Regal Rexnord Corp (RRX) 2016 Q3 法說會逐字稿

Good day, and welcome to the Regal Beloit third-quarter 2016 earnings conference call.

(Operator Instructions)

After today's presentation, there will be an opportunity to ask questions.

(Operator Instructions)

Please note this event is being recorded. I would now like to turn the conference over to Mr. Rob Cherry, Vice President, Investor Relations. Please go ahead.

Thank you, operator. Good morning, and welcome to Regal Beloit's third-quarter 2016 earnings conference call. Joining me today are Mark Gliebe, Chairman and Chief Executive Officer; Jon Schlemmer, Chief Operating Officer; and Chuck Hinrichs, Vice President and Chief Financial Officer.

Before turning the call over to Mark, I would like to remind you that the statements made in this conference call that are not historical in nature are forward-looking statements. Forward-looking statements are not guarantees, since there are inherent difficulties in predicting future results and actual results could differ materially from those expressed or implied in forward-looking statements. For a list of factors that could cause actual results to differ materially from projected results, please refer to today's earnings release and our SEC filings.

On slide 3, we state that we are presenting certain non-GAAP financial measure in this presentation. We believe that these are useful financial measures to provide you with additional insight into our operating performance and for helping investors understand and compare our operating results across accounting periods and in the same manner as management. Please read this slide for information regarding these non-GAAP financial measures and please see the appendix for reconciliations of these measures to the most comparable measures in accordance with GAAP.

Now, I will turn the call over to Mark.

Thank you, Rob, and welcome and thank you for joining our third-quarter call. And thank you for your interest in Regal. We'll follow our normal agenda.

I'll make a few opening comments, Chuck will give a financial update, Jon will provide color on markets, operations, and the performance of our three segments. After that I'll summarize, and then we'll move to Q&A. First an opening comment.

Our third-quarter results were generally in line with our expectations. We expected that organic growth and earnings would improve sequentially through the second half, and our results through the third quarter prove that to be true. As you can tell from our guidance, we see the fourth quarter continuing to play out pretty much as we expected.

Now at a macro level. Top line revenues challenged our results for the second quarter. Organic growth rates were better in all three segments but still down.

Looking across the segments, there were a few key items that put significant pressure on our top line. First, sales into our global industrial markets, including oil and gas and power gen, were down roughly $49 million year-over-year. Second, pricing, while sequentially improving, was still a $12 million headwind in the quarter, the majority of which was two-way material price formulas.

Next, demand from the Middle East HVAC businesses declined $9 million. And finally, on a positive note, North American residential HVAC was up $7 million due to the warmer summer. From an operating profit perspective, as expected, margins improved sequentially in the quarter.

Looking at year-over-year margins, when taking into consideration the 50 basis points of improvement from the tariff refund last year, margins in the third quarter of 2016 were actually up slightly. Overall, despite difficult sales headwinds we delivered a strong margin performance in the quarter. We had another good quarter in free cash flow, with free cash flow coming in at 234% of net income.

Part of the way we accomplished these results was by improving working capital. For the quarter, we improved cash cycle by an additional two days, and we reduced inventory by an additional $26 million. While the inventory reduction put pressure on our margins, we're seeing benefits in free cash flow.

With the strong free cash flow, we paid down a healthy $105 million of debt in the quarter. As we look forward and consider our fourth-quarter guidance, we expect the fourth-quarter organic growth rate to continue to improve and to be sequentially better than our third quarter. Our guidance reflects a slow start to the HVAC heating season due to the warmer fall weather.

While third-quarter sales in both North American PTS and C&I were relatively weak in the prior quarter, our orders in those businesses have modestly improved in the last few months. Our overall total Company guidance reflects fourth-quarter revenues in the range of flat to slightly down as compared to prior year. Adjusted operating margin rates are expected to be slightly down in the fourth quarter, which we are quite pleased with, taking into consideration that last year we reported a substantial LIFO benefit in the fourth quarter, and this year we have no LIFO impact included in our guidance.

Overall, our guidance now reflects second-half adjusted earnings to be 11% to 15% stronger than the first half. Our third-quarter performance and our full-year guidance confirms the positive momentum that we expected in the second half.

I will now turn it over to Chuck.

Thank you, Mark. Good morning, everyone.

Sales in the third quarter 2016 were $809.6 million, down 8.2% from the prior year. Foreign currency translation in the quarter was a negative 0.6%. The divestiture of the Mastergear business negatively impacted the third-quarter sales by $4.8 million or 0.5%.

