Enpro Inc (NPO) 2014 Q3 法說會逐字稿

Good morning. My name is Stephanie, and I will be your conference operator today. At this time, I would like to welcome everyone to the EnPro Industries' Third Quarter 2014 Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question-and-answer session. (Operator Instructions) Thank you.

Dan Grgurich, Director of Investor Relations and Corporate Communications, you may begin your conference.

Thank you, Stephanie. Good morning and welcome to EnPro Industries quarterly earnings conference call. I'll remind you that our call is being webcast at enproindustries.com, where you can find the slides accompanying the call.

Steve Macadam, our President and CEO and Alex Pease, Senior Vice President and CFO will begin their review of our third quarter performance and our outlook in a moment.

But before we begin, I will point out that you may hear statements during the course of this call that express belief, expectation or intention as well as those that are not historical fact. These statements are forward-looking and involve a number of risks and uncertainties that may cause actual events and results to differ materially from such forward-looking statements. These risks and uncertainties are referenced in the Safe Harbor statement included in our press release and are described in more detail along with other risks and uncertainties in our filings with the SEC, including the Form 10-K for the year ended December 31, 2013 and the Form 10-Q for the quarter ended June 30, 2014.

We do not undertake to update any forward-looking statements made on this conference call to reflect any change in management's expectations or any change in assumptions or circumstances on which such statements are based.

You should also note that EnPro owns a number of direct and indirect subsidiaries. From time-to-time, we may refer collectively to EnPro and one or more of its subsidiaries as we, or to the businesses, assets, debts or affairs of EnPro or a subsidiary as ours. These and similar references are for convenience only and should not be construed to change the fact that EnPro and each subsidiary is an independent entity, with separate management, operations, obligations and affairs.

I want to remind you that our financial results reflect the deconsolidation beginning on June 5, 2010 of Garlock Sealing Technologies LLC, Garrison Litigation Management and their subsidiaries, which we refer to as GST. The results of these entities will remain deconsolidated during the pendency of the Chapter 11 legal proceedings to resolve asbestos claims against GST. We refer to this as the Asbestos Claims Resolution Process or ACRP and you may hear us use that acronym during the call today.

In addition to a discussion of EnPro's GAAP financial results, we will also discuss pro forma financial information. This information illustrates the pro forma effect of the re-consolidation of GST based on the terms specified in GST's amended proposed plan of reorganization, which was filed with the bankruptcy court on May 29, 2014. However, formal reconsolidation could not occur until our plans for GST's reorganization has been confirmed and completed and GTS has exited the Chapter 11 process. Any pro forma information that we discuss on the call today is derived from the condensed pro forma financial statements included in our earnings release.

These pro forma financial statements are provided for informational purposes only and are based on estimates and assumptions made solely for the purpose of developing these pro forma financial statements. They are not necessarily indicative of what the consolidated company's financial position or results of operations actually would have been had the reconsolidation been completed as of the dates indicated, nor they necessarily indicative of the future operating results or financial position of the consolidated company. Therefore, the actual amounts recorded at the date the reconsolidation occurs may differ from the information presented in the earnings release or discussed on this call.

Please refer to our earnings release for information about how the pro forma financial statements were prepared as well as the risks and uncertainties related to the confirmation and completion of the amended plan of reorganization.

And now I'll turn the call over to Steve.

Thanks, Dan, and good morning everyone. I'm pleased to report a strong improvement in our overall operating performance compared to the third quarter of 2013.

Net sales increased by 10% over the third quarter of last year. Power Systems in particular made a substantial contribution to the increase, largely due to the return of parts and service demand following the effects of sequestration and the Navy's maintenance cycle, which affected last year in the first part of 2014.

Activity in our semiconductor, nuclear power, aerospace and heavy-duty truck markets remain robust and activity in automotive and industrial markets in Europe and Asia improved from last year. We continue to see headwinds in the pipeline project activity and in the Western Canada natural gas market, and in our refinery and petrochemical fall season turnaround business, it was slow in both Europe and North America.

