Ladies and gentlemen, thank you for standing by, and welcome to the Second Quarter 2020 AMETEK, Inc. Earnings Conference Call. At this time, all participants are in listen -only mode. After the speaker presentation, there will be a question -and-answer session. To ask a question during the session, you will need to press star one on your telephone. Please be advised that today's conference is being recorded. If you require any further assistance, please press star zero. It is now my pleasure to introduce Vice President of Investor Relations, Kevin Coleman.
Thank you, Andrew. Good morning, and thank you for joining us for AMETEK's second quarter 2020 earnings conference call. With me today are Dave Zapico, Chairman and Chief Executive Officer, and Bill Burke, Executive Vice President and Chief Financial Officer. AMETEK's second quarter results were released earlier this morning and are available on market systems and in the investor section of our website. This call is also being webcasted and can be accessed on our website. During the course of today's call, we will make forward-looking statements that are subject to change based on various risk factors and uncertainties that may cause actual results to differ significantly from expectations. A detailed discussion of the risk and uncertainties that may affect our future results is contained in AMETEK's filings with the SEC, including in our 10-Q, which we file later today.
AMETEK disclaims any intention or obligation to update or revise any forward-looking statements. Any references made on this call to 2019 or 2020 results will be on an adjusted basis, excluding after-tax acquisition -related intangible amortization and also excluding the gain from the sale of Reading Alloys in the first quarter of 2020, and the realignment charge taken in the first quarter of 2020. Reconciliations between GAAP and adjusted measures can be found in our press release and on the investor section of our website. We'll begin today with prepared remarks by Dave and Bill and then open it up for questions. I'll now turn the meeting over to Dave.
Thank you, Kevin. Good morning, everyone. Despite an economic environment as challenging and uncertain as any we have ever faced at AMETEK, our business stood strong in the second quarter, delivering outstanding operating performance that exceeded expectations. I wanted to start by thanking all AMETEK colleagues who are working tirelessly through this pandemic to provide our customers with great products and exceptional service. As our results attest, our employees are doing an amazing job. The safety of our employees remains our highest priority. We continue to implement our pandemic response plan, which provides a [framework] for our businesses to manage their facilities and workforce during this pandemic. We're following CDC and local health and safety guidelines and are adjusting and enhancing our safety protocols as required to ensure a safe working environment for our employees. Let me turn to our results for the quarter.
Sales in the second quarter were $1.01 billion, down 22% versus the second quarter of 2019. Organic sales were also down 22%, with recent acquisitions contributing 4%, the divestiture of Reading Alloys a three-point headwind, and foreign currency a one-point headwind. Despite substantial demand weaknesses, our business delivered exceptional operating performance. Operating income in the quarter was $227 million, and operating margins were very strong at 22.4%, while decremental margins were an impressive 25%. EBITDA in the second quarter was $289.7 million, and EBITDA margins were a record 28.6%, up 160 basis points over last year's second quarter. This drove earnings of $0.84 per diluted share, down 20% versus the second quarter of 2019. Our cash generation in the quarter was superb. Operating cash flow was up 28% year-over-year to $315 million. Free cash flow conversion was also exceptionally strong at 183% of net income.
Our businesses are focused on controlling what they can. The operating performance in the quarter is validation of the strength and flexibility of our asset-light business model, the quality of our niche businesses, and most importantly, the talent and commitment of our workforce. I will provide some additional details at the operating group level. Second quarter sales for our Electronic Instruments Group were $647.9 million, down 21% from the same period last year. Organic sales were down 26%, with the acquisitions of Gatan and IntelliPower contributing 5%. Despite the impact COVID-19 had on sales, our EIG businesses delivered excellent operating performance. EIG's operating income in the second quarter was $159.6 million, and operating margins remained strong at 24.6%. The Electromechanical Group also delivered excellent operating results, driven by better than expected organic sales and their operational excellence initiatives, which contributed to exceptional margin expansion.
EMG sales were $364 million, down 22% versus the prior year's second quarter. Organic sales were down 16%, with the recent acquisition of PDT adding 3%, the divestiture of Reading Alloys was an eight-point headwind, and foreign currency was a one-point headwind. EMG's margin expansion was outstanding in the quarter, where operating income decreased to $84.3 million. Operating margins expanded an impressive 170 basis points to a record 23.2%, driven by our proactive operational excellence initiatives. Truly exceptional work by our teams. Let me provide some color on the different end market dynamics we are experiencing within our business. AMETEK serves a diverse set of end markets, and across these end markets, we are seeing very different levels of demand and COVID-19 impacts.
As I did last quarter, I'll group our businesses into three buckets based on the levels of demand we are experiencing and provide some commentary on each. I'll start with the most challenged markets, commercial aerospace and oil and gas, which combined account for approximately 15% of AMETEK sales. The weakness in commercial aerospace was largely as expected and driven by the impacts of COVID-19 on both our commercial OEM and aftermarket businesses. We expect these businesses to remain challenged for the balance of the year. Along with the impact from COVID-19, weakness in our oil and gas business was a result of difficult prior year comparison, given several large project shipments last year. As a result, we expect solid sequential improvements in this business during the third and fourth quarters. Combined, sales for aerospace, commercial aerospace, and oil and gas were down approximately 45% in the quarter.