Therefore, organic sales declined 7.1% from the prior year. Our adjusted operating profit margin in the third quarter was 11.1%, a decline of 40 basis points from the prior year. The decline in sales volume and the impact of reducing inventory pressured the operating profit margin with partial offsets from the benefits of our simplification initiative and cost controls.

The prior year operating profit margin included the $4.9 million GSP tariff refund, which represented a 50 basis points benefit to the prior year margin. Excluding this GSP benefit from the prior year, we improved our operating profit margin by 10 basis points, despite organic sales declining 7.1%. Our third-quarter adjusted operating profit margin of 11.1% was also a strong sequential improvement above the 9.7% margin in the second quarter 2016.

Our third-quarter 2016 earnings per share reported on a GAAP basis were $1.32. There were two adjustments to the GAAP EPS in the third quarter. The first adjustment was $1.1 million, or $0.02 per share, of restructuring and related costs related to restructuring activities in all three reporting segments.

The second adjustment was the $1.2 million after-tax gain, or $0.03 per share, from the sale of assets of our Venezuelan oil and gas business. Net of these adjustments, the adjusted EPS for the third quarter was $1.31 per share. While not an adjustment to our GAAP EPS, in the quarter we had a discrete tax benefit in the third quarter of $2.2 million or $0.05 per share.

This resulted from the finalization of our 2015 income tax filings. Our final tax expense was lower than our earlier tax provision, creating the $2.2 million benefit in the third quarter. Now I'll summarize a few key financial metrics.

Our capital expenditures in the third quarter were $14 million and $46 million on a year-to-date basis. We expect our full-year 2016 capital expenditures to be $65 million. From a restructuring standpoint, restructuring expenses in the third quarter were $1.1 million, and restructuring expenses for the full year are expected to be $9 million.

Before I move on, I would like to comment on our full-year estimates on capital expenditures and restructuring expenses. We reduced our capital expenditure and restructuring guidance for the total year for three reasons. First, we were able to successfully complete a few of our key restructuring programs with less spending than we originally estimated, resulting in better returns on these programs.

Second, you may recall that earlier in the year, as we saw the weaker market conditions, we commented that we were accelerating our restructuring programs. We were a bit aggressive with our estimates of what we could incrementally accomplish this year.

And finally, throughout the year, we pulled back some of our capital expenditures in the businesses that were most heavily impacted by the weak end markets, such as oil and gas. None of this impacts our estimates of restructuring savings, as it's simply a one- to two-quarter timing shift.

Now on to ETR. In the upper right quadrant, we show our effective tax rate information. The ETR in the third quarter was 20%, which benefited from the $2.2 million reduction in our tax provision, as I explained earlier.

This was a discrete tax item in the third quarter and was not included in our earlier ETR guidance. Our ETR forecast for the fourth-quarter 2016 remains at 23%. In the lower left quadrant, we provide data on our third-quarter 2016 balance sheet.

Our total debt was $1.511 billion, and our net debt was $1.229 billion. In the third quarter, we achieved strong debt reduction, repaying $105 million of debt. Over the past 12 months, we have reduced our total debt by $292 million.

We expect continued debt reduction in this fourth quarter but at a lower amount than we accomplished in the third quarter. This should result in net interest expense for the full year 2016 of approximately $54 million.

In the lower right quadrant, we present information on our free cash flow. We generated $140 million of free cash flow in the third quarter, representing 234% of net income for the quarter. Our free cash flow was very strong in the quarter, benefiting from our progress in managing our working capital and reducing our inventory by $26 million in the period.

On a 2016 year-to-date basis, we have reduced our inventory by $89 million, as we balanced our production with the lower level of sales and improved our planning processes. Our free cash flow also benefited from the lower capital spending, but the impact was minimal, a 5% benefit in the third quarter.

Now I will review our full-year 2016 earnings guidance. Our guidance for 2016 reflects our expectation that the organic sales growth rate in the fourth quarter will improve sequentially as compared to the third quarter and will be flat to slightly down as compared to the prior year fourth quarter. We expect only a minor headwind from the negative impact of foreign currency translation in the fourth quarter.

Our outlook for the fourth quarter of 2016 is for adjusted operating profit margin to be down slightly to the prior year, which is impressive given the prior year had a $15 million LIFO benefit. We do not expect a significant LIFO impact in the fourth quarter, and we are not including any LIFO benefit or expense in our guidance.