Segment profit increased by 31% to $38.6 million and segment margins increased to 12.8% compared to 10.7% in the third quarter of 2013, largely due to volume, price and operational improvements, primarily driven by the results in Power Systems and Engineered Products. This improvement came even though growth related spending added about $2.3 million in costs in the quarter compared to the third quarter of 2013. This spending includes R&D investment related to the new version of the opposed-piston engine at Power Systems and implementation costs at the share distribution center for heavy-duty truck parts business at Stemco.

Consolidated GAAP net income of $8.6 million, or $0.33 a share rose 54% in the third quarter compared to the third quarter of 2013. Adjusted net income of $17.6 million, or $0.75 a share increased 35% from the same period last year.

The deconsolidated operations of GST reported fairly flat third party sales compared to last year. GST's adjusted net income of $7.3 million was down from $9.2 million in the third quarter of 2013, primarily due to the conclusion of two customer programs and some increased spending on growth initiatives.

Pro forma sales illustrating our results as if GST was reconsolidated were up 8% to $348.9 million for the quarter and pro forma adjusted EBITDA was up 6% to $55.6 million. These numbers are based on the assumptions noted on the pro forma consolidated financials attached to the earnings release.

In addition to these operational initiatives, we made significant changes to our capital structure in the third quarter by upgrading our revolving credit facility, increasing both its size and moving from an asset base to a cash flow structure. We completed a $300 million 5.875% senior debt offering. And we completed the tender offer that reduced the outstanding principal amount of convertible debentures from $74.8 million to $23.4 million in anticipation of their maturity next year.

Since our diluted share count includes implied shares payable to convertible debt holders. The reduction in the number of outstanding convertible debentures can essentially be viewed as nearly a three quarters of a million share repurchase.

Last, I want to give you an update on the Asbestos Claims Resolution Process. And an important decision in July, U.S. District Court Judge Max Cogburn ruled that key testimony and documents should have been made available to the public at GST's estimation trial. Then two weeks ago, Judge Hodges followed the suit and ordered that the public, including the media and other defendants and insurers is entitled to broad access to the record from the trial. As a result, the testimony and documents that led Judge Hodges to rule in Garlock's favor on estimation will be available for all to see as soon as they're redacted to remove protected personal information such as social security numbers, names of minors and medical information, other than the disease diagnosis.

Garlock had pushed for disclosure prior to that and that's the trial. And we believe this is a significant victory for both the public and the judicial process in general. Judge Hodges also said, September 30 of this year 2014 as the bar date for filing claims by asbestos players alleging, they entered into enforceable settlement agreements with Garlock, prior to the petition date of the ACRP.

Garlock had previously given notice that it would dispute the validity of any settlement agreements with claimants represented by the law firms who are the subject of Garlock fraud suits and some other firms, because of such alleged -- because any such alleged settlements were infected by the discovery abuses described in Judge Hodges estimation opinion.

The law firms in question did not file claims by the bar date, possibly because they did not want to open their conduct related to such claims to discovery.

Next up for November and December will be hearings on the claimant committees motion to reopen the estimation trial, approval of Garlock's disclosure statement related to its proposed Chapter 11 plan of reorganization and Garlock's motion for the appointment of a fee examiner. In addition, there will be renewed activity in GST's five fraud suits pending against pioneered firms, including commencement of formal discovery. Those losses suits have recently been assigned to Senior U.S. District Judge Graham Mullen. We are pleased with the continued progress in GST's case and we're grateful for your patience as we continue to grind through that process.

Now, I'll turn the call over to Alex, to review our results in the third quarter.

Thanks, Steve. As Steve mentioned on a GAAP basis, our third quarter sales of $302.6 million were up about 10% from the same period of 2013, led by a significant increase in revenue of Power Systems as the parts and service business for the government return.