Excluding these two markets, AMETEK sales were down mid-teens on a percentage basis in the second quarter. Our strongest markets are defense and medical. Combining these markets accounts for over 20% of our sales, and we have been experiencing solid internal growth while also strategically expanding our portfolio in these areas through acquisitions. In the second quarter, sales were up low -single -digits for these businesses, and we expect this strength to continue in the third and fourth quarters. For the balance of our markets, which include power, industrial, automation, metals, food and beverage, and research, we are seeing demand levels somewhere in between those other two extremes. We expect to see sequential improvements through the balance of the year for these businesses also. To offset these COVID-19-driven demand challenges, we remain focused on actively managing our cost structure through a mix of structural and temporary cost actions.
Our executive office meets regularly with each of our businesses to review current marketing conditions, their demand outlook for the coming months, and their operational plans. It is critical that each of our businesses develop an operating plan customized for their business and that this operating plan be adjusted if conditions change. This flexibility is key in our asset-light operating model, where costs can be quickly variabilized. This approach allows us to best align our cost structure with the demand levels we are experiencing by market and by business. We have the flexibility to expand cost savings initiatives, or as demand conditions improve, we can add back costs as required. In the second quarter, we generated $85 million in total cost savings, with $35 million in structural savings and $50 million in temporary cost savings.
This level of savings was above our initial estimate of $80 million in total cost savings in the quarter. As we look ahead to the third quarter, we expect approximately $65 million in total cost savings, with $35 million - $40 million in structural and $25 million - $30 million in temporary savings. For the full year, we now expect structural savings of $135 million and will flex our temporary cost savings either up or down based on volume levels in the fourth quarter. The spread of the coronavirus has oddly forced companies to adapt and adjust how they do business. Work-from-home requirements and travel restrictions have changed how companies interact and engage with customers. Our businesses have been proactive in developing and utilizing digital capabilities to help them stay engaged with our customers.
Our sales and engineering teams are working side by side with our customers through digital channels to cultivate and build relationships. These initiatives have included virtual events through newly implemented digital platforms to provide product demos, webinars, and collaborative business meetings. Some of our teams are finding innovative ways to help provide aftermarket services for our customers through interactive technologies. I commend our teams for quickly adapting to the new reality and for embracing these new ways of doing business. We remain committed to investing in additional technologies to support our customer experience. Despite the global demand challenges, AMETEK continues to invest meaningfully in new product development initiatives. We are seeing great success from these investments as our businesses are introducing many new innovative solutions to help solve our customers' greatest challenges.
Our vitality index, which measures the amount of sales generated from new products introduced during the last three years, was very strong at 26%. Here are just a few of the recent examples of new product introductions. AMETEK Land, the leading manufacturer of non-contact temperature measurement solutions, saw robust demand in the second quarter for their new VIRALERT 3. This newly developed non-contact temperature measurement solution is used to rapidly detect elevated skin temperature while allowing users to adhere to social distancing requirements. This safe, non-contact, easy -to-use, and highly accurate temperature solution is being used at entry points of offices, warehouses, hospitals, schools, and recreational facilities. Given the product's ability to complete accurate temperature screenings at scale, the VIRALERT 3 is playing a role in reopening key facilities around the world. Creaform, a leader in 3D measurement technologies, released the latest solution in their MetraSCAN 3D lineup.
The MetraSCAN BLACK is the fastest and most accurate 3D scanner in the world, with four times the speed and resolution of its predecessor. The MetraSCAN BLACK can withstand harsh production environments and is utilized in the most complex quality control and quality assurance applications. This incredibly versatile instrument can be used to scan various part sizes and surface finishes in real time, all with the same device. Additionally, MOCON, a leading global provider of food package testing instruments, released their latest version of the Dansensor CheckPoint. This new portable headspace gas analyzer provides quality control managers a more precise, faster, and more stable solution for measuring gases in specific food applications using modified atmosphere packaging or MAP. MAPs are used to extend the shelf life for packaged foods and pharmaceutical products requiring specialized packaging. Congratulations to the Land, Creaform, and MOCON teams on these impressive new product developments.
Now shifting to acquisitions. The overall M&A market remains relatively quiet given the high levels of uncertainty around the coronavirus and its impact on the economy. That being said, our M&A teams remain very active, and we are managing several opportunities. We have a very strong balance sheet and liquidity position and the ability to deploy meaningful amounts of capital on acquisitions. Our preference remains deploying that capital on strategic acquisitions that provide us the ability to add high-quality companies to our portfolio and drive excellent returns for our shareholders. Now turning to the outlook for the remainder of the year. High levels of uncertainty remain given the continuing spread of the coronavirus, especially throughout parts of the U.S. While visibility has improved from this point last quarter, it is still limited as customers remain cautious.
As a result, we will not be providing guidance for the third quarter or the full year. We'll issue guidance as conditions stabilize and visibility improves. However, I did want to provide some high-level comments around the third quarter and the balance of the year, given what we know now. First, we expect to see sequential improvements in the third and fourth quarters, with commercial aerospace being the only business not expected to see sequential improvements. Second, we still expect very strong decremental margins at approximately 30% in the third quarter. Lastly, we now expect full-year decremental margins in the 25% range versus our previous estimate of 25%-30% decrementals. In summary, AMETEK managed well through what was an extraordinarily challenging environment during the second quarter.