The slide provides the details on our guidance on a GAAP and adjusted earnings. I will focus my comments on the adjusted EPS. Our guidance for the fourth quarter 2016 adjusted earnings per share is $1 to $1.10.

The adjustments to our fourth quarter EPS include estimated restructuring expenses of $4.8 million or $0.07 per share and gains on asset sales of $0.01 per share. Our guidance for the full year 2016 adjusted EPS is $4.40 to $4.50. The adjustments to our full year EPS include $9 million or $0.13 per share of estimated restructuring expenses.

The final adjustment to our full-year earnings are the total gains on the sales of businesses and assets which are estimated to be $13 million or $0.18 per share. In summary, our full year 2016 guidance reflects a second-half improvement in adjusted earnings per share of 11% to 15% as compared to the first half of 2016.

Now I'll turn the call over to Jon Schlemmer.

Thanks, Chuck, and good morning, everyone. Let's start with segment performance beginning with commercial and industrial systems.

Sales were $389 million, a decrease of 9% from the prior year. The third-quarter sales were essentially flat to the second quarter and in line with our expectations. While organic sales declined by $34 million, or 7.9% from prior year, the organic growth rate improved by 110 basis points as compared to the second quarter.

The general industrial end markets in both North America and China impacted sales by $19 million in the quarter. The impact of oil and gas and the power generation end markets impacted sales by $14 million. And price, driven primarily by the two-way material price formulas, reduced sales by $6 million.

We experienced strength in residential pool, driven by stronger aftermarket demand, and we continue to experience strong demand for our Switchgear products sold into the data center market. Adjusted operating margin was 9% of sales, down 30 basis points from the prior year but up 250 basis points from the second quarter.

The GSP refund benefited the prior year operating margins by approximately 20 basis points in this segment. Excluding the GSP benefit, operating margins were essentially flat to prior year, despite the organic sales decline.

The ongoing investment in simplification and the work that has been done to right-size our oil and gas businesses are both benefiting the margin performance. The sequential margin improvement is benefiting from the right-sizing of our oil and gas businesses, as well as the more favorable price cost impact we are realizing in the second half of the year.

Orders across the North America industrial markets modestly improved as we exited the quarter and additionally, our organic growth rates will benefit from easier comparisons in the fourth quarter. Sales in our climate solutions segment were $251 million, down approximately 5% from prior year. While organic sales declined by $13 million or 4.9% from prior year, the organic growth rate improved as compared to the second quarter.

We continued to experience weakness in Middle East air conditioning market, with sales down $9 million in the quarter. For the year, our overall sales into the Middle East HVAC market will be down approximately 50%. And while comparisons are getting easier as we move forward, we don't anticipate organic growth from the Middle East until the back half of 2017.

Price, driven primarily by the two-way material price formulas, impacted our sales by $7 million, or nearly 3% of sales. We also experienced a decline in demand in the commercial refrigeration and general industries end markets. Our North America residential HVAC business grew by $7 million in the quarter.

We had strong OEM demand across our air conditioning products. However, the aftermarket side of the business was adversely impacted by the slow start to the heating season. Overall, we experienced OEM unit growth in the high single-digits and aftermarket unit growth in the low single-digits.

Adjusted operating margin was 16.9% of sales, an increase of 140 basis points from prior year and up 250 basis points from the second quarter. The higher HVAC volume, our simplification and cost reduction efforts, and improved mix all contributed to the strong margin performance. The combination of these factors more than offset the impact of lower sales and the sizeable GSP benefit in our prior year results.

Sales in our power transmission solutions segment were $170 million, a decrease of 11% from the prior year. While organic sales declined by $16 million, or 8.5% from prior year, the organic growth rate improved by 240 basis points as compared to the second quarter. The decline in organic sales was driven by weakness in our distribution channel and continued weakness in oil and gas.

In distribution, we saw considerable destocking in the quarter, which contributed to the decline. Renewable energy was a headwind in the quarter, and we expect to see the same in the fourth quarter. We've seen growth from this market over the past year.

However, the market is driven by large projects, and the sales can be choppy from quarter-to-quarter. The agriculture and metals markets were essentially flat to prior year, an improvement from what we've seen in the past quarters. And we continue to experience strength in food and beverage unit material handling.

