Welcome to Johnson Controls Third Quarter 2017 Earnings Call. Your lines have been placed on listen only until the question and answer session. This conference is being recorded. If you have any objections, please disconnect at this time. I will turn the call over to Antonella Franzen, Vice President of Investor Relations.
You may begin.
Good morning, and thank you for joining our conference call to discuss Johnson Controls' 3rd quarter fiscal 2017 results. The press release and all related tables issued earlier this morning as well as the conference call slide presentation can be found on the Investor Relations portion of our website atjohnsoncontrols.com. With me today are Johnson Controls' Chairman and Chief Executive Officer, Alex Molinaroli President and Chief Operating Officer, George Oliver and our Executive Vice President and Chief Financial Officer, Brian Stief. Before we begin, I'd like to remind you that during the course of today's call, we will be providing certain forward looking information. We ask that you view today's press release and read through the forward looking cautionary informational statements that we've included there.
In addition, we will use certain non GAAP measures in our discussions and we ask that you read through the sections of our press release that address the use of these items. In discussing our results during the call, references to adjusted EBITA and adjusted EBIT margins exclude transaction, integration and separation costs as well as other special items. These metrics are non GAAP measures and are reconciled in the schedules attached to our press release. All comparisons to the prior year are on a combined basis, which excludes the results of Adient and includes the results of Tyco, net of conforming accounting adjustments and recurring purchase accounting. GAAP earnings per share from continuing operations attributable to Johnson Controls Ordinary Shareholders was $0.59 for the quarter and included net charges of $0.12 related to special items.
These special items were primarily composed of transaction and integration costs, a mark to market pension, as well as restructuring and impairment charges. Adjusting for these special items, non GAAP adjusted diluted earnings per share from continuing operations was $0.71 per share compared to $0.61 the prior year quarter. Now, let me turn the call over to Alex.
Thanks, Antonella. Good morning, everyone. Thanks for joining the call today. So, if you've read in the release and our slides this morning, we reported a quarter of solid EPS growth, strong margin expansion, driven by the continued progress with our synergies and our productivity actions. I am on Slide 5.
As you will hear from George in more detail, we continue to be below our overall revenue plan. And I just want to point out that many of our businesses and our regions are seeing some good growth and others have fallen short. So it's not across the board. Also need to point out that within buildings, it would be wrong for me to say that I'm sure the merger itself and some of the changes that have come along with that have created some near term distractions that have contributed us not achieving our top line objectives. We believe we can get that back on track.
Our teams will, however, continue to offset the revenue shortfall by our continued driving of synergy and productivity benefits. Given our year to date performance and the expectations for the Q4, we are guiding to the low end of our prior range and we expect our full year adjusted earnings per share to be in the range of $2.60 to $2.62 This will be a 13% EPS growth year over year, strong growth, but not quite where we expected to be when we laid out our guidance in December. Although we haven't achieved all of our objectives, I do remain confident that our strategy and the strategic platform that we're creating, the decisions we're making around integration and organization are positioning us well to serve our customers today and in the long term. It's going help us lean out our cost structure and ultimately will drive both top line and bottom line results. And finally, let me talk about cash conversion.
This is clearly a need that needs to and will improve. In addition to the large cash outflows this year related to the tax payments and the merger transaction, we've also made some operational decisions that have affected our underlying cash conversion. Brian will talk about these in some detail and George will address it also. So let's go to Slide 6, let's kind of give you an overview of a recap of our results. The total company sales for the quarter increased 1% year over year to $7,700,000,000 Organically, our sales grew similarly 1% year over year.
Organic growth in buildings, little over 2%, partially offset by a modest decline in our power business of 2% and George will provide more color and the trends in both of those businesses. Adjusted EBIT dollars are up 15% year over year. We saw solid profitability growth in the segment EBITA level, primarily driven by the continued focus on cost synergies and productivity initiatives, and we benefited also from the lower corporate cost and amortization expense versus prior year, the corporate synergies and the Scottsafety transaction respectively. Adjusted EBIT margins expanded 150 basis points in the quarter to 13%. If adjust for impact of FX and lead, margins actually expanded 170 basis points year over year.
And lastly, EPS for the quarter was up 16% year over year to $0.71 With that, I'll turn it over to George to talk about the integration and also the business performance.
Thanks, Alex, and good morning, everyone. Let me start on Slide 7 by providing an update on the integration. The new organization structure and buildings is now in place and we have selected the best athletes and have asked them to play new positions on the field. Region by region and business by business, we have completely realigned the leadership structure in order to eliminate cost and redundant layers of management, as well as to optimize sales and service productivity. Naturally, this degree of change in a merger of this size brings with it the potential for short term challenges as the players familiarize themselves with the playbook.
With this in mind, we made a deliberate strategic decision to move as quickly as possible to implement our new organizational structure, recognizing this may result in a few false starts in the near term, but will result in a winning strategy and team in the medium and long term. We remain fully committed to achieving our synergy and productivity savings targets and have made great progress during the quarter delivering roughly $80,000,000 or about $0.07 in year over year savings. We continue to track towards the high end of the original $250,000,000 to $300,000,000 range in cost synergies and productivity savings for the year. With roughly $0.18 achieved through the 3rd quarter, we continue to expect to achieve $0.09 in the 4th quarter, which would total $0.27 in savings for the full year. I am proud of the work we've done across the organization and the significant progress we are making on achieving merger related cost synergies.