The strength of the AMETEK growth model was evident in our second quarter performance, and we will continue to allow it to operate at a high level through these dynamic market conditions. We are taking responsible cost actions and continuing to invest in our businesses to ensure they are poised to generate strong growth coming out of the downturn. We also have a robust balance sheet and liquidity position to allow us to capitalize on what we believe will be an opportunistic period for acquisitions. Finally, we're confident that AMETEK will emerge from these challenges a stronger organization, given the growth profiles of our differentiated businesses, the company's financial strength, and most importantly, the impressive level of talent within our world-class workforce. I will now turn it over to Bill Burke, who will cover some of the financial details of the quarter. We'd be glad to take your questions. Bill?
Thank you, Dave. I'd like to echo Dave's comments on the outstanding efforts of our employees around the world. They continue to deliver exceptional performance during these challenging times. Let me provide some additional financial highlights for the quarter. Second quarter general and administrative expenses were down $1.7 million compared to the same period in 2019, due to lower compensation costs and other discretionary spending cuts. The effective tax rate in the quarter was 19.5%, down from 20.4% in the same period last year. The lower rate in the quarter was due to tax planning initiatives. For 2020, we now expect our effective tax rates will be approximately 19.5%, and as we've stated in the past, actual quarterly tax rates can differ dramatically, either positively or negatively, from this full-year estimated rate. Working capital in the quarter was 19.6% versus 18.3% in last year's second quarter.
Capital expenditures in the second quarter were $10 million. We continue to expect full-year capital expenditures to be approximately $75 million, down from our initial expectations to start the year of $100 million. Depreciation and amortization expense in the quarter was $61 million. For the full year, we expect depreciation and amortization to be approximately $260 million, which includes after-tax acquisition-related intangible amortization of approximately $117 million, or $0.51 per diluted share. Our businesses continue to generate high levels of cash. Operating cash flow in the quarter was excellent at $315 million, up 28% over last year's comparable quarter. Free cash flow was also outstanding at $305 million, up 36% over the same period last year, and free cash flow conversion was superb at 183% of net income.
Total debt at the end of the quarter was $2.87 billion, up modestly from $2.77 billion at the end of 2019. Down $383 million from the end of the first quarter as we repaid a portion of the borrowings under our revolving credit facility. Offsetting this debt is cash and cash equivalents of $1.13 billion. Our gross debt-to-EBITDA ratio at the end of the second quarter was 2.1 x, as we are intentionally holding higher than normal cash balances. This ratio was comfortably below our debt covenants of 3.5x . Our net debt to EBITDA ratio was 1.3 x at quarter- end. Both our gross and net debt to EBITDA ratios improved by 0.1 x in the quarter. AMETEK remains well-positioned to manage this economic downturn with approximately $2.1 billion in liquidity to support our operations and growth initiatives.
This includes over $950 million in available revolver capacity. As we highlighted on our last call, AMETEK has a robust balance sheet with no material debt maturities due until 2023. To conclude, our ability to deliver solid results with outstanding cash generation despite these unprecedented challenges is a testament to the strength of our businesses and the dedication of our world-class workforce. The AMETEK growth model and our financial strength firmly position us to manage this economic environment and invest in future growth to deliver long-term success. Kevin?
Thank you, Bill. Andrew, could we please open the line for questions?
Certainly. As a reminder, to ask a question, you will need to press star one on your telephone. To withdraw your question, press the pound key. Please stand by while we compile the Q&A roster. Our first question comes from the line of Matt Summerville with D.A. Davidson.
Thanks. Good morning. A couple of questions. First, Dave, can you talk about what you saw from an organic order standpoint in the quarter and maybe provide some color on kind of what the monthly year-over-year cadence may have looked like from April into July?
Right. Our overall orders were down negative 22%, and organic was down about the same, so they really aligned with our sales. Both of our groups were down and really followed sales. We ended up with a book-to-bill of about 0.99. For orders, April was a low point of the quarter. It grew nicely in May and then again in June, so it followed a similar trend for sales.
Can you talk about your expectation for second -half decrementals? You indicated in Q3 maybe expecting something a little worse than what you had in Q2. Maybe that's what's driving that, and then maybe put that in the context of the sustainability you see for the record EMG margin performance you generated in the quarter. Thank you.
Yeah. The second one. I'll answer your second question first. The EMG margins were exceptional, and they were driven by strong operating performance. We had a positive mix in our defense businesses, and we also had the divestiture of Reading Alloys that contributed to 50 basis points at the EMG level. EMG had a great quarter, and the majority of that margin expansion was driven by excellent operating capability. In terms of the decrementals, we had good decrementals in both parts of the business. We had 16% decrementals in EMG and 31% in EIG. Those are really good. In terms of the guidance of 30% decrementals for Q3, we're adding back some cost, and we're really preparing for a larger fourth quarter. Still for the full year, we've increased our decrementals from 30% - 25%. That's what we're doing.