Adjusted operating margin was 7.1% of sales, down 370 basis points from prior year. The lower volume and the impact of the lower demand through distribution drove the reduction in operating margin. The distribution destocking subsided in the third quarter, and we have experienced modest orders improvement as we transition into October.

The synergy programs remain on schedule, and we continue to take additional cost actions across the business. With the modest improvement in orders and our continued focus on cost, we are expecting improved performance in the fourth quarter in this segment.

I'd like to wrap up talking about our focus on customers and the feedback we are receiving. Over the past several years, we've been focused on improving our performance and making it easy for our customers to do business with Regal. The goal is simple: to be the preferred choice by our customers.

Late in the second quarter, we completed our annual customer survey. This year we had a record level of participation with nearly 4,000 customer inputs, and we achieved the highest net promoter score since starting this process nearly 10 years ago. Our customers also gave us higher scores when answering key questions about quality, responsiveness, innovation, and overall value.

We also wanted to highlight the most often referenced comments by our customers when asked why they gave us positive scores on our performance. No question, the survey also pointed out areas where we need to make further improvements, and that's the real value in this process. It's about identifying what's most important to our customers and driving improvements in those areas.

Reinforcing the feedback from the broad customer survey, in the third quarter we received very positive recognition from our customers. One of our top five OEM customers recognized our performance with their shareholder value award, which was given to Regal at their annual supplier event. This award is given to a supplier for their consistent ability to provide superior quality, cost, and service.

We also received three awards from a network of wholesale distributors who service the pool equipment channel. Regal received awards for outstanding on-time delivery, partnership in growth, and supplier of the year. It was the second year in a row Regal received a supplier of the year recognition from this group of customers.

We believe that continuous improvement in our performance to our customers is critical to drive long-term growth, and we're pleased to get this feedback. I will now turn the call back over to Mark.

Thanks, Jon. Now before I summarize, we updated this chart to reflect our latest cash flow performance.

The annual average of free cash flow to adjusted net income over the past five years was 129%. Our bias right now is to use the cash to pay down debt, and over the last 12 months, we have paid down $292 million in debt. The key take away from this slide is the consistency of our free cash flow.

Now I would like to summarize our third-quarter performance, and then we'll go to Q&A. For the third quarter, as expected, our organic sales growth rates were still down year-over-year in all three segments, however, the growth rates improved sequentially. The biggest headwinds continued to be weakness in global industrial markets, especially in oil and gas and power generation.

Strong sales in the residential HVAC cooling market were offset by continued weakness in the Middle East and the impact of our two-way material price formulas. Our margins were somewhat resilient, despite the weaker sales and especially considering the impact of the tariff refund last year. Our cash flow to net income was 234%.

We reduced inventory by another $26 million, and we used a portion of the free cash flow to pay down $105 million in debt. The customer feedback we are receiving is encouraging and gives us confidence that our simplification efforts are not only eliminating unnecessary costs but also helping us improve our service to our customers.

Our guidance reflects fourth-quarter organic sales to be flat to slightly down, which would again be sequentially better than the third quarter. In our fourth-quarter sales estimate, we dialed down our HVAC heating season expectations to account for the recent warmer temperatures. We built in improvements in North American C&I and PTS due to recent order trends.

We forecast a sequentially improving two-way material price formula impact, and finally we expect easier comparisons in the oil and gas and power gen businesses. On earnings, our guidance reflects second half earnings 11% to 15% stronger than the first half. Overall, we feel like we've been ahead of the game on simplification, and we are positioned well for even the smallest improvements in organic growth.

Before I close, please note that Regal will host an investor day on March 10, 2017 in New York City. Please mark your calendars.

We will now take your questions.

Thank you very much. We will now begin the question-and-answer session.

(Operator Instructions)

Our first question comes from Julian Mitchell of Credit Suisse.

Hello, good morning.

Good morning, Julian.

I guess my first question is really on the power transmission solutions business. Just specifically on the margins, where, I guess, it sounds like the Emerson business integration is on track, but you had a very severe decremental margin sequentially and year-on-year.

Was that something around the business mix because of the distributed destocking? And maybe tell us if you think the margins in Q4 should show a much better performance.

So you're right on target, Julian. It was a tough quarter for that business. Sales were only at $170 million, which made it difficult to keep our margins in line.

But you're right in your assessment that the business mix was part of the problem with distribution, destocking occurring in the quarter, sales off $11 million in that space. And we also had some oil and gas decline, and as Jon mentioned, a decline in the renewable energy space, which is overall a good space for us but can be choppy from quarter-to-quarter.