As I review the regional performance in buildings, I will touch on some cross selling wins. Let's turn to Slide 8. On a reported basis, building sales in the quarter were flat versus the prior year at $6,100,000,000 as 2% organic growth was entirely offset by the impact of FX and net divestitures. Our field business, which as a reminder represents about 65% to 70% of total building sales, grew 1% organically year over year with mixed performance across the regions. We saw continued momentum in our global applied HVAC business, which grew in the mid single digit range.
Fire and Security, the legacy Tyco installation and service businesses declined in the low single digit range, partly due to a tougher comp with the prior year. Let me quickly walk through the region starting with North America. As many of you know, North America is the largest region for both legacy businesses therefore creates the greatest opportunity for growth from both a top and bottom line perspective. This is also the region that has undergone the most significant amount of change. At the beginning of Q3, we put in place a new regional organizational structure, which combined fire and security with HVAC and controls with 27 P and L leaders.
This structure eliminates an organization layer, while increasing our sales management and selling capacity. This now gives us an opportunity to make sure our processes are consistent, that we harmonize the way we go to market where it makes sense and we take advantage of scale. These 27 leaders are a mix of legacy Johnson Controls and legacy Tyco leadership, who know a lot about where they came from, but have a learning curve with the rest of the business. This added a bit of pressure to the quarter. Organic revenue growth was flat year over year with orders down 4%.
Keep in mind, order activity can be lumpy and when adjusting for the timing of large orders, year over year order growth was relatively flat. As we now have been operating in this structure for a few months, we are continuing to make progress improving the level of depth and expertise of the P and L leaders. Although there has been some short term impact, I am very pleased with the progress that has been made over the quarter, including the success we have had with cross selling wins. We designed and implemented a new sales operating model to enable our customers to buy how they want to buy. For example, during the quarter, we won a large project in the healthcare vertical.
The fire team secured the order to install a fire detection system in a new building, as well as the retrofit work in 2 existing buildings. Embracing the one team approach, the fire team brought in their HVAC colleagues who are able to successfully displace a large HVAC competitor. Moving to Asia Pacific, we had a strong quarter all around. Despite the concerns of softening macroeconomic conditions, both organic revenue growth and orders were up in the high single digits, driven by China and Northeast Asia. Contributing to the growth was a strong increase in service revenue.
We have added additional technicians in China and Japan, and we are seeing nice growth as a result. Additionally, the team had several cross selling wins in the quarter, which contributed to the high single digit order growth. For example, the team secured a nice win in Hong Kong for cooling systems in 19 rail stations. By leveraging cross business relationships, the team was able to secure this win over a seated competitor. Moving to EMEA, the macroeconomic indicators are mixed across the region.
Within our businesses in Europe, low single digit growth in Continental Europe was partially offset by a decline in the U. K, resulting in overall modest growth. The Middle East on the other hand continues to be challenged. However, the decline has moderated to the mid single digits. Lastly, Latin America continues to grow organically, primarily driven by our subscriber business.
Overall, orders in the EMEA region were down modestly. Looking now at our product business, which represents the remaining 30% to 35% of buildings, sales increased 4% organically year over year, a nice sequential improvement from the 1% decline we saw last quarter. We continue to see very strong growth in our North America Residential and Light Commercial HVAC Business, which grew high single digits organically, benefiting from a significant amount of new product launches despite beginning to lap more difficult comparisons. Our Hitachi business also grew high single digits organically, aided by a recovery in the timing of shipments we discussed last quarter. Additionally, as expected, our Fire and Security Product businesses have stabilized and are holding flat with the prior year.
Buildings EBITDA increased 7% year over year to $908,000,000 The segment margin expanded 110 basis points to 15% as strong synergy and productivity savings, modest volume leverage and favorable mix more than offset planned incremental product and channel investments during the quarter. Turning to orders and backlog on Slide 9. Total building orders increased 1% year over year organically, up 3% when adjusting for the timing of large orders, driven by a 4% increase in product orders, which drove the revenue growth in the quarter given the book and shift nature of that business. Field orders were flat with the prior year as strong growth in Asia Pacific was partially offset by a decline in North America and EMEA as I previously mentioned. In terms of the order pipeline, we are seeing continued momentum in the U.
S. Market with stable growth in non residential construction verticals year over year and expect to see orders growth in our North American field business next quarter. Backlog of $8,400,000,000 was 3% higher year over year, excluding the impact of foreign exchange and M and A. In summary, the teams are coming together well, having been very engaged with every member of the team through this process. I remain convinced that the strategy of this combined entity is going to continue to unlock significant value for customers, employees and shareholders.
Turning to Power Solutions on Slide 10. Sales increased 6% year over year on a reported basis to $1,600,000,000 driven by the impact of lead pass through, which benefited Power's top line by roughly 8 percentage points. Organic sales were down 2%, driven by a 3% decline in global unit shipments with declines in both the OE and aftermarket channels. OE unit shipments declined 6% versus last year with particular weakness in the U. S.
