Earnings Call: Q2 2016

Jan 26, 2016

Summary

Q2 sales and orders weakened sharply, but adjusted margins held up through restructuring and cost controls. FY16 adjusted EPS guidance midpoint remained $6.10, with weaker second-half organic growth now expected.

Good day, ladies and gentlemen, and welcome to the Parker-Hannifin Corp Fiscal 2016 Second Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. If anyone should require operator assistance, please press star and then zero on your touchtone telephone. As a reminder, this conference call is being recorded. I would now like to turn the conference over to Chief Financial Officer Jon Marten. Please go ahead, sir. Thank you, Abigail, and good morning to everyone, and welcome to Parker-Hannifin's second quarter FY 2016 earnings release teleconference. Joining me today is Chairman and Chief Executive Officer Tom Williams, and President and Chief Operating Officer Lee Banks. Today's presentation slides, together with the audio webcast replay, will be accessible on the company's investor information website at phstock.com for one year following today's call. On slide number 2, you'll find the company's safe harbor disclosure statement addressing forward-looking statements as well as non-GAAP financial measures. Reconciliations for any reference to non-GAAP financial measures are included in this morning's press release and are posted on Parker's website at phstock.com. On slide number 3 for the agenda. To begin, our Chairman and Chief Executive Officer, Tom Williams, will provide highlights for the second quarter of fiscal year 2016. Following Tom's comments, I will provide a review of the company's second quarter FY 2016 performance together with the revised guidance for FY 2016. Tom will provide a few summary comments, and then we'll open the call for a Q&A session. At this time, I'll turn it over to Tom and ask that you refer to slide number 4. Thanks, Jon, and welcome to everyone on the call. We appreciate your participation today. To start, let me make a few summary comments. It continues to be a very tough environment in many of our end markets and regions. We have responded decisively to adjust to these conditions and delivered impressive margin return on sales. We have tightened control of discretionary spending, reduced employment levels across all regions in our company, and implemented reduced work schedules where necessary. This is in addition to the previously announced actions we have underway to restructure our fixed costs and simplification efforts designed to streamline our operations. On both of those fronts, we made excellent progress in the second quarter. Given the current headwinds, we are very pleased with the way our teams have responded, as evidenced by the strong margin performance and our ability to control decremental marginal return on sales for the past three quarters. We expect strong decremental marginal return on sales to continue through our fiscal year-end. Moving on to specifics for the second quarter. Sales declined 14% as the effects of the strong dollar negatively impacted us by approximately 4%, and organic sales declined 10%, reflecting end market weakness. Total order rates for the second quarter declined 12% compared with the same quarter last year. Despite this downturn, I am very pleased we delivered total segment operating margins of 12.2% or 13.5% on an adjusted basis. During the second quarter, we delivered decremental margin return on sales of 17.2% adjusted, which represents excellent performance in this current business climate. This is really a testament to the way we are fundamentally changing Parker's operating structure. In previous downturns in which we've experienced such a significant reduction in sales volume, we would not have been able to maintain such strong margin performance. The primary drivers of our margin performance include savings from restructuring we have done in prior periods, immediate and decisive actions on cost containment, and the benefits of a range of simplification initiatives that we have implemented. Regarding simplification, we have announced a total of 28 division consolidations. We continue to review our organization and process to reduce overhead costs and simplify processes. This has also helped us to reduce corporate G&A costs. Earnings per share for the quarter are $1.33, or $1.52 adjusted for business realignment expenses. Operating cash flow year to date includes a $200 million discretionary contribution to the U.S. pension plan. Excluding the contribution, year to date operating cash to sales was 9.8%. During the second quarter, we repurchased $90 million in Parker shares, bringing our year-to-date total to $400 million. We have now repurchased $1.74 billion under our previously announced $2 billion-$3 billion Parker share repurchase plan over two years, which began in October 2014. Moving on to discussion on key market trends. As projected in the second quarter, we saw continued pressure on natural resource markets such as oil and gas, agriculture, mining, and construction equipment as the prices of commodities continued to move lower. Our distribution channel remained affected by these markets, particularly those with exposure to oil and gas. We continued to experience general industrial activity weakening due to the