to cover the majority of the inflationary costs.

Lastly, turning to liquidity on Slide 11. Cash flow was generally as expected in the seasonally weak second quarter, although we did build inventory levels in the first half of the year to support the expected top line growth, but we are targeting a meaningful reduction as we move through the back half. Our net debt to pro forma EBITDA leverage remains around 3x and should decline with the normal second half cash flow generation.

With that, I'll turn the call back over to Randy.

Thanks, Rick. Let's turn over to Slide 12. I want to spend a few minutes on the Energy investments and new product launches. Our investments in new product development have affected the margins, but we believe this is one of the most important capital allocation priorities. We are committed to reinvigorating our organic growth and the long-term health and sustainability of the businesses. During the quarter, we launched multiple new products in Enerpac tools, expanding our catalog and giving our dealers more to sell. Enerpac product launches this year will far exceed the total introductions released over the past several years, which is a key to our sustained growth. Engineered Solution also benefit from new product releases in multiple industries, including agriculture, aerospace and industrial applications. We're striving to accelerate the velocity of these launches, but overall, I'm pleased with the steady progress.

Moving over to Slide 13. The macroeconomic factors impacting the end markets continue to remain positive. Oil and gas prices remained generally stable since our last update with oil averaging around $60 a barrel. While it would be obviously like to see a higher price, we're beginning to see CapEx spend-quote activity and believe the resumption of normalized OpEx spend will follow. Off-highway mobile equipment continues to strengthen. The agriculture sector dynamics remained strong, and all major manufacturers in the construction equipment market are reporting improved customer demand in rental fleet utilization. The general industrial market continues to remain active globally and distributors are reporting good retail activity in pricing dynamics. And finally, the European on-highway truck market has remained strong with the latest registrations reflecting a 9% increase in heavy truck sales, while China truck sales have declined between 25% and 30%. The industry should level out at a run rate, which is higher than historical averages.

Turning over to Slide 14. We anticipate the overall core sales to increase to 2% to 4% on a full year basis as compared with prior guidance from 1% to 3%. However, consistent with what we have experienced in the first half of the fiscal year, we are tampering the Industrial core sales growth guidance to reflect lower heavy lift and concrete tensioning sales, and we are modestly increasing the core growth expectations for Engineered Solutions.

Moving on to Slide 15, as we take stock in the performance at the half way point, we have no reason to believe that the sales trends we've experienced will change meaningfully. In addition, we have a moderate tailwind with regard to currency translation. As such, we are updating our total sales guidance now be in the range of $1.140 billion to $1.160 billion. In terms of EPS guidance, we have a number of factors you must take into account. Project cost issues, inflation, growth investments we have experienced in the first half will lessen their severity but will continue to impact our margin on an ongoing basis. To that end, we're adjusting our full year diluted EPS range to $1 to $1.10 per share. Many of you have questions, the ramp of earnings in the back half of the fiscal year, and even with the reductions in profits reflected in the updated guidance, there is definitely a sequential uptick. So let's walk through the factors.

First, we have the leverage of higher volume in several of our higher margin businesses, most notably, Enerpac, which is stronger in the second half. Second, we have the benefit of service excellence and energy restructuring savings, which were weighted to the back half. This accounts for approximately $4 million to $5 million on run rate savings versus the first half. Third, the project overruns and warranty issues will moderate as we go through the years, swing of approximately $3 million less in headwinds in the second half. And fourth, the price increases we have already triggered should provide relief to material cost inflation.

Turning over to the third quarter, we expect sales in the $300 million to $310 million range, with EPS in the $0.33 to $0.38 per share range. Core sales growth is expected to be in the range of 1% to 3% similar to past quarters. Sequentially, core sales rate of change will be lower in Q2 for Industrial, which is entirely related to the heavy lifting business. Energy should see moderating core sales decline as we anniversary the downturn in maintenance. And finally, as we noted in the press release, we are lowering the full year cash flow guidance to approximately $70 million to $75 million with a 100% conversion rate.