By geography, we saw strong organic growth of about 6% in Europe, driven by improvements in demand for our high-performance seals, bearings and compressor products partially offset by softer demand in Germany and the UK for our industrial seals.

Organic growth was mixed in North America with solid improvement in our aerospace, heavy-duty truck and bearings market. And our refinery and petrochemical markets in North America have been slower than expected as some of the normal maintenance activities are associated with the turnaround season have been delayed.

For the quarter, gross profits were $14.1 million or 15% higher than in the third quarter of 2013 and gross profit margins increased to 35.1% from 33.4%. Favorable volume and a stronger mix of higher margin parts and service revenues of Power Systems were the key contributors to the margin improvement.

SG&A expenses in the third quarter were about flat as a percent of sales compared to the third quarter of last year. However, spending was up $6 million due to the $2.5 million increase in corporate costs and an increase of $3.5 million spread across our operations. The increase in corporate costs was attributed to higher employee medical costs and employee compensation and benefits.

Operating SG&A increases largely reflect investments in ERP systems, research and development and added manpower as we work to build the stronger platform for our growth.

Before I get into the performance of our operations by segment. I want to refer you to the slide showing the series of events that have impacted our results in the quarter year-to-date, particularly as we compare performance on a year-over-year basis. We have discussed many of these items in prior calls, so I won't take the time to cover them again. But some of you have asked for such as table to help estimate the impact of these items.

As you can see our 2014 results have been unfavorably affected compared to 2013, by items such as the Stemco distribution center implementation, higher R&D investments and some higher than normal cost for severance and bad debt reserves. We also show that year-to-date September 2013 benefited from an earn out credit and an R&D tax credit that did not recur so far this year.

In total, these items impacted the year-over-year comp in our segment profits unfavorably by $3.5 million for the quarter and $11.7 million year-to-date. I hope this table provides some clarity to our communication of significant impact as we have mentioned during our quarterly calls.

Now let's take a look at the performance of our operations by segments. Sales in the Sealing Products segment were $168.9 million in the third quarter, up 7% over the third quarter of 2013. The organic increase was about 6%. Foreign exchange in two small acquisitions added a total of 1% to the segment sales. Sealing Products segment profits were down $1.2 million from a year ago to $23 million and margins dropped to 13.6% from 15.3%.

The largest drivers of the change in segment profits and margins are mix shift to OEM sales and higher operating and SG&A costs. The increase in operating costs includes approximately $1 million associated with the implementing of the Stemco distribution center and other discrete items. SG&A increased as we added the sales and engineering staff needed to support our growth initiatives and ongoing IT projects. Within the segment, Technetics benefited from stronger demand in semiconductor, aerospace and industrial sealings market, while at Stemco, demand from OEMs for wheel-end and suspension products improved.

The Garlock family of companies reported softness in oil and gas and process manufacturing markets in Europe, as well as weaker demand for pipeline products. Demand for the pipeline products is largely related to new oil and gas pipeline construction and water infrastructure projects, both of which have been soft primarily in the Middle East and Europe.

In the Engineered Products segment, third quarter sales of $88.1 million, or 5% higher than last year's third quarter. On an organic basis, excluding foreign exchange, sales were up 4%. Segment profits more than doubled to $6 million (Technical Difficulty) partially offset by declines in Canada. Our business turnaround efforts are starting to result in modest improvement at CPI. Their margins grew due to cost improvement initiatives and lower restructuring expenses compared to last year's third quarter.

In the Power Systems segment, sales were $46.5 million, a $11.6 million or 33% higher than in the third quarter of 2013. Engine revenues were lower by about $2 million, but parts and service sales increased as the segment benefited from U.S. Navy ship overhauls and higher demand from power generation customers.

Margins in the segment tripled to 20.6% as the higher volume and mix of parts sales, plus the benefit of manufacturing improvements more than offset higher SG&A expense primarily related to the development of the OP 2.0 engine. Work on the OP 2.0 engine increased in the segment by about $1.3 million compared to the third quarter of 2013.