And in response to the final part of your question, as we mentioned, we do expect better performance from this segment in the fourth quarter.

Thanks. And then you talked a little bit about price cost tailwind to earnings in the commercial industrial business. Is there any detail you could give on for the overall Company, perhaps? How you see price cost -- or price on the revenue line and price cost on the gross margin or the EBIT line -- what kind of tail wind you're thinking as you end this year going into next year?

Thanks, Julian, this is Chuck. So you're right. We had some price cost negative impact in the first half, but we are expecting the improvement in the second half. So a couple of reasons behind that.

Number one, the material price formulas are turning sequentially positive in the second half of the year. While not directly impacting our gross margin or the price cost mix, at least we're seeing an improvement in that overall trend.

The second and larger impact is on the sales volume not covered by the two-way material price formulas. So our blended cost on our copper and aluminum hedges are taking some of the volatility out of the cost of those commodities, and we have then put in a lower cost of inventory in the first half of the year, which we'll see benefits from in the second half of the year as we turn that inventory into sales in the second half and fourth quarter.

Great. Thank you.

Thanks, Julian.

Our next question comes from Joshua Pokrzywinski of Buckingham Research Group.

Hello. Good morning, guys.

Good morning, Josh.

Just maybe put a finer point on the climate expectation here going into the fourth quarter. Mark, I hear you that the weather is off to a warmer start in the fall here than normally you would get into seasonally, but the comp does get quite easy. And I think in the context of expecting overall for the company to be flat to just down slightly, it seems like climate does have to grow. Is that a fair assessment?

Well, we had commented at the last quarter that we were expecting a normal winter in our guidance. And it's clear that at least for the first month of October and coming into November that that's not going to be the case.

And as John mentioned, our aftermarket saw that already. We saw the impact of that already. We didn't have the aftermarket performance that we had expected coming into the heating season.

So as we go into the fourth quarter, we dialed down our expectations on the heating season, and as we went into the fourth quarter. I do agree with your view that it is a relatively easy comp because it was such a tough time last year.

Okay. And then Chuck, for margins in C&I, clearly great execution there. Should we think about this as a jumping off point sequentially going forward, or anything that we should keep in mind in terms of LIFO or other charges in the quarter, or anything that seasonally might have stood out that wouldn't show up in the fourth quarter or as we think about a launching point for 2017?

Thanks, Josh. There was nothing really in our fourth quarter 2016. There was a modest benefit in LIFO in the third quarter of last year, but nothing this year. And while copper prices have become more volatile recently, we don't expect any material changes in our LIFO, either benefit or expense in the fourth quarter, and we have nothing built into our guidance.

Okay, so a normal drop-through one whatever sequential volume changes we think are happening from here is a fair starting point?

Yes, I think so, Josh. Thank you.

Okay perfect. Thanks a lot, guys.

Thanks, Josh.

Our next question comes from Robert McCarthy of Stifel. Please go ahead.

Good morning, everyone.

Good morning, Robert.

So I guess the first question I have is maybe just thinking about the fourth quarter and then Q1. I know you're not going to give guidance for next year, although that would be nice.

But maybe you could just talk about the factors you're looking at because you're coming up against two pretty interesting comparisons. And what are you looking at to give you some sense of the cadence of whether we're going to go into a reacceleration underlying order trends or whether we're at the precipice of something worse of maybe more of a cyclical rollover? How do you think about that? What are you looking at? Because you have some pretty interesting -- easy comparisons here Q4 and Q1.

Well, a big portion of the Company is short-cycle orders. And so we pay a lot of attention to our shorter cycle orders, and at least as we came through October we were pleased with the order rates coming out of our PTS business, specifically the distributors seemed to be ending their destocking activity, and we saw that boost back to normal demand in our PTS space. And on the commercial -- North American commercial and industrial business, we did start to see an improvement as we entered October.

So we are paying quite close attention to our short-cycle order businesses as we enter the fourth quarter, which gives us the confidence to give the guidance that we did.

Then just as a follow-up, on PTS -- obviously Julien kind of got the relevant nuggets out of kind of the Q3 to Q4 cadence, but clearly this is a business that has been a disappointment in terms of probably what you bought and what you got in terms of revenues.

Now your synergy programs remain on schedule. You feel pretty good about your cost position, but could we see some added benefits down the road, or how do you feel about what we could see in 2017 and beyond in this business if we actually get back to some normal level of demand or some stabilization?