And EMEA related to lower OEM production volumes, which declined at a similar rate. On the aftermarket side, which accounts for roughly 75% of our volumes, unit shipments declined 2% year over year. Weakness in the aftermarket channel was more prevalent in EMEA and China, where customers delayed order decisions based on the drop in LME lead prices throughout the quarter. Given the typical restocking that takes place in the late summer months, we expect lowtomidsingledigitorganicgrowth in the 4th quarter. Global shipments of start stop batteries continue to expand with a 17% increase year over year, despite a difficult plus 22% prior year comparison, including another quarter of significant growth in China and the Americas.
The decline in EMEA was tied to the lower level of production in Europe. Power Solutions segment EBITDA of $304,000,000 increased 8% on a reported basis or 7% excluding foreign currency and lead. Power's margin expanded 40 basis points year over year on a reported basis, including a 120 basis point headwind from the impact of higher lead cost. On an EBITDA dollar basis, lead was a slight tailwind in the 3rd quarter. Underlying margins, excluding the impact of lead, increased 160 basis points year over year driven by favorable price mix as well as productivity benefits partially offset by lower volume leverage.
Now let me turn
the call over to Brian to walk through corporate and the consolidated financial details of the quarter, as well as our outlook for the Q4.
Thanks, George, and good morning, everyone. So on Slide 11, you can see that our corporate expenses were $23,000,000 or 16%, lower than last year as we continue to see the benefits from the ongoing synergy and productivity actions we have in place. And we continue to feel that the corporate expenses for the full year will fall at the low end of the $480,000,000 to $500,000,000 range we originally provided. Before we go into the financial highlights section here, I'd just comment that our results for the quarter do reflect some special items, again, transaction and integration costs, restructuring costs and primarily mark to market charges. Those are outlined for you in the appendix, both for Q3 on a year to date basis.
And as I go through the commentary, I'll exclude those items from my comments. I'll also just say that I'm going to move through the financial highlights section pretty quickly here because I'd like to spend a little bit more time in the area of free cash flow. So on Slide 12, you can see that our sales in the quarter were up 1% to $7,700,000,000 on both a reported and organic basis. And SG and A expenses are down 6% quarter over quarter, again reflecting our team's ongoing focus on cost and synergy realization. If you look at equity income of $69,000,000 significantly higher than a year ago, and that again So for the quarter, EBIT was up 15% to 1,000,000,000 So for the quarter, EBIT was up 15 percent to $1,000,000,000 and overall EBIT margins of 13% were very strong, up 150 basis points from 2016.
Moving to Slide 13, you can see that net financing costs are up $124,000,000 versus last year, and that's primarily due to the debt issuances that we discussed with you last quarter. Our effective tax rate of 15% continues to compare favorably to our prior year rate of 17%, and you can see that our income attributable to non controlling interest is $74,000,000 which was up $18,000,000 from the prior year, and that continues to reflect the strong performance of the Hitachi joint ventures. The overall diluted EPS for the quarter of $0.71 is up 16% versus the $0.61 a year ago. Moving to Slide 14, just a quick EPS waterfall here for Q3. You can see that we delivered our targeted $0.07 benefit from cost synergies and productivity savings in the quarter, Organic growth in buildings and some favorable mix in buildings and power provided additional $0.03 and we again picked up the $0.02 from the tax rate.
These were partially offset by incremental investments in our business of $0.01 and $0.01 of foreign exchange. I would just comment that each of these bridge items are right in line with the Q4 or Q3 waterfall guidance we gave on our Q2 call. So now let's move to free cash flow. Given the significant cash impacts of special items during the year, we've provided a reconciliation for you both for Q3 and Q4 I'm sorry, Q3 year to date. The items that we have called out relate to transaction integration costs and restructuring costs as well as the tax payments.
When you look at our Q3 year to date adjusted free cash flow of $200,000,000 it's obviously well below where we would typically be at this point in the year. And I'd just like to make a few comments on a few specific items here. As Alex mentioned, there were some specific operational decisions that were made in the quarter, which have resulted in cash outflows versus our original guidance. These include a $400,000,000 inventory build in Power Solutions as well as the establishment of our hedge of our stock based deferred compensation liabilities. And I'll comment on each of those in a second.
In addition to those two items, the timing of dividends from several of our equity affiliates have been delayed, pending further discussion with our minority partners on whether those dividends when those dividends will be paid or if they'll be reinvested in the business. So, talking about the Power Solutions inventory bill, it was really driven by customer requests to ensure that we meet their stocking demands during the Q4 of this year and the Q1 of fiscal 2018. I just comment that in the Q1 of fiscal 2017, we incurred incremental service and support costs and likely lost business opportunities due to inventory shortages that we had during the peak season and we want to minimize that as we move into this year's second half of the calendar year. In addition, the lower sales volumes in Q3 and Q2 increased our overall inventory levels. Consistent with John's Controls past practice pre Tycho merger and the Adient spin off, we made a decision in Q3 to hedge our stock based deferred compensation liabilities in order to reduce the future income statement volatility associated with the movements in our stock price.