As Steve mentioned, we reported GAAP net income of $8.6 million, or $0.33 a share for the quarter. This compared to GAAP net income of $5.6 million, or $0.23 a share in the third quarter of last year. After excluding restructuring cost, loss on the exchange of debt, interest expense and royalties with GST and other selected items, we earned $17.6 million compared to $13 million a year ago. On a per share basis, adjusted net income was $0.75 in the third quarter of this year compared to $0.59 in the third quarter of last year.

For the first time we have adjusted our diluted earnings per share number for the unrealized benefit of a call option, which is part of the hedge purchased in October 2005 to reduce the potential dilution to our common shareholders from the conversion of the convertible debentures.

For accounting purposes the warrant piece of the hedge is included, but the anti-dilutive call is not. The hedge which is on the original $172.5 million amount of the convertible debentures will expire and the corresponding benefit will be realized in October 2015, this adjustment is about 2.6 million shares. This leads to a normalized share count of 23.5 million shares, which adds about $0.07 this year and $0.06 in 2013, assuming the third quarter's average price per share of $67.50. For the fourth quarter, we continue to use 23.5 million shares as our normalized adjusted share count.

Cash flow for the nine months ended September 30, 2014 was $134 million compared to $21.2 million in the same period of 2013. This increase is primarily the result net proceeds from EnPro's newly issued 5.875% senior notes. Financing activities provided $176.9 million of cash for the first nine months of 2014, after giving effect to the purchases of the company's convertible debentures under our tender offer. Financing activities in the first nine months of 2013 provided cash at $12.8 million, primarily consisting of net proceeds on short-term borrowings.

Free cash flow was use of $34 million for the first nine months of the year compared to a generation of $23.2 million year-to-date in 2013. A significant factor with that we made about $48 million in contributions to the company's pension plan this year, which significantly improved our funding status and will reduce our pension related expenses going forward. As a result, we do not expect to make any further pension contributions for the balance of 2014 or 2015. By comparison, we made approximately $17 million in contributions to the pension in 2013.

Working capital increased by approximately $34 million in the first nine months of 2014 compared to $20 million in the first nine months of 2013 as the result of investments in Stemco's distribution center and several large engine programs underway at Fairbanks Morse.

Capital expenditures were $20.4 million for the first nine months of 2014 compared to about $22 million for the comparable period in 2013.

Taking a look at the results of deconsolidated GST for the third quarter, net sales were $61.1 million, up 4% from $59 million in the third quarter of 2013. Third-party sales were about flat, but there was an increase in intercompany shipments to foreign affiliates. GST's operating profit before asbestos-related expense was $10.9 million or 17.8% of sales compared to $14.8 million or 25.1% of sales in 2013.

In 2014, GST had higher manufacturing in SG&A expenses. GST's adjusted net income was $7.3 million in the third quarter of 2014 compared to $9.2 million in 2013. Asbestos-related expense was $4.9 million in the third quarter of 2014 compared to $15.8 million (sic - see press release, "$15.9 million") in the third quarter of 2013. The year-over-year change reflects lower litigation expenses compared to the third quarter of 2013 when the liability estimation trial was underway.

GST's cash and investment balance was $223.1 million at the end of the third quarter compared to $172.6 million at the end of the third quarter of 2013.

Now I'll turn the call back over to Steve.

Thanks, Alex. Before I go into the wrap up guys. I just noticed the typo on the slides. I apologize for this. Everything Alex said in the script was correct and the earnings release is correct, but on the Power Systems segment slide in the slide show, the segment profit numbers listed for Q3 '14 and Q3, '13 were wrong. That's just a typo, and I apologize for that. Accurate numbers for Q3 of this year for segment profit in Power Systems is $9.6 million and in the third quarter of last year it was $2.3 million. So those are consistent with what Alex said in the press release, but we somehow missed that typo on the slide. I apologize.