In closing, I'm satisfied with the sales traction and the growth we're seeing. We've worked very hard to achieve this and we're not willing to sacrifice sales coverage, reduce investments in new products and the means to offset short-term margin pressures. However, we have implemented off-cycle price increases, driving cost control and actively managing the portfolio to mitigate margin pressures without compromising our strategic plan. I'd also like to take the opportunity to welcome Jeff Schmaling, our new President of our Consolidated Industrial and Energy segment. Jeff and I've known each other for more than 25 years, and I have no doubt Jeff's going to bring a tremendous amount of value in driving our retail distribution, our service operations, in creating one of the best tool companies in the world. So welcome aboard, Jeff.

And with that, I will turn it over to questions. Operator, back to you.

(Operator Instructions) Our first question comes from the line of Ann Duignan from JPMorgan.

Could you talk a little -- in a little bit more detail about, I think you said concrete, agriculture and tools were the 3 business units that will be the most impacted by steel and aluminum prices. Can you talk a little bit more about who the customer is in those businesses, is it that easy just to turn around and say I'm raising my prices? And then can you also talk a little bit about who specifically is the biggest competitor to those businesses and are they U.S. or international? I'm trying to get a sense of, do you run the risk of increasing prices and then your competitor doesn't and they gain market share. So if you could just address those questions for those 3 businesses, I'd appreciate it.

Sure. Try to give you a little more color there. First, just stepping back, when you look at the tariffs and how they impact our business in general, the -- keep in mind, first of all, the majority of our revenue comes from foreign operations, and we typically manufacture where we sell or assemble where we sell. So as we -- as I indicated, we've got U.S. entities that -- or businesses that will have pressure from the tariffs. We mentioned the concrete tensioning business, that is raw material being sourced, and so -- and it's being sourced overseas, and so that will be subject to tariffs. However, we are, as I mentioned, actively pursuing exemptions for some of the categories of steel, particularly, specialty steel. In this case, for tensioning, that would be applicable. So our estimate of the impact doesn't assume we get any of those exemptions, and so kind of a full impact is in that worse case $5 million estimate that we gave. When you look at -- now obviously, that we have competitors to the -- within the tensioning business, but without getting into -- I can't speak for what they're doing and what that impact might be, but for all of these, there may be competitive pressures that certainly if there is an overseas competitor that's not subject to the tariff. When you look at the rest of our business, really outsourcing direct, while steel for those businesses -- what we'll estimate here is the impact of steel purchases that we make for value-added product that may be -- where the raw steel may be purchased from someone outside of the U.S. So that's more flow-through estimated cost increases. Now there, obviously, we're estimating just based on our sourcing and based on volume and what we know about their purchases and sources, and that would account for the balance of that estimated $5 million. Obviously, from an -- if you get into agriculture, that's going to be more OE, and as we mentioned about price, those would be layered in on time to -- over time to offset them, and clearly, we have competitors in the ag space as well. Industrial, to a much lesser extent, just keeping in mind, most of those are sourced or component type purchases, and when you look at the balance of our activity, it will impact that business far less than the other, in fact, it's an insignificant impact of our $5 million in terms of its inclusion. So that's what I can tell you about tariffs. Hopefully, that gives you enough color.

Not quite, you didn't answer my question on who specifically is your key competitor for each of those businesses.

Well, we won't get into that detail. We typically don't comment specifically about customers in each business.

Not customer, competitor.

Competitor. I mean, Ann, when you look at some of those businesses, there's many and they're small and they're niche players.

And are they primarily U.S.-based? Or are they international?

Spread out across the board.

Okay. And the $5 million, is that after tax or before tax?

That's before tax as worse case.

And I just want to clarify, I'm sorry, that I'm pushing on this. But I just want to clarify that, that $5 million includes what you anticipate might be price increases that you received from component suppliers who have steel in their components. Is that correct or doesn't it?

That is. It does include that as well. And again, I just want to stress that's our initial estimate. There are lot of actions that we're taking. We fully believe we'll be able to minimize that $5 million. But that's a worst case, no actions on our part what we see as the potential impact.

And our next question comes from the line of Jeff Hammond from KeyBanc Capital Markets.