As many of you know, Q4 is always a strong cash quarter for John's Controls and historically for Tycho as well. And we expect to deliver adjusted free cash flow of approximately $900,000,000 which is slightly higher than last year on a pro form a combined basis of JCI and Tyco. I'd like to do a little walk here to take you back to the original guidance that we provided of $2,100,000,000 if you adjust that for the decline in our earnings per share for the year, you arrive at a number of between $1,900,000,000 $2,000,000,000 And so the bridge that I'd like to kind of take you through here is for the 1st 3 quarters of this year, we've got adjusted cash flow of $200,000,000 as you see on the chart. We've got Q4 projected cash flow of $900,000,000 to get to the 1.1 dollars And then if you add to that the inventory build of Power Solutions, the equity hedge of $100,000,000 the delayed dividends from the JV of $100,000,000 you get to $1,700,000 And then on top of that, we have seen in the quarter and a little bit late in the second quarter a build in receivables within the buildings business.
And that relates, I think, in part to the fact that we're consolidating a lot of activities into our shared service centers globally right now, merging the Tyco locations with the JCI shared service centers. And we've seen a little bit of a build in receivables that we've got to go after here in the Q4 and into fiscal 2018. I would also kind of step back and look at the trade working capital as a percentage of sales. And if you look at, I guess, I would call it our entitlement as to if we would target trade working capital as a percentage of sales in the buildings business to be around 12% and the power solutions business to be around 20%, I think we have got about a $500,000,000 plus opportunity to go after some trade working capital opportunities here beginning in the Q4 through fiscal 2018. Our free cash flow is below plan levels and we recognize it's been very choppy in 2017 both in terms of the number of adjustments we are talking you through as well as overall free cash flow conversion rates.
We are committed to improving working capital in 2018 and we think the gap between our reported cash flow and our adjusted free cash flow should tighten. We also think that our free cash flow conversion rate should now be above the 80% as certain of the operational items that I just talked about should in fact turn in the 4th quarter late in Q4 or into fiscal 2018. Moving to Slide 16 on the balance sheet. At the end of the third quarter, our net debt to cap ratio is 41.2%, up from 40.3% at the prior quarter end. And as most of you know, we are moving forward with the share repurchase program in the second half of this year that was up by about $500,000,000 in the Q2.
And year to date, we have repurchased 10 200,000 shares for about $426,000,000 and we would expect the full year repurchases to be in the range of $650,000,000 to 7.50 Just quickly talking through a couple of other items that you'll see in Q4, We'll see the items related to restructuring, transaction integration costs and income taxes. We also will have our normal mark to market on pension and OPEB in the Q4. And in addition to that, I would mention that we've got the reportable segment change for buildings that will be made in our Q4 of fiscal 'seventeen. And as part of our earnings in Q4, we will provide restated quarters on our new segment basis for buildings. And then finally, I just wanted to confirm that the sale of our Scott Safety business to 3 ms is expected to close in Q1 of 'eighteen and the net proceeds of between $1,800,000,000 $1,900,000,000 will be used to pay down the $4,000,000,000 TESARO debt that was incurred in connection with the Tyco transaction.
Turning to Slide 18, as far as Q4 guidance is $0.86 to $0.88 which is a 13% to 16% increase versus $0.76 last year. We've got a year over year waterfall. As we've mentioned before, we continue to believe there will be $0.09 of benefit related to cost synergies and productivity savings. And we'll have volume and mix of $0.01 which reflects some price cost pressure that we expect to see as we move through the Q4. Our effective tax rate of 15% compares favorably to the prior year of 17%, So that contributes a couple of pennies.
And I would just comment we continue to evaluate additional tax synergy opportunities related to the Tyco merger. And finally, continued investments in our buildings and power businesses represent a $0.01 impact in the 4th quarter. So overall, our organic growth is now estimated to be 2% to 3% over last year with overall EBIT margin expansion of 70 to 90 basis points. As far as full year guidance on Page 19, given our reduced Q4 organic revenue growth, we are guiding full year EPS to the low end of the range previously provided. That range is $2.60 to $2.62 which represents a year over year increase of approximately 13% versus the $2.31 on a pro form a basis last year.
And with that, Antonella, we can open it up for questions.
Thank you. We'll now begin the question and answer Our first question comes from Deane Dray with RBC Capital Markets. Your line is now open.
Thank you. Good morning, everyone.
Good morning.
Maybe we can start with, Alex, your opening comments, you referred to some of the distractions on the integration and maybe George was referencing the same thing about some false starts. But maybe you could give some examples or some specifics around where that might have been seen in the quarter and how that has been addressed as we look at fiscal Q4?
Yes. So the two things that I'd point out is, one is kind of clear when Brian talked about our receivables issue, if you look at it, as we started moving to shared services, I think that I think there's a distraction there. So either some cash that wasn't collected, processes change, people have moved and locations have moved as it relates to some of our collections. So that's one that's pretty easy to get your head wrapped around. We'd like to think that we're not going to have things aren't going to hit the ground.
But obviously, if you just look at if you see the underlying receivables with some of the stuff that Brian talked about, you can see that it's something we can get back, but we lost a few days, if you look at our DSO. And if you think about where the I think George referenced the largest part of our business being North America, and that is where both businesses came together. And as we came together, it's just you can't point to a specific thing and say, well, we lost a project or somebody got distracted. But you just know because those changes happened right after the end of the Q2. I mean, we timed it to make sure that we got through the Q2 and then we made the changes.