But that pretty much covers our wrap up of the third quarter. So let's talk about where we're expecting to be in the fourth quarter. Most of our businesses, except Fairbanks Morse have some normal seasonal slowness in the fourth quarter.

OEM order activity remains firm in our semiconductor, aerospace and trucking markets and we have a substantial shippable backlog in Power Systems in the fourth quarter.

Nevertheless, we're cautiously optimistic that sales for the fourth quarter will be near the third quarter's level. However, margins generated by engine revenues and OEM sales are generally lower than our aftermarket margins. That said, although we've not begun to feel any significant softness in Europe and Asia, we're concerned about the direction that might be headed. As a result, we expect fourth quarter segment margins to be lower than those we reported in the third quarter, but we remain very excited about the longer-term benefits, the number of strategic growth initiatives underway, and the potential for additional growth that our new capital structure now affords us.

So now, we'll open the line for your questions.

(Operator Instructions) Jeff Hammond.

Hey, good morning, guys.

Hey, Jeff.

So, I'm assuming -- just lot of moving pieces in sealing. So I just wanted to understand, one, how should we think about 4Q margin for sealing. How should we think about the normalized margin trajectory into '15, and maybe within that you can speak about where you think that the Stemco distribution center cost go as we move forward and maybe how you're thinking about some of those one-time factors?

Yes, Jeff, it's Steve. We're expecting the Stemco distribution costs in Q4 to be about half of what they were in Q3. So $0.5 million plus or minus. And then going forward next year, we expect that to be at worst to neutral, so there won't be any added costs for that. We did get by the way the transition to the STC is now fully in place and functioning pretty well from an on-time delivery standpoint and so we're really working now to optimize all the cost levers and customer behavior and shipment behavior patterns and so forth that we anticipated for why we actually did the project.

So that really is the primary impact that's affecting margins in sealing in Q3. Then the rest of it is just kind of what I would call normal fluctuation OEM to aftermarket mix variance of margins across our various business -- the businesses within sealing and so forth. So, in the fourth quarter we normally see a little bit of a decline in margin, because that's the business, that's the segment that's typically fairly affected by the seasonal slowdown in both Garlock and Stemco.

We continue to see robust orders into Stemco but it's mostly OEM going into the end of the year. So, I would expect to see margins maybe a couple points lower in Q4 this year than we had last year for sealing. But I think for the full year, next year, I think you can expect more like what we've seen full year this year or trended at full year, certainly above the mid teens, a little bit above the mid teens level would be my best look at this point.

Just to clarify that the 3, 4 year-to-date and call it $4 million of Stemco distribution cost, do those go away, next year or that's a new sustainable level?

No, no, no, they go away. We'll be back where we are now with Stemco. Now the thing that won't come back will be the GPT the pipeline business that Alex has referred to in every call this year that we're seeing slowness in pipeline construction activity globally for both oil as well as water infrastructure. We certainly don't expect that business to come back from a demand standpoint. Hopefully, it won't be any worse next year than this year, but it -- we're not expecting a recovery there.

So it seems like the kind of run rate to think about is what you've seen in the second half X this kind of Stemco noise. So kind of 14%, you're not getting back to the '15, '16 that you saw in '12 and '13. But more on that '14 level?

Yes, I mean we're going to be in sealing for the year where we're thinking will be right around 15% for the full year basis, and I don't see any reason why we wouldn't be there slightly north of that next year.

Okay. And then just shifting gears to GST.

Jeff, that's a full year number, what I was giving you before, I thought you'd ask for Q4 -- are sent to Q4 margins in sealing.

Right, right. Okay. And then for GST you cited kind of some programs running off and the margins have been under some pressure there. So how should we think about kind of the structural goal for -- is this kind of the right run rate to think about, we're may be over earning last year or what's kind of the right structural run rate for GST?

Yes, we were clearly over earning last year, we had a competitor that had a fire in one of their plants, and so we made a bunch of product, kind of unbranded product for them, but it was pretty attractive margins to us. We knew that that was a temporary thing. So it's not like a customer that we have lost. But it was a program that went away and -- so we knew that wouldn't happen again this year.