We're managing the business, looking at the focused on cash, focused on managing the decrementals, and focused on driving key growth opportunities. We're doing an excellent job of managing the decrementals and really keeping our net income, our cash EPS down at the same level where sales dropped, which is pretty amazing when you consider their profitability level of the company. I'm pretty pleased with that.
You got it. Thanks, Dave.
Thank you, Matt.
Thank you. Our next question comes from the line of Allison Poliniak with Wells Fargo.
Hi, guys. Good morning.
Good morning, Allison.
Dave, could you talk? I know you mentioned the structural versus cyclical cost. Could you give a little bit more color on the structural cost savings that you're doing? Is it widespread across the verticals, or is it focused specifically on the more challenged ones, say, like aerospace?
Yeah, I would say the structural costs are more focused on the more challenged markets. They're resizing those businesses to the new demand level that we have. Those businesses are profitable. They'll remain profitable on the way down, and the way we're looking at it, as the businesses start to grow from a bottom, they'll be very profitable on the way up. There's a quick change in revenue, and the team has done an excellent job of adjusting to the new demand level. Also, there was an element of those structural savings that are pulled forward from projects in our strategic plans. We look out every three years, and when we get a time like this, we pull forward some projects that are some efficiencies. Plan consolidations, but mainly the structural consolidations. While across the board, they were mainly targeted at the commercial aerospace and the oil and gas business.
Great. Just turning to the M&A market, obviously still challenged there. Could you give us a little color on your pipeline in terms of size? Have you pivoted to a specific end -market vertical? I guess even just comfort level, just given the uncertainty, relative to the size of potential deals that you're likely looking at.
Yeah, great question. As you know, Allison, M&A remains our first priority, and we feel there's going to be a substantial opportunity for us as we get through this crisis because there's going to be pent-up demand on deals. We have the balance sheet and the cash flow-generating capability to execute on the opportunity. While the broader deal activity is subdued right now, we're very active in pipeline development, and we actually have a couple of deals we're looking at right now. We're actually in diligence. Those are deals that have been working through our pipeline. There are larger deals and there are smaller deals. I'm quite optimistic about the pipeline.
You still have the situation where to get to the end of a deal, buyers and sellers have to agree on new pricing expectations based on the cash flow visibility, and that impacts the valuation process. We're adjusting our process because we have the inability to perform the face-to-face diligence that we used to take for granted, and we still need to have some of that to feel really comfortable with what we're buying. We still think it's going to be late 2020 before the market returns to some kind of normal, but we are active on some properties right now. I'm pretty pleased with how hard the team is driving the pipeline and some of the good candidates in our pipeline.
Great. Thanks so much.
Thank you.
Thank you. Your next question comes from the line of Josh Pokrzywinski with Morgan Stanley.
Hi, good morning, all.
Good morning, Josh.
Dave, can you just remind us, with all of the structural and temporary cost elements coming in, I know you're still kind of leaving it open on the fourth quarter based on demand. How should we all think about incremental margins for next year? Obviously there's a lot of torque in the business. Gross margins are high, so a volume recovery would feel pretty good. If I had to cross-check that against maybe some of the temporary costs that come out, it would still be fair to say that incrementals can start with a three next year, or should we think about that differently or maybe more specifically knowing what we know about the temporary side?
Right. That's a great question. I don't think there's any doubt that incrementals can start with a three. If you look at past downturns, AMETEK's really driven margin expansion as we come out of the downturns. The temporary costs we're going to put back in as we progress throughout the year, that's not stopping us from putting up positive incrementals. I think largely we are going to end up with contribution margins in 2021 in that kind of range. I'm optimistic about that because the other thing you have to factor in is our pricing. Our pricing was very strong in the quarter, it's holding up well. I'm very pleased with it.
Got it. That's helpful. Then kind of a two-part second question. First, anything in July? I think Matt Summerville asked about it, but I don't know if there was anything specific. Maybe talk about the role of backlog in some of the momentum. Are you feeling like you're living hand to mouth in most of the businesses, or was the backlog maybe kind of distorting 2Q, where there are still some longer -cycle businesses that need to run off?
No, our backlog is pretty flat at $1.7 billion. As you know, we withdrew our guidance, what you and what Matt were asking is a sense of where the business is going forward, and we can give you that. If you start with Q2 or sales, April was the worst, it improved in May and further improved in June. If you look at that improvement trend and you look at July, which is supportive of it, we think that we'll be down roughly 15% in the third quarter. That's an estimate based on what we know, and there are many uncertainties. That's kind of what we're tracking too right now.
Understood.
Yeah. Okay.
That's very helpful. Thanks a lot, Dave. I'll give back in queue.
Thanks, Josh.
Thank you. Our next question comes from the line of Nigel Coe with Wolfe Research.
Thanks. Good morning. You mentioned research. I'm just curious how your research end markets performed. Can't imagine the stay-at-home, work -from-home trend is very helpful there. Just curious what you see in that, because I know that's more of an EIG kind of exposure.