And so it's just logical to understand when you go through that kind of change in your field organization that you're going to have a little bit of time that people need to adjust to new bosses and new organization. But in the end, when you get out in front of the customer, that hasn't changed. So the reason we have confidence that this is a short term challenge and one that's hard to put your finger on is that when you get in front of the customer, the people that were calling on the customer service and the customer and their boss at the local level has not changed. But when you look above that, they have a much leaner structure, a much more logical structure and one that's going to work in the long term. But it's just changed.
And I think that it would be naive for us to think that, that didn't have somewhat of an impact probably on some of our order securities, my guess. And so hopefully orders aren't lost, it's just we just got to go through a process. So that's the way George, you probably have more color on it, but that's the way that I would characterize it. North America is probably the place that we're going to see it is where we see it.
Yes. Just a little bit to add, Deane. I would say that when you look at the buildings organization, you've taken 2 very large organizations. And although we talk about legacy JCI, legacy Tiger, we're running these businesses across the globe together. And so you can imagine from a leadership standpoint, the changes that had to occur.
And I am more confident than ever the way that the teams have come together in the sales management and the sales capacity that we've created, while taking out layers of management that that is going to translate to accelerate the acceleration of orders and growth. Our pipeline, although we didn't convert in the quarter, we see a very nice pipeline build across the globe with opportunities and the quoting activity as a result of that pipeline is increasing. So I'm developing more confidence every day that as we put these organizations together, building off of the strong customer relationships that we had within the legacy structures, working together now into one operating system, we're now seeing that coming through.
Got it. And then just as a follow-up on the free cash flow situation for the quarter. For Brian, is that $500,000,000 trade working capital opportunity, that sounds like a new target, just the degree of confidence in going after that, the pace of which you think you can begin to ring that out. And does this change in any way the JCI longer term goal of reaching 90% free cash flow conversion by 2020?
No. The 90% is still intact, Dane. And as far as the $500,000,000 that's a target that's based upon where we think our optimal position is on trade working capital as a percentage of sales in each of our businesses. And historically, Building Efficiency and Tyco, I think when their trade working capital is well under control, we feel on a combined basis that a target of 12% there makes sense. And we're 150 basis points higher than that right now.
And when you look at Power Solutions, we're of the view that 20% is a historic targeted level that we think is optimal. And we're at $22,500,000 to $23,000,000 right now. So if you do the math on that, you pretty quickly get to a number of about a half $1,000,000,000 that should be achievable and we've got teams that are going after it.
Dean, some of that is some of the same stuff that we talked about. We have an optimal level of inventory within Power Solutions that is not as high as it is today. But one of the things that we've done is we've gone through because of the customer issues we had last year, the orders we missed and the service penalties we paid. We put capacity and as you know our capital spending is pretty high in North America. We put capacity and that will help us in the future.
But this year we're needing to put inventory in order to get through the season. I think we've got some capacity that's going to go in place that will help us offset some of the need for inventory in the future too.
Thank you. Our next question comes from Andrew Kaplowitz. Your line is now open.
Hey, good morning, guys.
Good morning. Good morning.
Alex, maybe you can talk a little bit more about what's going on in your power business. You guys have leading market share in the business. And I know last quarter you suggested that your power team was feeling good about the rest of the year and then you missed your own quarterly projections by significant amount. We know that part of the issue is customers waiting for lead price reductions, but why wouldn't that have been somewhat of a concern last quarter and something that maybe your teams could have been better prepared for? So just sort of commentary on visibility around that power business going forward?
Yes. That's a good question. What I would say is it's not a North American phenomenon because of the closed loop system in North America. I think both in Asia, specifically China and Europe, we see that phenomenon. And I think there's just been a lot of tension within the business.
How much in order to motivate your customers, how much do we want to do to pull orders forward, which would mean essentially we would give them relief early versus being able to deal with the price changes as they happen. So I think that we were probably hopeful that we could pull some stuff into the quarter. I think that naturally it's going to happen. I think we'll see that happen in the Q4. And it's hard to it's hard the only thing I can tell you for sure is we haven't lost any share.
And it's the team is just as frustrated as you are because it also double dinger, it also hit us in the inventory. If you think about our inventory and power, it's not only the inventory we built on purpose, but the fact that we didn't get the sales coming out in the quarter that we expected. So I don't think it's we didn't have our eye on the ball. I think we're probably a little optimistic that we could pull in front of the price changes for lead.
And Alex, when you talk about sort of the low to mid single digit growth in the business going forward, is that still optimistic or is that sort of realistic now based on what you see?
I think it's realistic. I think that quarter to quarter, we obviously are seeing some volatility. But if you just look at the orders that we have, we are going through a change where a lot of our customers are now moving to AGM products. So I think one of the limiting factors are we going to have the batteries to be to serve that market as we move forward. Some of the challenges, the reasons why it's only 17% growth in AGM, which is not as high as it's been, as part of it is we're capacity constrained.
So our customers are going through changes and we're putting the capacity as fast as we can. I think the market is there on an overall basis, because you just look at the build and the replacement cycles, the market is there, the timing of it is something that we don't control. And it got away from us this quarter because it caught us both on the inventory and the sales.