The only thing I'm disappointed about with that business is the markets that we inherited once we acquired it. Everything else has gone exactly the way we had expected and exactly the way we had wanted it to. In terms of the integration and the management team we got, the talent, and with our being on track from a synergies perspective, we feel great.

But I agree that we've been tagged by the markets we're participating in. So the business is really -- if we get any improvement on the top line, we're just going to be in a great position in that business to see the benefits.

Thanks for your time.

Thanks, Robert.

Our next question comes from Scott Graham of BMO Capital Markets. Please go ahead.

Good morning, Mark, John, Chuck, and Rob.

Good morning, Scott.

So I'm looking at the gross margin, and I'm seeing that you guys have continued to manage your materials situation really, really well. Materials price formulas are working as expected.

What I'm wondering is with steel prices still up kind of 20% year-over-year, a little bit more than that, the 2017 -- and I'm not asking for guidance, I'm just sort of asking for maybe -- when the material price formulas kind of reach a threshold where they're not benefiting gross margin anymore.

So I'll remind everybody that roughly 30% of the Company, we have two-way material price formulas with our customers. We have them for a very long time. It's not something we just put in place.

But the material price formation shows up in our C&I business and in our climate business. So copper and aluminum started turning downward back in 2014, and as we entered this year, they started to flatten out. And there's a lag to the impact, and so we start to see the flattening of those commodities from a material price formula perspective in the back half of this year.

Steel, on the other hand, started to become inflationary. It's turned down a little bit, but yet on a year-over-year basis, it is still inflationary. That causes our material price formulas to start to turn up.

Still negative as we enter the fourth quarter, still a headwind as we enter the fourth quarter and probably the first. But nevertheless, less of an impact on our top line than it has been throughout the year. And if Chuck or Jon want to add anything else, you guys ought to add in.

Mark, I would add that we did -- we expected and we did see incremental improvement from the MPFs as we entered the third quarter, and we expect the same in the fourth quarter, another incremental improvement because of the -- primarily driven by the inflation in steel that you mentioned, Mark. So that's built into our guidance here for the fourth quarter.

And in terms of what we will see in 2017, it will depend a little bit, I think, on what's going on with copper right now. We've seen recent inflation on copper, so we need a little bit more time to tell whether that's going to stick or not. But what commodities do now in the fourth quarter will determine largely what happens then in Q1.

Right. And if I could just add something as well, Scott. The MPFs are neutral to gross profit dollars, but they do have an inverse relationship to the gross margin percentage. So we benefited slightly in our margin as commodity costs have come down from the operation of the MPFs. As they start turning up, there will be a little bit of pressure on the gross margin going forward as a percentage of sales.

But most of the benefit in the third quarter is really the benefits of the simplification initiatives, even overcoming the benefit of the GSP, which we posted in the third quarter of last year.

That's very helpful, thank you. That's very comprehensive.

My follow-up question is, I mean, is it fair to say here -- I guess this is more of a question for you, Jon -- that with the organic sales decline in 2015, we saw the operating expenses as a percent of sales increase, and then we had another total and organic sales decline in 2016, and here we are again seeing the operating expense increase as a percent of sales. Is that just a function of volume, Jon, at this point, or is there something we can do to kind of arrest that continuing rise in operating expenses in this slack environment?

Yes, I think if you look at operating expenses this year, I think, other than the third quarter, we had some timing that affected some of the expenses that we took in Q3. We're expecting more favorable performance in the fourth quarter, and I think when you step back then and look at the year, we'll see that there's actually been a nice reduction in overall operating expenses.

Now clearly not to where we need it to be given the amount of volume we've had on the organic side. So we've got pretty significant volume decline on the organic side, and while we've made some progress, we'll see progress for the full year, as we exit the fourth quarter, still lagging, I would say, overall top line. Now, we're offsetting obviously normal inflation and some of the other things that impact us every year, so I'm glad we're able to make a reduction there, but -- and I think the simplification effort is key in that. That's allowing us to get some cost out that we can not only get out in the short-term but keep out in the long term.

So we'll see more of a benefit to the operating expenses next year when sales are maybe a little bit more stable, flatter?

That's what I would expect.

Scott, just to remind you, when you look at year-over-year SG&A, the prior year only had 11 months of PTS and this year will have a full year of PTS. So as we adjust the SG&A for that and some of the other items going through year-to-date through the third quarter, our adjusted SG&A is down 3.1% from the prior year.