knock-on effect from natural resource markets. These challenging markets outweighed positive growth in other markets such as power generation, air conditioning, lawn and turf, rail, and heavy-duty truck. In summary, our second quarter sales were in line with our October guidance, and Lee Banks will provide some more color on our end markets in the Q&A portion of the call. Switching to our outlook. For fiscal year 2016, we are narrowing the range of our guidance for earnings to $5.90-$6.30 per share on an adjusted basis, which maintains the earnings midpoint of $6.10 per share. It also means that our implied guidance for the second half of the fiscal year has been adjusted downward for sales and earnings to reflect weaker order entry levels that we experienced in the second quarter. We will continue to aggressively manage costs in this challenging environment. Our primary focus will be on maintaining strong decremental margin performance and positioning Parker to weather this downturn and emerge stronger as conditions improve. We are also continuing with actions to execute the many growth opportunities we have identified under the Win Strategy. Just to reinforce, our long-term financial objectives to be achieved by the end of fiscal year 2020 are: targeting sales growth of 150 basis points higher than the rate of global industrial production. We are also targeting 17% segment operating margins, and progress towards these goals is expected to deliver a compound annual growth rate in earnings per share of 8% over this five-year period. We are excited about opportunities we had to position Parker as a top quartile company compared with our proxy peers. Growth initiatives are underway to further expand our distribution network, commercialize new products and systems, improve the customer experience, expand our service offerings, and to leverage e-business and Internet of Things capabilities. During the second quarter, we developed a comprehensive long-term plan to accelerate our e-business capabilities. We see opportunities to leverage our distribution channel as part of our strategy to grow our business and create a better customer experience. Parker's Internet of Things initiative gained significant momentum in the quarter. We hosted a global Connectathon that garnered dozens of rich Internet of Things application ideas. In summary, execution of the Win Strategy is expected to deliver top quartile performance versus our proxy peers. For now, I'll hand things back to Jon to review more details on the quarter. Thanks, Tom. At this time, please refer to slide number 5. I'll begin by addressing earnings per share for the quarter. Adjusted earnings per share for the second quarter were $1.33 versus $1.80 for the same quarter a year ago. This excludes business realignment expenses of $0.19 and compares to $0.04 for the same quarter last year. On slide number 6, you'll find the significant components of the walk from adjusted earnings per share of $1.84 for the second quarter FY 2015 to $1.52 for the second quarter of this year. The impact of fewer shares outstanding equated to an increase of $0.11 per share. Increases to adjusted per share income include lower corporate G&A expense equating to $0.11 due to reduction in long-term incentive accruals, as well as our simplification efforts, as Tom mentioned. A reduced tax rate for the quarter contributed $0.02, driven by the passage of the tax extenders from which the company recognized R&D credit. Reductions to adjusted per share income include lower adjusted segment operating income of $0.39 per share due to the impact of foreign currency and the continued weakening of end market demand, and increased interest in other expense that totaled $0.18 per share as compared to the prior year in which various one-time favorable adjustments were recognized. Moving to slide number 7 with a review of the total company sales and segment operating margin for the second quarter. Total company organic sales in the first quarter decreased by 9.6% over the same quarter last year. There was a modest 3% contribution to sales in the quarter from acquisitions. Currency impact as a percentage of sales was slightly higher than planned, equating to a negative impact on reported sales of $139 million or 4.4% in the quarter. Total company segment operating margins for the second quarter, adjusted for realignment costs incurred in the quarter, was 13.5% versus 14% for the same quarter last year. Restructuring costs incurred in the quarter were $35 million versus $9 million last year. The lower adjusted segment operating income this quarter of $366 million versus $439 million last year reflects the impact of reduced volume and unfavorable mix from the continued weakening of several industrial end markets. Moving to slide number 8, I'll discuss the business segments, starting with Diversified Industrial North America. For the second quarter, North American organic sales decreased by 15.2% as compared to the same quarter last year. There was modest impact from acquisitions and a negative impact from currency of 1.3% in the quarter. Operating margin for the second quarter, adjusted for realignment costs, was 15% of sales versus 16.3% in the prior year. Restructuring expenses incurred totaled $20 million as compared to a nominal spend in the prior year. Adjusted