Yeah, I'll break the research market into a couple different areas. In the material science area of research, both university and corporate R&D, it was weak. Those projects have been pushed to the right. In the life sciences area, the market's holding up very well. It was shown by our Gatan business, the business that we acquired last year. They had performed very well, slightly ahead of our expectations, and actually had flat revenue year-over-year in the second quarter. Their top line held up well, and that was driven by the life sciences market. The Gatan products have been influential in the fight against COVID. In fact, researchers at the University of Texas used a Gatan K3 camera. They were the first people to structurally image the spike protein on the coronavirus, that's driven a lot of excitement and demand around demand tools.
In fact, Gatan K3 was the first person to structure the coronavirus; the next two people that did it used the K2, which is slower. The speed of the cameras, the K3's faster speed, allowed the researchers to get done quicker. Good demand drivers in that business really point to, again, our research market. There are some areas that are doing very well and some areas that aren't, in certain parts of the world, those research institutions have not really opened up. They're still closed. We're hanging in there, it's a complex story.
Okay. On balance, it doesn't feel like it's any worse than the average.
No.
Maybe just a little bit of context on the geo-markets, if you could give us how the U.S., Europe, and China, et cetera, are performing versus?
Right.
Then just on the export exposure, has that changed materially over the last several years? And I'm just curious how the U.S. dollar weakness maybe benefits you going forward.
Yeah. As you know, we're naturally hedged at the top line and the bottom line based on currency. The currency swing doesn't really impact our profitability, but when the dollar weakens, we do get more competitive. It's something that we're looking at. It's a good thing for us because we export over $1 billion. In terms of the geographical storyline, we really have broad-based weakness, and Europe and the U.S. were most challenged. Europe was down 29% on broad weakness, and it also had a difficult comp because there was some Middle East project business for our oil and gas business. The U.S. was down about 20%, but it was pretty broad-based, and Asia was the best of the markets. It was down mid-teens and had notable strength in Asia in our automation business. China improved for us.
China was actually up 3%. It was a positive rebound in China, driven by our automation and CAMECA business. That's the story. Broad-based weakness. Asia was the best. Driven by China.
Thanks, David. Good luck.
Thank you.
Thank you. Our next question comes from the line of Deane Dray with RBC Capital Markets.
Thank you. Good morning, everyone.
Hello, Deane.
Hey. I did notice that you guys put free cash flow in your release for the first time, so we really do appreciate that.
I'll let Kevin know that. Kevin's got a smile on his face.
I'm sure he does, because I've pestered him about that for quite a while, but we really do appreciate it. Now I feel obligated to ask a free cash flow question, so here it is. Did you benefit at all from the timing of tax payments? We've seen other companies that have had upside on free cash flow. Was that a factor?
Yeah, not a huge factor, Deane. It was probably about $18 million or so. That 183 would still be a pretty strong number, probably in the mid-160s to 170 kind of place.
Good. I really like how you segment the business into those three buckets, just to kind of give us the color in real time as to the COVID impact. Last quarter, I'm pretty sure you included defense in the better bucket, better -performing—
Yes.
...It got called out as a positive mix this quarter as well for—
Yes
...EMG. Can you comment on defense—
Yes
... be in that bucket?
Defense was in the good markets in both last quarter and this quarter. Defense, the buckets haven't changed. Defense and medical were positive in Q2. They were also positive in Q3. As you'll recall, our defense business is about 5% of the company, and it's doing extremely well. It was up low -double -digits in the quarter. While the commercial market was challenged, defense market was strong.
Great. Then on Gatan, really like the update there, especially on the imaging of the spike protein. When is the next generation due to be released? Would that be the K4?
It is. There's a K3 plus and the K4, and we're working on them both, and we have an announcement: the next one will come to market.
Terrific. All right. Last question on CapEx. You had cut $25 million out just for cash preservation.
Right.
When might that come back? Just share with us a bit of your decision-making as to what you would trim and why and what types of projects do you bring back on? Thanks.
Yeah. The important point for us is our RD&E spending is roughly flat with 2019. We thought that was going to be up coming into the year, and we trimmed that back to flat, but we're really investing in RD&E. The types of things where we've delayed our expansions in regions of the world where we're trying to put extra capacity in place, in a new region of the world that we're putting some capacity in. Those kinds of projects got delayed. Quite honestly, we have a decentralized entrepreneurial team, and they understand the situation, so they make natural decisions, and we really don't have to push that number. That's what comes up to us. That's what our business leaders want to spend.
I can see as we get later in the year, we start evaluating turning on some of those expansion projects we have in the various geographies of the world that we've put on hold. It was very difficult to complete those.
That's really helpful. Thank you.
Thank you.
Thank you. Our next question comes from the line of Rob Wertheimer with Melius Research.
Thanks, and good morning, everyone.
Good morning, Rob. Congratulations on the book.
Thank you so much. That's kind. I just have two questions on the temporary side, if I can. I think last quarter you talked about delays and difficulties in getting the customer sites or whatever, pushing out a little bit of revenue. Is that still ongoing, and does that come back at any point? That's the first.
Yeah, that certainly was with us throughout all of Q2, and it's still a bit of an issue, especially now traveling the U.S. Really what it comes to is you can travel, but you're quarantined. That was a big issue in China. Now that's abated, but that's a spotty issue around the world, and it was a big factor in Q2. It'll be a diminishing factor in Q3.
Is that a few points of revenue that kind of come back to you in 4Q or whatever? Or is there a risk—
Yeah
...that it cancels, or is it too small?