That's a good point. Thank you, Chuck.

Thanks, Scott.

(Operator Instructions)

Our next question comes from Bhupender Bohra of Jefferies. Please go ahead.

Hello. Good morning, guys.

Good morning, Bhupender.

A question for Jon here. You talked about the orders growth in North America market. Can you just give us a sense of what you're seeing and what you're hearing from the customers in terms of which particular end markets do you think are improving and which are kind of deteriorating here? Thanks.

Bhupender, I'll give you my view, and then if Mark wants to add anything.

I would say -- I'll start with oil and gas. Really no improvement in oil and gas. I'd say its been steady as we went through the third quarter and entered the fourth quarter.

On the agriculture and metals side, especially in PTS, we were essentially flat from a sales standpoint in the third quarter, which is the first time in a while we've talked about those markets being flat. So I'd say similar to oil and gas, it seems that the order rates have steadied at a low level, but it has at least steadied. And we saw a little bit of improvement, actually, in part of our ag business.

The general industrial markets is where we saw the improvement in broad based in terms of the end markets. But I think when you think about commercial and industrial equipment in general, and the general industry side, we saw improvement in both PTS and C&I -- North America C&I. So that was good to see, and we saw that over the last couple of months and then through October.

China -- I would say that the order rates have been steady, no real improvement or decline as we went from the second quarter through the third quarter, but still a challenge on a year-over-year basis.

Okay got it. Now when you guys talk about restructuring which is in place right now, Mark, can you speak about -- I'm not asking like anything on details in like 2017 -- but overall, when you look at the Company and the restructuring programs, are there any big buckets left where, if we think about like a flat environment next year or maybe a modest growth, you think you can actually take those restructuring or those buckets where you can actually dip into to get the margins or operating income higher? Thanks.

Yes, we do believe there's more opportunity in our simplification initiative, which is where most of the restructuring gets allocated to. So you'll see us as we move into 2017 to continue the efforts to simplify the business on every front, and we still see a deck of projects to do as we head into 2017. None as big, as large as perhaps some of the larger ones we've had in the past, but still yet a lot to do and more singles than home runs.

Okay got it. Thank you.

Thank you, Bhupender.

(Operator Instructions)

Our next question is from Sam Eisner of Goldman Sachs. Please go ahead.

Yes, thanks and good morning, everyone.

Good morning, Sam.

Just wanted to go to your commentary on inventory. You've done a nice job this year of bringing down the absolute value of inventory. But I guess if I think about it as a percentage of revenue, what's the kind of range that we should be thinking about in the medium term for operating this business? Are you thinking it's north of 20%? How do we just think about the overall inventory to sales going forward?

I'll take a shot at this, and then I'll see if Chuck has anything to add. But as we entered the third and fourth quarters, we estimated that we had probably another $30 million of inventory that we were going to take out in the second half. And $26 million of it came out in the third quarter. So as we enter the fourth quarter, there's probably -- you're not going to see another significant move down at this business level. Obviously, if the world changes, we would adjust, but at the current business levels, we've about arrived at where we think we ought to be operating at.

I think in terms of a percentage of sales we finished last year at about a 29% net inventory as a percentage of sales, and we're now running at just under 26%. We're going to continue to try to drive that, but we've gotten a majority of the improvements that we were trying to improve on.

And you know, I think as we go into 2017, it will be more incremental improvements from all of the process changes we're making to improve our planning processes.

So maybe just an early look on 2017 in terms of free cash flow. You commented obviously that inventories were down substantially this year. That's a nice driver of free cash flow. How much of that should we expect to come back in kind of a -- if revenue is up in the low single-digit range, how much of your working capital will ultimately come back into the business being a drag on free cash flow?

I'll point you to the chart that showed that our -- over the list five years, we averaged 129% free cash flow to net income. That's probably an interesting way to think about it as we go forward. Obviously we're not quite ready to talk about 2017 beyond that.

And maybe just lastly, how much was the inventory reduction, the $26 million that you guys took out via presumably under production, how much of that was a drag on your operating margins this quarter?

I think generally, we estimated it at about 25 basis points in terms of our adjusted op profit margin in the third quarter.

Great. Thanks so much.

Thanks, Sam.

This concludes our question and answer session. I would like to turn the conference back over to Mr. Mark Gliebe for any closing remarks.

Thank you, everyone, for your questions and for your interest in Regal. Have a great day.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.