Thank you. Our next
You built about $1,100,000,000 of trade work capital this year. And Brian, you're saying there's about $500,000,000 of relief from that. So I'm just wondering, is the message that you came in post merger kind of low on working capital and you have to rebuild some of that and as a result you've lost some business and therefore now you've kind of gone above that target range you have to dial back. So that's the first part of the question. And the second part is, you're not really assuming much working capital benefits in 4Q.
Is that right? And if so, why is that?
Yes. So the 4th quarter benefits, I mean, if you look at the bridge that we provided to get to the $1,900,000,000 I think there's going to be late Q4 into the Q1. I do think we're going to see at least $200,000,000 dollars of the inventory build flush out. And then I think the dividends from the JVs, we also are still of the view that that is going to be received. As I mentioned, we're sitting in the situation now where we're discussing with our joint venture partners whether there's going to be dividends to each of the partners or whether or not we're going to reinvest in the business.
But we believe at this point that's a timing item as well. And then on the receivable build of a couple of $100,000,000 I would expect that we would start to see some of that turn as well as we get after this trade working capital initiative that we've got we're moving forward with here. So I do think that there's $400,000,000 of that bridge that I gave you that we're going to see come back in relatively short order between now and mid fiscal 2018, which should improve our cash flow north of the 80% level that we had originally targeted for fiscal 'eighteen. As far as your first question on optimal levels of trade working capital, I mean, there's no doubt that we have gone backwards in the 1st 9 months of this year. The biggest pieces of that tended to be the inventory build at Power and the receivable we've talked about.
There were also payables is also about $100,000,000 headwind there. So I think when we look at our overall initiatives for fiscal 'eighteen, we're going to work toward trade working capital as a percentage of sales of 12% at buildings and 20% at power. And we think that's a good place to be both from a customer standpoint and from a company standpoint.
Thank you. Our next question comes from Jeff Sprague with Vertical Research. Your line is now open.
Thank you. Good morning, everyone. Good morning, Jeff.
Just back on cash flow here.
Can you give us a sense
of what you're expecting for CapEx in 2018 relative to 2017?
Yes. So Jeff, if you look at Power Solutions, we're finishing the AGM capacity in North America and we've got 2 plants that we're finishing up in fiscal 2018, early 2019. So it's a pretty heavy year from the standpoint of I would call it, growth CapEx in Power Solutions. As you know, this year, we guided to $1,250,000,000 to 1,300,000,000 dollars I think we're going to be in line with that. I'm guessing next year could be in the 1,400,000,000 dollars range plus or minus is kind of what we're thinking right now given the power solutions investments.
And just trying to get
my head around the conversion, obviously, on the cash flow miss here. I understand not wanting to overpromise for next year, but let's call it $100,000,000 headwind on CapEx. If you've got this big of a working capital swing, actually feels like the number could be could have a 9 handle on it. I mean, is there something else I'm missing there? I wonder about other kind of charges that are maybe not in the deal integration numbers, etcetera.
What other consideration should we have in mind when we think about 2018 free cash flow?
No, I understand the math you're doing to get a 9% in front of it. I think we're still in the process of finalizing everything for fiscal '18, Jeff. And we'll provide more color on this when we go through our 'eighteen guidance. But I mean suffice it to say we all recognize that given the poor performance in 2017 and certain of the working capital areas that should certainly provide some tailwinds for us as we go into 2018. And I would say, but all I'm committed to say right now is it will be north 80%.
I think that's the responsible way for us to answer the question, Jeff, at this point. But your math, we understand your
math. Thank you. Our next question comes from Steve Tusa with JPMorgan. Your line is now open.
Hi, guys. Good morning.
Good morning.
What exactly is the hedge for deferred comp? And I have a follow-up on that.
So we have got stock based compensation awards that we give to our employees and you essentially work with a financial institution. You give them the money to purchase the shares and they essentially allow you to provide a hedge against future movement in your stock price. So to the extent that we buy in at, I believe in the 10 Q that you'll be seeing, I think we bought in at $42.21 And that hedge is going to offset movement upward and downward in the stock price versus the $42.21 So essentially what it does is, it takes the volatility out of your income statement for any movement in your stock price, which is required under GAAP to be either a compensation expense or a compensation benefit as you move through the year.
And does that have any influence on what ultimately your employees receive? No. Okay. Okay. And then just on just looking a bit ahead, these are just basically items that are probably known at this stage of the game.
And any view on kind of what ForEx looks like if you kind of snap the line here for 2018? And any other parts of the bridge in 2018 that are kind of would be more just financially oriented? We can all kind of do our own math around volume and mix, but and any planned changes in the tax rate? And also are you reaffirming kind of the synergy forecast that you guys gave at EPG? I assume there's no change there given you're executing well this year.
Yes. So the synergy number of $250,000,000 we reconfirm. The tax rate, we haven't finalized all the effective tax rate work at this point in time for 2018, but I would say that it will be 15% or lower. And as far as FX, I don't think I've got any specific guidance at this point in time on that, Antonella?