No, that will come back. They've been rescheduled. They're pushing things out. It will definitely come back.
Perfect. Then on the cost side, if I may, can you kind of roll the temporary costs indefinitely? The way you described it, it's obvious that commercial aero may be in trouble, oil and gas for a bit, so maybe more permanent restructuring is appropriate there. For the other markets that are just depressed during COVID and we don't know when they will come back, can you roll that indefinitely, or does it come to a point where costs have to sort of come back into the system?
Yeah.
Thanks. I'll stop.
Yeah, that's a good question, Rob. We did a restructuring early on, you recall, and we think we got the balance correct. We'll bring back those temporary costs, but if it gets to the point where there's a diminished long-term viewpoint on revenue, then we can't run with the temporary costs forever. I view those temporary costs as coming back during the course of the year, and if demand doesn't come back, then we may have to do something extra on the cost side. We're certainly not looking at that as a long-term situation.
Okay, thanks.
Thank you. Our next question comes from the line of Christopher Glynn with Oppenheimer.
Thanks. Good morning, everybody. David, you mentioned some different adaptations around delivering and administering some of your aftermarket services operations. I'm wondering if you're revealing any or if any business is coming up with delivery models that might actually be productivity levers and kind of remain post-COVID?
That's really the case. The accelerated adoption of digital capabilities is really opening our eyes, and it's obviously in the digital marketing area and the way we interact with our customers. The one thing I point to is we have complex systems that are installed, and they need to be calibrated, they need commissioning, and we have some service teams that are using augmented reality to remotely service and install our products and really interesting tools right now. I think some of those will be long -lasting, and we're certainly adapting our business and learning as we move through this pandemic.
Okay, thanks. Then in terms of the third quarter outlook for kind of everything getting a little better, other than commercial aerospace, are there some areas you could maybe call out where you're seeing the sharpest kind of rebounds, and in particular, anything just getting back to normal?
Yeah. Our automation business has kind of led us back. That's doing well. Our oil and gas business is going to recover, but that's because of a lack of a comp as much as anything. Those two businesses are ones that will recover, and I think our defense business will be strong, and the other thing we see is in the medical space, we saw really good demand for the COVID-related products like COVID testing and COVID breathing apparatus, but we saw the elective surgeries tail off. In the second half of the year, what our med -tech customers are telling us is the elective surgeries are going to rebound. That's the kind of thing I pointed to.
Thank you.
Thank you.
Thank you. Our next question comes from the line of Scott Graham with Rosenblatt Securities.
Hey, good morning, Dave, Bill, and Kevin
Good morning, Scott.
I wanted to understand a little bit more on the cost side, where you talked about the third quarter; your cost reductions are going to be $65 million. If my calculations here are right, you were a little bit below what the annualized number would be for structural in the quarter, and that should pick up in the second half of the year, which would suggest a pretty significant reduction in your temporary in the third quarter, yet you're not providing full -year EPS guidance. I guess I'm trying to maybe connect those dots there if you're—
Yeah
dropping down on temporary. Why don't you feel more comfortable with giving guidance?
Yeah. There are too many variables and uncertainties to give guidance with our typical precision. I do appreciate your question, and I understand why you're asking for that information. In normal times, we give you that type of information, but these aren't normal times, and we withdrew our guidance, and we just don't feel comfortable putting it back in place yet because of COVID-19 and the lack of visibility and with the typical precision that we have.
Can I maybe take a stab at one of them? Would it be that you're unable to predict what your second half mix will be? Is that part of it?
I was pleased that the mix held up, the pricing held up. That isn't a concern. It's really, if you think about it, we're in a pandemic, and we can have hotspots show up in places, and we're constantly managing things. There's a lot of uncertainty now, and we just don't feel we can give guidance with a typical precision.
Understood. Thank you. Couple of others, if you could.
Sure.
Typically, you give that by business unit stuff. Maybe you can just kind of call out specifically what you saw in the quarter in automation and power research, specifically, and maybe if you could split for us commercial aerospace OE versus aftermarket.
Right. I'll take you through the market segment commentary because that covers a lot of ground, and I think we'll be able to answer your question there. In our process business, overall sales were down high -teens in the quarter. We had the contributions from Gatan offset by organic sales declines in line with AMETEK's organic sales decline. We talked about widespread travel restrictions in addition to project push-outs and delays in our ability to provide service. That impacted the process significantly. The largest weakness in process was our oil and gas business. Our medical businesses performed well in the quarter, as did our ZYGO business, with ZYGO seeing solid growth driven by some semiconductor fabrication work and extreme UV, EUV.
While the end markets remain challenged and visibility is limited, we do expect to see sequential improvements in the third and fourth quarters across our process businesses, including oil and gas. In aerospace, we've talked about that. The defense business was up low -double -digits. The commercial business was down in the high 40s. In the commercial business, the aftermarket was a little worse, and the OE was a little better. We expect our defense businesses to stay strong in the third and fourth quarters. The commercial aerospace business is bouncing around the bottom, and we may have some shifts between aftermarket and OE, but we're not calling that one out as improving. We may be conservative on that, but that's where we are. In our power and industrial business, they were down in the high 20 range. A lot of similar dynamics to our process business.