Second is, we had a program where we actually make the internals or some valves for a company, we're actually coating them with an elastomer. And we had always just had the overflow business from that customer and they decided to in-source the remaining amount that we used to have about half of the business and they expanded their factory to be able to do all of it themselves. And so that business went in-house and we didn't have that this year as well.

And although it wasn't a great margin business for us, on an incremental basis it was reasonably good. So those are the two programs, specifically that Alex mentioned because I don't want anyone to get the impression we're losing business in Garlock, that is absolutely not the case. The only thing we've seen that has been negative to Garlock other than those two and those two -- I would both put those in the category you mentioned, Jeff, which is we were over earning last year relative to a normalized run rate.

The only thing weakness that we're seeing is really this demand, this demand situation on the pipeline business driven by slowing of capital investment in oil pipeline projects, mostly in the Middle East and Europe and South America. The U.S. has been still a decent market there. And water infrastructure, globally which has been weak really since the recession has not come back very robustly. So, those two parts of the pipeline products business at Garlock had been weak. The other of it is just, I would say, normal, we haven't lost customers, we continue to feel like we're doing pretty well actually in the core GST product launch.

So from a margin standpoint, I think something in the 15% to 16% range is a very reasonable estimate for next year for all of sealing.

Okay. Thanks guys.

Yes.

(Operator Instructions) Todd Vencil.

Hello guys, good morning.

Good morning, Todd.

So, I was thinking about the Power Systems business, nice to see it a two handle on the margin there again. Obviously --

We told you it was common Todd. Remember in the last call, we told you guys -- we told you it was common. So we won't mislead you.

So obviously, couple of things, one is, obviously, resurgence of the parts and service business and you mentioned sequestration and [winding] effects there in the Navy's schedule. I mean strictly looking at the parts business and service, is that likely to kind of stay recovered or is it going to be lumpy, or how you thinking about that?

No, I think we think it is solid, I mean certainly it will be strong in Q4 because as we know the shippable backlog, but we don't see anything next year that's got has concerned, I think we're going to be back to the normalized level that would I think exclude. Quite frankly and probably exclude the second half of '12, because as we've told you before the Navy pre-bought a bunch of stuff in the second half of '12, because they were worried about sequestration coming in '13. In '13, we got hit with the double whammy of the sequestration and just a normal maintenance cycle that did not include mid-life and major overhauls for ships that had our engines on them.

And then because of sequestration that kind of breaks were not let off until the first half of this year, but because of the normal lag in order cycle for spare parts, we didn't actually start shipping product until the second half of the year. So you saw that in Q3. So this whole sequestration thing in that really I would say very unusual and weak maintenance cycle that we had last year. This is the worst one we've had since we kind of had been keeping track of these things.

Those two effects are both behind us, but they really did (inaudible) had a minimum Q4 of '12, all four quarters of last year and the first two quarters of this year. So, I think to get a normalized rate, we're going to have to just wait and see what happens in shipments in Q4, you guys are and then we can almost go back to kind of '11 and the first half of '12 and extracted for a normal rate of government parts and service in that business. We'll try to give you a little bit more insight on that when we start next year, and talk about what we see for all of 2015. But we certainly don't see anything on the horizon that has it's concerned on the parts and services side for '15.

Good. Glad to have that behind us. And is it fair to for me to assume that there wasn't a whole lot of OEM revenue in the third quarter, which allowed you to get up above 20% or am I wrong in that?

So we did ship about three completed contract engines and --

I think those are 3% completion, fully the contract coming --

Yes. Right. We did have 3% completion engines. It was a lighter OEM mix, it was very heavy parts and service oriented but the OEM mix I would say is more normal, that was the parts and service revenue that really drove the year-over-year comp, Todd.