Yes. I mean, if you take a look at kind of how rates have moved, particularly now, you could see that we brought down our FX headwind expectation for the year. So I mean, if rates stay how they are, I mean, if we take Q4 as an example, there's really not much of an FX either headwind or tailwind. It's actually pretty neutral. But as you know, rates move.
So as we get closer to 2018, we'll obviously adjust to the more current rates to see what type of impact that gives us.
Thank you. Our next question comes from Tim Wojs with Baird. Your line is now open.
Hey, everybody. Good morning. I guess I was just on cash flow again. Is there any thought or is there any concern just as you kind of trade off working capital that, that has any impact on kind of the growth algorithm for the businesses?
I'm sorry, you mean not having or having?
I guess if terms are tighter, I mean does that have any impact on how you guys think how growth could come into P and L in the buildings business? If maybe terms are a little less favorable.
No, I don't think so. I don't think that I don't see I think that what we're talking about now is we've got some process issues that we need to fix and some terms that we need to harmonize, that's our opportunity. I don't see that we're going to do anything that's going to affect the growth of the business. And that's why I think when Brian talked about it being an entitlement, I think that's the reference the way that he was framing it. I thought maybe you're talking about Power Solutions.
We did lose some growth because we didn't have inventory last year or didn't have batteries. And you can either think you need to have capacity or you need to have inventory. I think that at this point, we got the worst of both worlds because we've got extra inventory and we're putting capacity in. So we won't be in that shape we won't be in a similar shape again next year from an inventory in power. But if you look at receivables and buildings, there's I think Brian talked about right, it's an entitlement.
It's not going to affect our growth. And if you look at inventory and power, it's the same thing that we can take our inventory down and not hurt our growth because we're putting new capacity in.
Okay, great. And then just what's the as you look at kind of price cost that's been a theme this earning season, I mean, how would you guys frame the price cost discussion heading into fiscal 2018, particularly in the building side?
Yes. So if you look at buildings in the Q3, we are up 110 basis points on margin. That was driven by volume leverage. We got the synergies and productivity as well as now we are seeing the growth come through the products businesses, which is a higher mix. Now that was somewhat offsetting some price cost of about 20 basis points and that's mainly driven by steel, copper, aluminum as well as some refrigerant.
And so as we look at this going forward, we will still have the strong synergies productivity. We will continue to see increasing volume leverage, we will get the mix of our products beginning to accelerate, but we are going to see continued headwind here in the 4th quarter, which we are estimating now to be about 20 basis points.
Thank you. Our next question comes from Noah Kaye with Oppenheimer. Your line is now open.
Yes. Good morning, everyone. Thanks George, you mentioned earlier that you're starting to see a very nice pipeline and favorable quotation activity. Can you just give us a little more color on maybe where that is geographically or kind of within the segments?
Sure. So, if you start let me start in North America, because that's certainly the big focus area. That the new organization that we put together, we freed up a lot of resources that when we took out the layers of management to put back into sales management as well as selling capacity. Now as we are putting the businesses together, we got a little bit behind of our hiring plan with our sales force, but we are significantly increasing our sales capacity as we speak. And then with the work that we have done, the team has done a nice job in putting together processes in the field as we're now leveraging the existing customer base that we serve to be able to better serve the customers with the complete portfolio.
And I talked a little bit about that in my prepared remarks, making it simpler for the customer to be able to buy from us the total capability. So when you look at the pipelines that have been developed across the globe within our direct channels, we are beginning to see that. Now there is a timing of conversion as we go through this, but it gives me confidence that based on what we see, we are going to begin to see an improvement on a go forward basis. In our product businesses, the team has done a really nice job not only making sure that we have got we are leveraging the channel, our direct channels, but also expanding our indirect channels across each one of our product businesses. So not only are we investing in our direct sales capability, but we're also expanding our channels.
You'll see that some of the bright spots during the quarter in our DX business with a very difficult compare. Last year, we were up about 17%, we were up another 10% this year. That is really an output of some terrific work that's been done expanding our channels to be able to capitalize on the growth in the market share. So what I can tell you across the board, it's certainly a key focus in being able to not only get world class sales management, but increasing capacity in our direct channel, as well as our indirect distribution that will enable us to be able to capitalize on a broader part of the market.
Okay, great. Thanks. And then
just on Power Solutions, Alex, I think you mentioned kind of some capacity shortages around AGM. With all that we're seeing and reading around kind of changes to drive chains across the auto industry, Is AGM demand kind of trending globally the way that you thought it would as you look out the next couple of years? Or is it perhaps accelerating? How do we think about that and kind of your own capacity build plants?
Yes. It's a good question. There's so much being written about every all this whole topic, but what we're seeing is probably going to move faster than we can afford to even meet the capacity. So I think we're going to have to be we're going to have to make sure that we put the capacity in the right place and leverage it because I think it's just going to escalate. What we do see people trying to do is put some batteries in that aren't quite AGM capable.
And then what we find is they come back later and say we need to do something else. And our capacity plans are pretty significant. Our share is really high. I think there will probably be more demand, which will be a good problem to have. I just think we're going to have to be pretty choosy, I think, on who we serve.
I think that's where we're going to be in the next few years.
Thank you. Our next question comes from Julian Mitchell with Credit Suisse. Your line is now open.