So, Randy, just on these kind of overruns and execution issues, it just seems like a lot of these things are lingering in. I just kind of want to get a sense from you for, I mean I guess, your patience around kind of getting these done and the risk that some of this falls into fiscal '19?

Well, as far as the -- my patience factor went off about 3 quarters ago on that topic, relative to the impact on our first half of the year, absent those issues, particularly, of accepting some contracts that we shouldn't have and then overrunning the cost of those particular contracts had a significant impact to the Industrial business. And so what we do about it? First of all, we change out the entire management team. Secondly, we've implemented restructuring project in our Dutch operations, which you can imagine, is difficult given the localized law in Holland to make those changes in that business. So the outcome is going to be a business that's -- it's focused on our standard product ranges in gantry heavy lifting applications, strand jack applications and things that we know that are good margin, very unique products in the industry that we can make money at. We're basically through creating any specialized projects that have the potential to damage the business going forward.

Okay. And then on Hydratight, can you just talk about any signs of that business inflecting. I mean, we're hearing a little bit better commentary about turnaround activity. And just as you think about some of the structural dynamics in that business, do you feel like that the rate of, I guess, turnaround activity and actions that the people are taking are impaired kind of longer term at all?

So if you look around the world, where we see positive results, is in our Mid East and Asia Pacific operations. Both businesses are doing much better. The Middle East operations are getting better bookings and they're also getting -- their profitability is getting up to a more reasonable level. They're making their forecast. And Asia Pacific, we've landed one very nice project that's helping us. And so that'll come in over the next couple of quarters and into '19, but it's a nice beachhead in Malaysia that we didn't have before. Where we still have cost issues and low profitability is particularly in the U.S. operations. And Jeff and the team have already implemented some restructuring actions. We're taking major cost out of the U.S. We're focusing that business in to areas we haven't had a lot of focus, which is selling tools. We have a nice distribution center, so that we want to increase our tool sales from those locations. We want to improve our rental operations in those locations, and we want to do high-quality service, which typically is more complex than what we've done in the past. And so we have a good pathway to get the U.S. operations profitable. North Sea is seeing some activity, I think that's improving sequentially, but still a long way before it's going to be back on its feet totally. But generally speaking, I think we've got a glide path now on Hydratight. It is going to sequentially improve.

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

I want to go back to the guidance. If I look at the midpoints, essentially, it looks to me like the fourth quarter earnings are guided to be a little bit higher than the third quarter. This is obviously unusual versus what we normally see. So I guess I'm trying to understand, in terms of the swings that you mentioned earlier, how are you thinking about this cost swing third versus the fourth quarter? Is fourth quarter more relying on pricing acceleration or is it more savings driven? And maybe you can also help us think through these dynamics at segment level because it's, at least for me, it's getting kind of hard to see how this flows through for your business.

Yes, sure. I'll start off and then Rick can chime in on the rest of it. So if you look sequentially at our quarters and how we took restructuring actions, particularly. A lot of those costs hit us quarter 1 and quarter 2. We started feeling some of the positive effects of those actions in the very end of our second quarter. As we get into the third and fourth, by the fourth quarter, we should have full effect of our restructuring and cost outs of the business. Secondly, the pricing is in the similar arrangement where we will see the pricing benefits flowing through. And then third, which I think is something that I don't want to downplay is that the elimination of bad projects that have cost us a lot of money. So if you go back to what I just said in our commentary, that's a $3 million headwind that's going away on our third and fourth quarter, which is going to positively affect us. So if you line up everything we have -- it's cost-outs, pricing actions, elimination of cost issues that should not recur and then improving our manufacturing operations, then there's a pathway to get there. But clearly, as I said in my commentary, there is a sequential uptick in the third and fourth quarter.

So just a little more details on the restructuring. When you think about the Energy or Hydratight restructuring, keep in mind, we began that in the fourth quarter of last year. And the actions we're talking about now are really that Phase 2 we described last year. And those savings, while we've seen savings that Randy talked about, really from those fourth quarter actions, those savings are the ones that will start to kick-in in the back half, particularly in Q4, so that Phase 2 of restructuring. And then also, the heavy lift and the PHI, well, concrete tensioning restructuring that we talk about, those will all be full bore come Q4. So there is definitely a lift in Q4 profitability and top line even from an Energy perspective when you compare it to last year's fourth quarter Energy, which was the low point.