Got it. So, looking at the fourth quarter then would you expect to see a less heavy parts and service mix or is the 3Q mix kind of --

It's going to be tough on the mix, because we're going to ship. We're going to ship. The plan is to ship in Q4, the plan is actually to ship 15 engines now. Yes, about 12 to 15 are completed contract, sorry, percent completion, so -- obviously that revenue. There is only three completed contract engines in the quarter and we expect parts and service to be more or less the same in Q4 that they were in Q3, maybe not quite as strong but --

So split down the margins there, just from that effect anyway, all else equal?

It will deliver margins a little bit. That's correct. Just because of the mix, but like I said, it will be a pretty good quarter for Power.

And. So given that we're now hopefully back on a normalized basis and I understand you said you're going to give us more guidance kind of going into next year. What that is going to look like? But in general, I mean broad strokes, how are you thinking about sustainable operating margin in the Power Systems business, now that parts and service is kind of gotten over this arm.

Yes, I think we're still looking at a kind of a mid-teens number for next year. Because remember, we're still investing a lot in the R&D for the opposed-piston engine, which by the way is continuing to deliver very good. I'm extremely encouraged about it, we'll be testing our new design by the middle of next year, but that'll probably cost us even more money next year, because in addition to some ongoing R&D work and I guess this will be Canada's R&D, we're going to have to run the thing on the testing which will be consuming fuel. So, even under the best case we won't be selling any new OP engines until '16 or '17. However, we are going to be building a lot of the EDF contract, we'll start a bunch of EDF engines next year as well. So, we think next year will be a decent year for Fairbanks, but not yet as good as we hope it will be down the road because we won't have the OP actually in the market next year. Hopefully, we'll be able to start marketing it and selling it late in the year, but we certainly won't have any orders until I would guess '16 at the earliest.

Hey Todd, just some additional clarity on the fourth quarter building almost Steve said, just so everybody on the call sort of fully understands. The engine shipments is going to be substantially higher than our usual run rate. So, to the tune of the revenue will be to the tune of two X, what it usually is. And the parts and service volume will basically be a normal run rate to what we usually see. So you will see a mix effect in the fourth quarter. Now that said, you'll still continue to see strong performance in the level of the teams that we typically put up with our normal mix because these engines are fairly profitable engines. But there will be a mix effect, so the 20% that you saw this quarter was driven, like we said earlier, very, very heavily by the parts and service side of that business, which was a bit of an anomalous a peak.

Now that makes sense. Given that, Alex, I mean should we looking for -- I mean I would take it from what you just said, given if parts and service are kind of, at the same run rate you're looking for in fourth quarter and you're going to have more OEM revenues, a standard reason that you're going to see, do you expect any way to see more revenue in Power Systems in 4Q than 3Q?

Yes.

Okay, good. Digging into the some of the cost, you guys, the cost headwinds in the quarter you guys called out. Thank you very much by the way for that slide in the deck. I think that's very helpful. So I just want to make sure that I got it right. So you guys called out within sealing, ongoing project related spending in Stemco's distribution center as well as severance in inventory reserve adjustments. And if I heard you right, you said that spending was a $1 million at Stemco for the distribution center. And then severance, you call out as [300,000] in inventory reserve adjustments of 1.3, am I got that right?

Yes.

Can you walk to those two last items that you --

Some of the inventory adjustments were engineered well.

Okay.

Right.

Okay. (inaudible).

And of course the R&D -- the R&D spending the delta is almost all driven by the OP, but the R&D spending is across the Board in the company.

Yes, it's just the delta there from '13 to '14 is almost all OP.

Got it. Can you give me some color on that inventory adjustment in the severance?

I don't know what additional color to give on the severance other than we had a few people leave the company and we've had a severance for that. It wasn't part of large-scale restructuring if that's what you don't -- (inaudible) that we've had to put in place is we've been primarily focused on a lot of the back office optimization work that we talk about periodically. On the inventory adjustments, really the bulk of the inventory that we took adjustments forward in the last quarter, I would say this is more sort of normal aging type adjustments.