operating income was $174 million, as compared to $227 million, driven by reduced volume as a result of softening trends in key end markets. I'll continue with the Diversified Industrial segment on slide number 9. Organic sales for the second quarter in the Industrial International segment decreased by 7.1%. Currency negatively impacted sales by 10%. Operating margin for the second quarter, adjusted for realignment cost, was 11% of sales versus 12.3% in the prior year. Restructuring expenses incurred in the quarter totaled $14 million as compared to $9 million in the prior year. Adjusted operating income was $109 million as compared to $146 million. Impact of the foreign currencies, as well as weaker end markets. I'll now move to slide number 10 to review the Aerospace Systems segment. Organic revenues decreased nominally at 0.7% for the second quarter. Currency posed a modest negative impact of about 0.4%. Sales for the period were maintained as a result of higher aftermarket sales volume, which offset modest year-over-year declines in OEM sales. Operating margins for the second quarter, adjusted for realignment costs, was 14.8% of sales versus 12% in the prior year. Nominal realignment expenses were incurred for the period. Adjusted operating income was $82 million as compared to $67 million, reflecting the favorable mix of higher aftermarket sales volume this quarter, combined with reduced development and costs as a percentage of sales. Moving to slide number 11 with the detail of orders changes by segment. As a reminder, Parker orders represent a trailing average and are reported as a percentage increase of absolute dollars year over year, excluding acquisitions, divestitures, and currency. The diversified industrial segments report on a 3-month rolling average, while Aerospace Systems are based on a 12-month rolling average. Total orders were a negative 12% for the quarter end, reflecting the further softening of the industrials segment stemming from natural resource-related end markets, as Tom mentioned. Diversified Industrial North American orders decreased to -15%. Diversified Industrial International orders decreased to -10% for the quarter. Aerospace Systems orders improved to a -11% for the quarter, which continues to be impacted by lumpy prior year comparables. On slide number 12, we report cash flow from operations. Cash flow from operating activities year to date was $347 million. But when adjusted for the $200 million discretionary pension contribution made in the first quarter, cash from operating activities was 9.8% of sales. This compares to 8.4% of sales for the same period last year. In addition to the pension contribution, the significant uses of cash year to date were $572 million returned to our shareholders via share repurchases of $400 million and dividends of $172 million. $68 million was spent for acquisitions closed during the first quarter. No acquisitions were announced in the second quarter. And we had $75 million for CapEx, equating to approximately 1.4% of sales year to date. Slide number 13 provides the four FY 2016 guidances outlined. Guidance is being provided on an adjusted basis. Segment operating margins and earnings per share exclude expected business realignment charges of approximately $100 million, which are forecasted to be incurred throughout FY 2016. Total sales are expected to be in the range of -12.6% to -9.3%, or -9.9% at the midpoint as compared to the prior year. Adjusted organic growth at the midpoint is -7.9%. Currency in the guidance negatively impacts sales by 3.4%, which is nearly all attributable to the International Industrial segment. We have calculated the impact of currency to spot rates as of December 31, 2015, and we have held those rates steady as we estimate the resulting year-over-year impact for the balance of FY 2016. For total Parker adjustments, segment operating margins are forecasted to be between 14.4% and 14.6%. This compares to 14.9% for FY 2015 on an adjusted basis. As Tom mentioned, we're very pleased to be guiding to this level of adjusted segment operating margins, given the magnitude of the end market softness and order decline. The guidance for below-the-line items, which includes corporate admin, interest, and our category other, is $484 million for the year at the midpoint. Our full-year tax rate is projected at approximately 28%. The average number of fully diluted shares outstanding used in the full year guidance is 137.1 million shares. For the full year, guidance on an adjusted earnings per share basis is $5.90 to $6.30 or $6.10 at the midpoint. This guidance excludes business realignment expenses of approximately $100 million to be incurred in FY 2016. Savings from these business realignment initiatives continue to be projected in the amount of $70 million, which are reflected in the segment operating margins. Some additional key assumptions for full year 2016 guidance are: sales are divided 49% first half, 51% second half. Adjustment segment operating income is divided 49% first half, 51% second half. Adjusted EPS is $3.04 in the first half and $3.06 in the second half. Q3 FY 2016 adjusted earnings per share is projected to be $1.40 per share at the midpoint, and this excludes $0.17 of business realignment expenses. On slide number 14, you'll find a reconciliation of