Okay, right. But if I look at ES, for instance, your guidance on the top line implies that the business will contract in the back half, maybe a little more in the fourth quarter, just given the nature of the comps. Can you deliver a flat to up margin in this segment? And is that required to get to your guidance?

Well, the top line, we're saying it'll be up, but low single digits. And that's really on -- that the comps in the back half. With that and the warranty issues behind us through pricing kicking in, yes, we do think we can deliver the margins and the guidance.

Our next question comes from the line of Scott Graham from BMO Capital Markets.

And not to sort of blow up the well here, but I was just maybe hoping you can give us a little bit more granularity on some of the things that you're expecting to be better in the second half, but specifically around warranty, around mix as well as these operating efficiencies that just seem to pop up from time to time. Maybe just a little bit more on those 3 items. And essentially, have you circled it, ring-fenced it and kind of what are you doing to make sure that those are non-factors in the second half or close enough to that?

Sure. Starting with mix, I guess when you look at ES, and it's part of that back half margin expectation for ES. That mix will likely stay as you got a 25% reduction in China volume. And so there is definitely a mix impact there that's in our guidance for the back half. I think the warranty issues we discussed, that was related to a specific situation with one of our customers in the front half -- and that issue is completely behind us, impacting -- largely impacted Q2. And so that's a onetime -- a true onetime warranty hit that is not in the back half forecast. I think those 2 combined from an ES perspective as well as the pricing are -- that the big things that plagued us -- the mix and the warranties is what plagued us in Q2 or even in the front half. The mix stays, the warranty goes away. Operating efficiencies -- so that -- we really talked about that in terms of the heavy lift precision or concrete tensioning. Those inefficiencies will abate, but the -- kind of be that less worse concept as we talked about. The share loss in tensioning will continue, as we said, will continue to impact us but to a lesser extent. And then the heavy lift, we've got continued pressure in the back. With the volume that we're seeing, we do see and we did early on have inefficiencies associated with the ramp up to deliver those high volumes that includes freight over time, things like that. We expect those to be better in the back half, but to continue to see those issues. So you take all those factors in place plus a benefit of pricing and I've kind of gone through them here all over, but that's -- those are the impacts, the one-timers that we saw in Q2 in the front half that we -- and our expectations for the back half.

Rick, that's really, really helpful. So my follow-up question is, kind of more with you, Randy. I know that one of your big thrusts early on was to go visit the facilities and what have you and you kept telling us that the number of facilities that you considered world-class or in that territory on their way to there, continued to increase through like last quarter. Can you kind of tell us where you are if you had to rate them? It seems like we get a lot of progress this quarter, and please tell me if I'm wrong on that, the idea here obviously is not only to improve the margins, but also to kind of -- as it came down all 4 corners of the canvas, so that things don't keep springing up. So could you give us an update to that end?

Yes. Of the 24 plants that I've talked about at Investor Day and a lot of our meetings in prior calls, when we started out, we really only had 3 that would score in a category that you'd classify it as a B student on a lean manufacturing scale. Today, we have about 8 or 9, that are now classifying into an AB category. So we've made progress there. The next phase of getting plants cleaned up, we have probably 3 to 4 that we'd still classify as either a D or F category plant. One of them, in particular, we've got a team of people on it right now because they're seeing significant increases in volume, that if we can get it cleaned up quickly, it's going to have a nice margin impact for us because it did have significant margin drag for our ES business in the first half of the year. That manufacturing inefficiency is going to start going away. Most of that was related to, not necessarily laid out of the factory in the throughput of product because we've completely changed the flow of the product. But what we haven't gotten our teams fully implemented yet is how you schedule planned material so that you can build product quickly and you can get it out the back door and invoice it. So we find that we're getting a higher degree of back orders. And quite honestly, we've set very high targets in reference to our turn ratios, and I think in some cases, we've taken our inventory down faster than we're capable of handling because of the way that plant was set up. That's about $100 million plant. We got to get it cleaned up. It's going to happen before we exit our third and fourth quarter. And the remaining ones, there are several projects around the world to really improve efficiency. But -- and largely on a lean manufacturing process, we've made a lot of progress in the last year and a half. The next phase is to really get our supply chain operations functioning at a level where I'm happy, and that means we're training people because there were very few that had ever been trained in true supply chain operations and so that's happening now as well. So we're still working it. That's all I can say, and we know that there is a lot of margin being left on the shop floor still.