Demand impacted by the global shutdowns and travel restrictions. The orders in our power business were stronger. We're looking to the second half, where we expect conditions to improve modestly with sequential growth in both our power and industrial businesses. Finally, our Automation and Engineered Solutions business was down mid-teens on a percentage basis. We're seeing automation trends improve across Asia and within China, and healthcare is the other big driver for our automation business. We're seeing good sequential improvements there, and we expect that to continue in the second half.
That's great. Thanks so much.
Thank you, Scott.
Thank you. Our next question comes from the line of Ivana Delevska with Gordon Haskett.
Good morning, guys.
Good morning, Ivana.
I just wanted to ask about the structural cost opportunities as we get into next year. I know there were some volume-related benefits that you were originally expecting to get this year that may get pushed out to next year. Could you just give us a sense of how do you see next year shaping up, and what will be the different buckets?
Sure. We haven't done a lot of thinking about next year at this point, but the one thing that we do know, we'll probably have about $45 million or $50 million flowing over into next year from the structural reductions that we did in 2020. We'll have a good head start on whatever cost reduction plans that we put together, and we'll couple that with the traditional material cost outs and the other projects that we'll put together. We typically have a pretty healthy project list, and we decide on that list during our budgeting process. Haven't really done much planning, but we have a good head start with the structural flow over from the things we've done in 2020.
How much was the volume sourcing expected to help this year that didn't materialize because of the environment?
Yeah.
How much benefit?
Yeah, sourcing was a big driver. I'm just going from memory now. You can check this with Kevin before that. We probably lost about $10 million or $20 million of sourcing savings because the volume isn't there. We had to make that up with the other structural savings.
Perfect. Just one more question in terms of synergy realization. Could you compare next year to this year in terms of how much synergies do you expect from the different deals and the timing?
Yeah. The way I can answer that is we're on track with all of our deals. I mentioned Gatan. That's the biggest deal that we did last year, and we just did a review of that business, and we're actually slightly ahead of our acquisition model. When we combine that business with our EDAX business, it is another business within our portfolio, and they're in the same market. That combination is driving good synergy because they have the same customer base. All of our acquisitions are progressing, and we're certainly focused on the synergy. Some of the top line may not be there, but we're focused on the synergy. It's pretty hard to tell you right now in 2021 what that's going to be.
We'll typically tell you that in the beginning of 2021 when we go through everything and understand it at a granular level, what actually is going to happen and what we're going to do.
Thank you very much.
Thank you.
Thank you. Our next question comes from the line of Andrew Obin with Bank of America.
Hi, yes. Good morning.
Good morning.
I'm going to try the first question. One of the sorts of companies that I cover today sort of took a stab at when they thought revenues were going to turn flat year-over-year. Would you guys care to guess if and when that happens? Hopefully when.
Not going to guess at that.
Okay. Figured that much. You guys highlighted automation doing well. Are you seeing any of your customers sort of moving their supply chains around the globe? What other sources of outside of China automation are doing well?
Yeah, that's a good question. We are seeing that. Supply chains are regionalizing. There was a point in time where there was some overdependence on China, and I think a lot of companies are reconfiguring their supply chains, and there are some reshoring activities going on. That's going to help us because our process businesses help businesses manufacture things efficiently and at lower cost. It's happening. The seeds of that are just beginning now, but that's going to be a good long-term driver for us.
What industries are you seeing reshoring in, particularly North America?
Yeah, it's just the beginnings. There are definitely plans in place for a lot of companies to make their supply chains more durable. We're seeing volume intake and potential volume upticks in places like the U.S. and Europe for reshoring activities. This is really on the early edges of it. It's fundamentally people who want regionalized supply chains and want to reduce their dependence on parts of the world.
On M&A front, you sort of highlighted that you're engaged in some due diligence on these smaller deals. How do you look at your sort of firepower in terms of how much you can spend on M&A over the next couple of years, and how big a deal can you guys get to?
Yeah, I look at it like we certainly can look at our free cash flow and look at our operating cash flow. It's a billion-plus -year type thing. We have current liquidity of about $2.1 billion. Very clearly, our balance sheet's strong. I think Bill mentioned that it deleveraged during the second quarter. In a pandemic, when our top line was down 22%, our balance sheet de-leveraged. That's a testament. I don't know if you want to comment on that, Bill.
Well, I think we certainly did. You mentioned the $2 billion. We could do more than that and still remain below our covenants. As we've always said, this is not a capital-constrained strategy. This is more about finding the right businesses that will move the portfolio in the right direction and drive the returns that we're looking for. The strength of the balance sheet can certainly support a couple of billion dollars worth of deals.
More appetite for larger deals going forward?
We're looking at some larger deals. Gatan, we spent close to $1 billion on, and we have some businesses that are in our pipeline right now that are of that size.
Thank you so much.
Thank you, Andrew.
Thank you. Your next question comes from the line of Andrew Buscaglia with Berenberg.
Morning, guys.
Good morning, Andrew.
Can you forgive me if I missed this? Can you comment on the price versus cost in the quarter?