Okay. So if I think about the outlook for these things on the -- and just to sort of weigh in or not weigh in going forward on Stemco the distribution center, you said, it's going to cutting to that half in the fourth quarter and then we basically fall into just tag ends in the first and second quarter next year and then zero in the back half. That's what I would think about it.

No, I think we'll be pretty much done by the end of the year. So I don't know what you mean by tag in, but --

Well I mean, [minus] small numbers.

Yes, well, I mean, we're going to stop keeping track of it at some point, because it is not really relevant. So it will be smaller than our size.

Effectively done.

Yes.

Okay. And then the inventory and cost adjustments you called that out, but is it fair to say Alex, the comment you just made that that's kind of -- its bit of just to the normal level?

It's really higher now than normal for a couple of reasons, one is the distribution center. So, we're carrying a lot more inventory at the distribution center, then we would typically and now that that is fully implemented. We'll start bleeding that down. And so the way we calculate the inventory reserves is really based on a schedule. And so what happens is because the implementation of the distribution center has taken longer than we would anticipate. The way we calculate the reserve requires us to take a reserve adjustment. The point is Todd, that's not obsolete inventory, we're going to sell it. It's just then in the warehouse for longer than we would anticipate.

The second piece is related to a new product that we're building at GPT to address some of the competitive issues that we've talked about. This is the pipeline business within Garlock. The ramp-up for that new product has been much slower than we would have anticipated it would otherwise.

The sales ramp-up has been slower, Todd, we've built, so we're carrying more inventory than we're able to sell it.

Yes. The sales volume.

Again, it's not an obsolescence issue, it just has been there a while, and we have policies about what to reserve for.

Got it. So on that 1.3 not necessarily, things like this might happen, but this is going to be an ongoing kind of number?

Right. And so that's kind of the point is that we've taken these reserve adjustments because that the inventory is aged, because of some of the strategic investments we've made, we don't believe that it's obsolete. We don't think that this is a normal thing that we'll do every quarter and that's why we called that out here.

Got it. Perfect. Thanks, guys.

Jeff Hammond.

Hey guys, just a couple quick follow-ups. So just to kind of close the loop on Power Systems margins, it sounds like you think as things normalize, this is kind of a mid-teen margin business and it feels like maybe based on the mix being more normal in 4Q we're kind of in that range in 4Q?

Well, on a margin basis, I think it'll be a little bit lower than that in Q4, just because we're shipping so many engines, Jeff.

Okay.

On a total profit basis, obviously, it's going to be pretty strong. But (Technical Difficulty) and I don't actually have real accurate view, again, we can't guide on that when we get to Q1, but my guess is that 2015 will look pretty close to 2014. It's not -- I don't think it will go up appreciably, if at all. I think it will be in this same neighborhood.

Okay. And then finally, can you give us kind of how you're thinking about the quarterly interest expense run rate going forward?

Well, the effective rate, if we take the intercompany note out and talk about that If you want to, but --

Yes, actually intercompany.

Yes. So basically the new notes that we put in have an effective rate of 6%, the coupons 5.875% and there was an original issue discount that will get your effective rate to 6% on the $300 million and so that especially the run rate for the company for the bond, the revolver has a carry cost of commitment fee of 25 basis -- I'm sorry, 20 basis points, so that negligible. And then it's going to be LIBOR plus about 175 is a good number to use. We drive that down, but we don't anticipate driving back down given the cash balance that we have from the bond deal.

The last remaining pieces of the puzzle is the convertible note, which is it roughly $24 million there. The effective rate on that is a little bit confusing, it's about 9%, because you have to think -- consider the equity component as well as VOID (Technical Difficulty).

(Operator Instructions) There are no further questions in queue at this time. I'll turn the call back over to presenters.

Okay. Thank you very much for joining us on our call this morning. If you have further questions, please don't hesitate, give me a call at 704-731-1527.

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