Our next question comes from the line of Josh Pokrzywinski from Wolfe Research.

Just on the Industrial margin cadence in the second half, can you help us, Randy or Rick, on how 3Q versus 4Q should lay out? I know it's a bit more color than you normally give. But just given kind of the pace of overall EPS 3Q to 4Q, it seems like Industrial margins need to be a big component of that snapback. Could you just kind of size us on how we bridge from this kind of 18-ish number today to something a little bit healthier in the second half?

What I think broadly here, we're saying Q3, Q4 up and then maybe up on less HLT noise, tools kind of continuing a little bit of increase there and then maybe, again, a small step in the Q4. I think it's more of elimination of the HLT noise and some tools growth in the back half.

Okay. So, really, the overall earnings step up into the fourth quarter needs to come, I guess, disproportionately from margins elsewhere in the business if we're not going to see another big step up in the fourth quarter in Industrial. Because overall EPS is just a little higher seasonally than I would have thought in the fourth quarter, and I get that maybe tax is some of that, but it does seem like it's a little lopsided and if Industrial is not incrementally contributing, it seems like that's (inaudible) function?

Sure, Industrial is up, and so it is contributing. We also have the Energy piece, which will -- certainly will -- to last year and sequentially will improve. And so that's higher-margin impact as well. So I think those combined, will all drive that Q3, Q4. I think it's important, Industrial is up, so it will contribute, and let's not lose fact -- sight of Energy's up versus, unfortunately, a horrific Q4 last year.

And our next question comes from the line of Charlie Brady from SunTrust Robinson Humphrey.

This is actually Patrick Wu signing in for Charlie. If I -- Randy, if I heard you correctly earlier, you mentioned that the pricing increases for Industrial tools have already gone into play. Can we just talk about sort of how the market is receiving that at the moment? And then in terms of offsetting the inflation, you guys called out the $5 million. Price is going to offset most of that, I think you mentioned. What about the other call-outs that you guys have mentioned on the freight costs and the wage inflation and things like that? Can we add a little bit more color on those items as well?

Yes, so I'll cover the price actions. So we've accelerated price actions throughout the, particularly, Enerpac and other businesses within Industrial. In those types of businesses, that is distribution related, you can bring them forward. Now, there were scheduled prices that would normally hit in June, so we've just accelerated them. Our dealers understand that we have significant material cost increases, so they're not seeing tremendous pushback yet from either dealer or retail activity. We're watching the retail activity closely because we don't want to let pricing impact our overall share progression. But it's something you have to balance. The pricing elasticity in the market right now appears to be pretty good. And so the price realization that we baked into our full year guidance is taking that into account. And it will help us on not only margins in the back half but also certainly the top line volume is there as well. So for the Industrial business, that's where the primary price actions are taken. Now contractually, in the ES business, you have contractual agreements with OEMs that have trigger points based on producers price indexes and other indices. And how those layer in, we have to go contract by contract and then negotiate those price increases. And I think most of our suppliers understand that as well. So we're pushing back where we can. And so we push back our own cost increases and when we try hard to make sure we pass through what we can to the OEMs we deal with. So it's not an easy story, but pricing elasticity is not bad at the moment given the market is moving up.

Okay. I guess, the second half of my question, where I asked about pricing offsetting inflation. And that's just strictly the $5 million that you guys called out related to steel and aluminum, right?