Yeah, you didn't miss it. We talked about it, but we didn't give the numbers. Very pleased to see our pricing held up well. Q2 was similar to Q1. We achieved about a point and a half of price across the entire business. Total inflation and the impact of tariffs were a little less than 1%. Quite a good positive spread added to margins, and that drove some of the margin and performance in the quarter.
Okay. David, you've been around the block a few times. Given you've had a few more months to kind of digest what's going on with the situation with aerospace. Last quarter everything was so fresh. Do you have any updated commentary about what you're seeing, what you're hearing from customers, and how you expect that market to go over the next couple of years?
It's going to take several years to get passengers back to the same volume in 2019. There's no doubt about that. Our base model for aerospace assumes that there's a medical solution to the virus, whether it's a vaccine or a therapeutic. People have to be comfortable flying again, and that's going to take some time. We're balanced in our aerospace, and our military business is doing extremely well, and we're very pleased with our portfolio. It's a high-quality set of businesses, and our strategy is to focus on a diverse set of markets. We think we're well-positioned with our leadership positions to recover with the market and recover profitably. That's one market that it's going to depend on the government funding, it's going to depend on the capacity decisions of many airlines. It's going to depend on the confidence of the flying public.
There's still some uncertainty associated with that. We just manage what we know, and we can resize the business. I was running our aerospace business back on 9/11, so I've been through a similar type of hit, and you can look at what our aerospace has done since then. We resized it, and it's been a tremendous contributor to AMETEK over time, and we're doing the same thing right now. We have a great team in aerospace and leadership positions in many areas and excellent positions with wide moats, and we're controlling what we can control right now, but it's certainly going to be an extended recovery.
Yeah. All right. Thank you.
Thank you.
Thank you. Your next question comes from the line of Richard Eastman with RW Baird.
Yes. Thanks for the questions. Dave, just to expand on your last answer there, could you just recalibrate us on maybe the percentage of the business at AMETEK that is aerospace and also how the four businesses maybe will perform, or the four segments will perform, for 2020?
Yeah. The aerospace presence is 15% of sales. 5% of that 15 is in the military market, and 10% of that 15 is in the commercial market. That commercial market includes our OE market, includes our business jet market, and includes our third-party aftermarket. That's the business that we're saying is a small part of our company, about 10%, but we're saying that we're not seeing as clear a recovery path during the second half of the year. I think we did a little better in Q2, so we call that at maybe 45% for the balance of the year. It's pretty difficult to get too granular on that market right now because you don't know what many variables that you don't control are happening, and we're just managing what we can control.
In terms of the process business, we're saying we're going to grow in Q3 and Q4, and that includes our oil and gas business. In terms of power and industrial, we're saying we're going to grow in Q3 and Q4, and in terms of our automation and engineered solutions, we're going to grow in Q3 and Q4. We think that sequential improvement that we're seeing will continue as the economy gets back to normal.
Okay. Just one question on the gross margin. Bill, the gross margin declined maybe 110 basis points, I guess, year-over-year. Could you just break that out a little bit? It sounds like you had a positive contribution from price, maybe only 30 basis points or something, but could you just give us a little bit of a walk up there, or walk down on the 110?
Yeah, I think you've got the positive there in terms of the price versus cost, but what you're really dealing with is just the reduction in the sales levels. The incremental margins on the fixed cost. I don't think there's anything more interesting.
Okay. Yeah okay. All right. Mix here, was mix much of an issue here between EMG, again, I guess you favor EMG a little bit with less of a decline versus EIG. Mix was negative there?
I think the military market and the healthcare market held up well for EMG, and in EIG, we have a good part of commercial aerospace, and you also have the oil and gas business.
Mm-hmm. Okay. Very good. Thank you.
Thank you, Rick.
Thank you. Our next question comes from the line of Joe Giordano with Cowen.
Hey, guys. Good morning.
Morning, Joe.
Hey, correct me if I'm wrong, but I thought the view last quarter from an organic standpoint was that EIG probably does a little bit better than EMG. Curious as to what kind of shifted up during the quarter from a market standpoint that would've kind of flipped that around?
Yeah. Everybody here is shaking their heads. We didn't signal EIG would be better than EMG.
Okay.
We talked about the automation business getting stronger. We talked about the military business.
Commercial aerospace.
commercial aerospace was going to be weak, and oil and gas was going to be weak, and those are predominantly in EIG. It kind of laid out like we thought.
Okay. Fair enough. On the R&D side, you talked about some of the advancements some of your businesses have made during the quarter and new launches. Can you just kind of talk to us about how R&D is so critical to what you guys do, and how are you guys doing it in this environment with social distancing and this and that? What has had to change in order to allow R&D to progress at this pace?
Yeah, that's a great question, Joe. I've been pleasantly surprised at the quality and effectiveness, and we're getting the work done. For R&D, it's not ideal. We have to have technicians interact with engineers, and they have to find a way to get together, and there's a certain spontaneity and productivity that comes with people getting together. We're still learning. We're using the tools and doing things safely, and we're making good progress. It's certainly an issue that we specifically have worked on, and it holds us back certainly. The digital tools are helping mitigate the problems.
Thanks, Dave.
Thank you, Joe.
Thank you. Ladies and gentlemen, this concludes today's conference call. Thank you for participating, and you may now disconnect.