Hi, good morning. Just wanted to circle back on the Power Solutions division. So I guess it's obviously unusual to be sort of growing inventories while sales volumes came in a bit light. I understand that the guidance is for aftermarket sales to recover in the next few months. But just thinking about the risks that the inventory stay high, right now?
And then also on the power side, I understand the drawdown of working capital not really having a revenue impact, but maybe just talk about any profit or EBIT margin impact as you get that adjustment on working capital in Power? Thank
you. Okay. I'll address the first one. This is Alex. What you our inventory is much higher than it was a year ago.
And that's twofold. One is, it's a response to the fact that we you may recall, we called out when we were having service problems over the actually over the last year and a half, we had service problems in the peak season because our peak capacity is probably 120% of our total capacity and to have inventory and be able to serve our customers. We've done meetings with our customers, particularly in North America, our very large customers who essentially put us on notice that they're not going to be short of batteries anymore. And so I think we've compensated for that in a way that we have the inventory and we're also putting it at capacity, so that we don't have to have this much inventory on an ongoing basis, so a year from now. So I'd say it's sort of a kind of in between where we are and where we need to be as we put capacity in.
Our inventory levels won't be quite as high, but they won't be as low as they were a couple of years ago. But that still gets us in the range of where Brian was talking about as far as what we would believe our entitlement for working capital. And that certainly is within Power Solutions, it really is an inventory story.
Yes. I don't think there's going to be any impact negatively on margins as that inventory turns out. I mean, as we've kind of talked about in the past, sometimes your margin rates can vary depending upon where lead is, but I don't think there's any downward pressure on margins at Power Solutions as a result of that inventory turning out.
Thank you. And then just my follow-up would be on the building side. You've had a big push on trying to reinvest more to take share, and you had pretty good quarter numbers in the legacy buildings business this quarter. So that seems to be working. When you think about the incremental investment from here, do you think there's a need for another big step up?
Or do you think that the organic investment in HVAC in particular is running around the right level today?
Yes, Julien, this is George. As you said, we are getting really good traction with the new products that we're bringing to market. And when you look at the performance in across our portfolio, I think that's beginning to show whether it be in the residential, like commercial or across applied as well as within our controls and that's where a lot of the investments are being put in. What I see going forward as we continue to gain the momentum, we are going to continue to reinvest and look at incremental investments that we see as given the success we've had in each one of these segments that we see a lot of opportunity with the investments we're making. So we are going to obviously take that into account as we are beginning to accelerate and gain market share, but it gives us a lot of confidence that with the investments we are deploying, we are beginning to see the growth come through and it's coming through at very attractive margins.
Yes. Just to add to that, Julien. We have some really exciting things that are going to happen over the next couple of years as it relates to some of the products we're developing. So I think that I think it's just going to get better. And one of the opportunities for us, particularly, look what's happened not only with Hitachi but just our business in Asia, I think you'll see investments there to where we'll be able to take advantage.
We have a great position and we can take advantage of our position in the marketplace. Some of that top line that we're getting in through Hitachi, you don't see particularly in China because it's unconsolidated, but it's growing pretty well, particularly in China.
Operator, I think we may be at the top of the hour, but we're going to try and squeeze in one more.
Thank you. Our next question comes from Gautam Khanna with Cowen and Company. Your line is now open.
Yes, thanks for fitting me in. So following up on Jeff Sprague's question about the cash flow. In Q4, how much of the items that you've mentioned that slipped out of Q3 and perhaps this year do you expect to recover? So, powers inventory build, the 400 $1,000,000 the hedge, the dividend and of the receivable, the 2 $200,000,000 receivable? How much is embedded in your expectation for Q4?
So in what we've talked about, none of it is expected to come back in Q4. We think most of it will come back in 1st and second quarter of fiscal 'eighteen.
Okay. And so given that and I think previously you've talked about a $300,000,000 tax item coming back to you in Q1 as well. Should we expect that Q1 and perhaps Q2 of fiscal 'eighteen will be very, very strong free cash flow relative to history?
Should be stronger than we've seen historically. That's right.
And Gautam, the one thing to remember is, remember when the cash went out for the tax payment, we had it as one of our reconciling items. And when the cash come back, we said we would do that as well.
Yes. So we won't take credit for it. We'll just take the money.
Operator, is I want to pass it over to Alex for any last comments.
Let me just wrap up here. Thank you everyone for the call and all your questions. We really appreciate it. So I just want to make sure that I understand your feedback and three things I'd like to point out. First is the synergy and productivity numbers are doing as well or better than we expected.
We don't really expect that to change. And so I want to make sure that as we talk about this, that we show that we're making progress there. Top line, I think, is mixed. We have some opportunity, but we also are seeing some benefits and we haven't lost those benefits, but there's some opportunities for us to make some improvements. And then clearly, cash flow, we get it.
There's work that needs to be done. We're a little gun shy talking about, as you can see from our responses around how this is all how and when this is going come back, but we know the opportunities there and we're committed to make sure that you're going to see the cash flow numbers as good or as better than what we've talked about in the past. So I just want to wrap on that and I want to thank our employees. A lot of work, hard work is being done in order to make this one company. Thank you very much.
Thanks, Allison. Operator, that concludes our call.
That concludes today's conference. Thank you for your participation. You may now disconnect.