Yes, that's material pricing alone, but what we look at freight over time and all wage increases as well, so that's what our scheduled price increases do anyway is try to make sure that we're capturing that -- those cost increases in our pricing. The second thing that we do as a course of operation, part of our lean process on the quality cost delivery safety metrics, is our cost metric. So we're trying to drive everything from material savings, technical savings and operational efficiency savings, that also helps us offset those costs. I can say we're not particularly good at that yet. But that's one of the things Rick and I are pushing really hard to get this company where we are good at it.

So just to be sure, pricing is -- overall, pricing is not just aimed at the estimated impact of cash, and those tariffs that impact -- that they ran over the Q3 and Q4, so the pricing actions we're talking about are all of the pressures. And really these are actions that were in place based on inflationary activity before the tariffs were even implemented.

Our next question comes from the line of Seth Weber from RBC Capital Markets.

Just -- first, just a couple of clarifications. Rick, did you say that the Industrial margins are up year-over-year? Or is that sequentially versus the second quarter when you're talking about the back half?

It's both, actually, and certainly sequentially. Up modestly year-over-year, but up nonetheless.

Okay. And then, I think what I heard you say was the warranty cost for ES was -- it's a $3 million flip basically from second half versus first half, is that right?

No. That was all of the issues between -- for HLT and warranty, that's the flip first half versus second half, not -- certainly not $3 million of warranty for ES.

Okay, so warranty was more like $1 million, because I think you said heavy lift was $2 million. I'm just trying to get my numbers squared up here, was the warranty...

Yes, roughly, kind of the all other bucket amounts to about $1 million.

Okay. That's helpful. Thank you. And then my question is really on the Industrial, on the core tool incremental margin. I think you said it was 20%. What I'm trying to just make sure I'm understanding is that it sounds like you're pulling back on some of the growth investments, I think you said it was $2 million in the quarter. But what I'm trying to understand is, are the new products that you're coming out with, the new initiatives, are they coming out at a lower margin initially or are there kind of startup costs associated with these new products that are structurally lower weighing on your incremental margins? And I guess, do you expect incremental margins to kind of snap back to that 30% to 40% range for the core Industrial business?

So let me try to address, when you start doing product development after essentially a total standstill in a company, where you had very, very little investment in new product development. And as I said in my commentary, what we will launch this year will exceed the combined total launches over the past several years. And so question one you had is what about margins and how will the new products come in on online average? We have targeted margins that are, in my opinion, world-class in the Enerpac tool company. We're trying to bring in all our new product introductions at that range, and we've been able to accomplish that. But what -- where we spend money on launching products during the year, is you've got to get (inaudible) units out, you've got to get training materials out, you have to seed the inventory into the channel and you have to train the channel and get them excited about selling it. That doesn't happen for free. And so as I said, that is one of the most important capital allocation decisions I think I can make is investing in ourselves to drive one of the best tool companies on this planet. We know the kind of margins this company drives, every incremental tool that I can put into the catalog will expand what we do for our distribution. I am so committed that, that is the right direction. So as Rick said, absent the investments and what we've made in that business, we were in the 20s on incremental margins on a year-to-date basis for our tool company. Going forward, as we anniversary the baseline of our investments, you'll see an incremental margin between 35 and 40. And that's what I've been very consistent about the days of having a 65% incremental margin is not indicative of a company that's investing in itself. It's a company that's milking a business unit for cash and not investing in the future. And my very strong opinion on this and where we're driving this company is to invest in our tool business and drive that to another level. And that's going to take product development. Now we've whipped our sales force into shape, we're capturing share. But I got to give these dealers and sales guys on the ground something new to sell next quarter or that'll level out. So that's why it's so important to keep that going.

So just to pile on and be clear here. The incremental margins that you see in that 20% range are not the result of launching new product at a less than run rate margin for tools. It is reflective of the investments, as Randy pointed out, little bit of inflation, but we're not launching products that are diluting the margin in any way. I think more importantly, that the products have to get out there and have to take traction. And that's why Randy talks about going forward next year, you'll see normal incrementals as we go forward and we kind of anniversary these investments, but not diluting the margins for standard tools by new products.

Our next question comes from the line of Justin Bergner from Gabelli & Company.

A few quick clarification questions. The $5 million in costs that you highlighted for the Industrial segment, the $2 million, the $2 million and the $1 million has been sort of headwinds that will dissipate. Should we expect all those $5 million in costs to dissipate in coming quarters and perhaps by Q4, if not by Q3?

No, we talked about -- there should be less than they are today, but the $5 million is comprised of the tensioning business and that was about $1 million, the heavy lift was about $2 million. Those 2 and specifically, we said will continue -- will continue to have those pressures, but there will be less than that $3 million you saw in Q2, specifically. And then we just talked about the $2 million of SAE. And while you'll see less investment in the back half, you'll still see some investments. So to answer your question, no, they don't completely go away. It's just less spending on it and fewer losses in the back half.

Okay. And then the $4 million to $5 million of restructuring savings run rate in the second half versus the first half, just to understand that, does that mean you're going to have a $4 million to $5 million benefit in the second half versus the first half or in each quarter of the second half versus the first half?

Two things, the $4 million to $5 million was the entire service excellence and some of the restructuring activities that we did for Hydratight. So just want to clarify it's not just restructuring. And it's the back half, front half benefit and the $4 million to $5 million is really more a run rate level savings than what you're going to see in Q -- the restructuring piece will be muted because it's not the full run rate of the savings, the service excellence will be the full bore in Q4 primarily.

(Operator Instructions) Our next question is a follow-up question from the line of Mig Dobre from Baird.

Randy, just in your prepared remarks, you were talking about focusing your investment in your higher-margin business. I don't want to read too much into it, but are you implying here that there are a portion of your business that maybe get a little bit less attention or a lot going forward, can we be looking at additional portfolio adjustments down the line?

The answer is yes. If you recall from the Investor Day, we've targeted around $100 million in businesses that arguably where we were improving, but from a strategic standpoint, they didn't fit, that we intended to explore all options to move them out of the portfolio and do what we could do. And then redeploy those dollars into great businesses. That's what that means. Plain and simple is that we have to get this portfolio to a world-class level in terms of margins. And that's going to take some cleanup on the portfolio. And it's what we discussed in October and we are accelerating that now.

I mean, where are you in the process, what sort of inning are you in conducting these evaluation -- these evaluations.

I'd say we're in late innings in the process of evaluation. We know exactly what we need to do. The process of beginning to action that and explore the alternatives, I'd say, we're in the first couple of innings.

And our next question is also a follow-up question from the line of Scott Graham from BMO Capital Markets.

So Randy, has there been any thought given to -- we seem to be spending money to drive sales, but not really having the funding to spend that money, yet still drive the margins. So -- and I know you're peeling back some of your spending in the second half of the year. I guess, my questions are; a, are you peeling that back just to make sure you make the numbers; and b, what can we view on the ongoing -- not restructuring, none of the onetime stuff, but what do we do in the factories that we really need to push up their quality, let's put it that way. What can we do in those factories to get productivity going to fund the expenses?

Yes, so let me deal with the investing part first, particularly in 2 areas. Area one is in our tool companies. And so we had to completely reconfigure and recruit an engineering staff. As I've discussed in other meetings with our investors is that, when I came there were no chief engineers of any tool platform within the business. And so we had to do recruiting to get, number one, structure, in place. We had to get some processes in place. And then we had to get a pipeline of what those tools look like. So now that we've made those investments and I can tell you that, that total investment on the scale of its return is quite small. Now what my commentary was referencing is that we're going to hold that level of investment at a static level until we start getting the remaining products launch this year. And then we'll go back at it again, once we've established, okay, this is an appropriate level, we're getting the number of projects we want and we're being successful in the marketplace. On the manufacturing side, what can we do there? So we've cleaned up these factories, and we've got some of the efficiency cleaned up, we've got the quality better, we've got the delivery better. In fact, most of our OTD rates and quality rates have gone to best-in-class, and that's why we've recaptured a lot of our OEMs that have walked away from us. Where we really have a lot of work left to do is on the cost side. And that falls directly on our ability to schedule our labor appropriately and cycle material to those either machines sales or assembly sales and do it well. And when you don't schedule right, what do you get? You get 60% labor efficiency. And I can tell you there's a lot of our factories left that only have 60% labor efficiency, which means we're leaving money on the shop floor. So that's the big thrust between now and the end of the year. We've gotten our customers happy. We're getting their business back. Now we've got to be a quality supplier and deliver the types of margins we need to get to be successful. And so that's the game plan right now. And I can tell you of all the businesses I've run in my career, this has been one of the most difficult turnarounds on the factory floor.

Right. But are you talking about getting to that equilibrium where you can gainfully spend and the sales are obviously showing that, that's working, but how do you...

Yes, it's a tail of different...

... respond to that spending through productivity -- ongoing productivity, not restructuring. Are you getting to that sort of point? Or is that maybe not in the plan?

Well, some of the businesses, I'd say, we're seeing the ability to outgrow the market, which helps us fund what you're describing. And then you get a compounded effect, where when the plant starts really performing, well, I can tell you that the Columbus operations, which is our primary Enerpac tool plant, when we started, that was not a well-run facility. They have just achieved an A rating in terms of quality, cost, delivery and safety. They have some of the best safety records that we've gotten in years. We've gotten our OTD rate well above the 95% level. Our quality rate now is the manufacturing levels that would be acceptable in the auto industry, which is a DPPM rate of less than 500. It's all the things that we should be delivering if we're going to be a world-class tool company, and that's helping us be a more responsive supplier. What's left to do at Columbus and with the Enerpac team is to better forecast on material demand and getting our supply chain cleaned up, so that we don't have to put inventory in to be a world-class supplier. Now that's still some heavy lifting that will generate additional money, and particularly, cash flow for us. So we've got couple of million dollars of excess inventory pinned up in our Enerpac business. But as I've said, when you have the kind of margins we do, I'd rather have it on the shelf and not if it can get you an order. So we've -- Jeff and I are working through how to make that happen.

And our next question is a follow-up question from the line of Justin Bergner from Gabelli & Co.

On the Enerpac side, are you seeing a better outlook for the fiscal year than you saw 3 months ago? I know you mentioned the concrete tensioning and heavy lifting have a more subdued outlook. But with the sort of good end market and macro data, are you seeing an improved outlook for Enerpac at this point?

So the tool side, I'd say, it's slightly better than what we had planned. We've seen some nice high single-digit, double-digit growth in the tool side. And if you've looked at a lot of the latest report, particularly, Cleveland Research, the vertical markets are in the best place they've been in a long, long time. So what we're really feeling is the confidence that the -- our tool companies -- it will continue to grow at the rates that we have. And then as we start launching more and more new products in our third and fourth quarter, that's going to help us as well. But I think that the core sales growth that's associated with tools is pretty well pegged where it needs to be with some slight upside.

Operator, let's just take one more. We're over the hour. So last question.

Certainly, the last question is from the line of Stanley Elliott from Stifel.

Quick question on the dual brand strategy on the tools, within this quarter, did kind of the second tier brand have also 20% sort of incrementals. And then when we think about some of the costs kind of out of the equation, that we're looking at incrementals for that particular segment of the tool business being north of 30% as well?

Yes, the 2 sub-brands that we have which are at second-tier price points and second-tier of technical is in the Larzep business and our Simplex business. And we've seen some nice growth there. We're dealing with some issues with some of our regional markets of distribution -- getting distribution set up quickly enough. And in North America, we had one area, in particular, that kind of muted our growth. But overall, it's doing better. The thing I like about this business, it has line average margins very similar to the standard product in Enerpac. So by taking technical content out, and it's the way it was designed, that you're not giving up margin as a means of grabbing market share, which is what we didn't want to do. We didn't want to cannibalize the top-tier product with the second-tier product range, and it still appears to be working.

And I'll turn the call back over to you.

Thanks. Well, thanks, everyone, for joining our call today. I'll be around all day to take any follow-up questions you have. Please mark your calendars now for June 20, that will be our third quarter earnings call date. Have a great day.

Thank you, ladies and gentlemen. That does conclude the conference call for today. We thank you for your participation. And we ask that you please disconnect your lines.