the major components of the revised FY 2016 adjusted EPS guidance of $6.10. Per share at the midpoint from the prior FY 2016 EPS guidance. Increases include $0.12 from a reduced tax rate, $0.13 from a reduced corporate G&A interest and other, and $0.05 from fewer shares outstanding. This is fully offset by a decrease of $0.30 reduction in segment operating income, reflecting further reduced volume and unfavorable mix forecasted within key industrial end markets. Please remember that the forecast excludes any future acquisitions or divestitures that might be closed during FY 2016. For consistency, we ask that you exclude restructuring expenses from your published estimates. This concludes my prepared comments. Tom, I will turn the call back to you for your summary comments. Thanks, Jon. We expect the difficult environment to continue through the rest of our fiscal year. As our margins year-to-date indicate, we are responding well. We are making meaningful progress with our restructuring initiatives, which remain on track for the year. We also continue to find opportunities to streamline operations through our simplification initiatives. I am very encouraged by the response of our Parker team members. It has been just about one year since Lee and I took full responsibility for the company. It has certainly been a challenging year from a market perspective. However, our teams have not only adapted quickly to the challenges before them, but they have also embraced a new path forward for Parker and are working hard to build a stronger and better Parker for the future under the direction of the Win Strategy. I look forward to sharing more with you on our progress throughout this year. At this time, we are ready to take questions. Abigail, if you would like to get us started. Certainly. Ladies and gentlemen, if you have a question at this time, please press star and then one on your telephone keypad. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. Our first question comes from the line of Jeff Hammond with KeyBanc Capital Markets. Your line is open. Hi, guys. This is James Picariello filling in for Jeff. Just a quick question on order trends. Can you speak to maybe the pace of what you are seeing through January, and how that maybe compares to December and November? This is Jon. I think, James, the pattern is consistent. What we saw during Q2, I think what we are seeing in January is consistent with what we are seeing in guidance. January is, of course, the first two weeks of January are a little bit very difficult to judge. But, I think from what we can tell so far, that we are consistent with the guidance that we have got together for Q3. So nothing really remarkable to give you an answer on there. Okay. Just to follow up, on Aerospace Systems, what is the visibility in terms of the mix between OE and aftermarket for the back half? Just trying to get a better understanding for the margins. Well, it would be, in general, we have good visibility for the OE, and the question is always in the aftermarket. What is included in our guidance is 65% OE, 35% aftermarket. That is what we have been running consistently for the last several quarters. There is a little bit of variation periodically, but that is what we are projecting here for the balance of the year. Thanks, guys. Okay. Thank you. Our next question comes from the line of Nicole DeBlase with Morgan Stanley. Your line is open. Yeah, thanks. Good morning, guys. Morning, Nicole. I guess I'll ask the question that someone's bound to ask is, can you guys go through your usual spiel on how the end markets progressed during the quarter? Sure. Nicole, this is Lee. Like I've done before in the past, I'll just kind of walk around the regions and I'll make some comments on the end markets, and I'll also comment on our distribution channel. I think one common thread that hasn't changed is the whole natural resource-driven markets, ag, mining, construction equipment, oil and gas. They really, by and large, continue to be challenging everywhere around the world. Starting off with North America, I think, oil and gas in terms of distribution continues to be the big story when you think about distribution in aggregate. Having said that, if I focus on distribution that doesn't have heavy content in oil and gas, we've got positive year-over-year growth. But what's happened with oil and gas and its pervasiveness through the distribution base, that is still very difficult. Looking at really air conditioning refrigeration markets in North America, we've seen good North America residential air conditioning growth. This is a result, obviously, of the continued strengthening of the housing market. We've seen share gains on our behalf, and then really an increase in product content, which has to do with the SEER efficiency changes that occurred last year. So we're really happy what's happening in those markets. Commercial air conditioning refrigeration markets really have been down year-over-year, but we are expecting growth in the balance of calendar 2016 and moving into 2017. Lastly, if I look at the aftermarket channel in this segment, which would be different than the industrial distribution, we've really remained solid year-to-date growth. This is really one based on the markets, but also a big part of some new products and some SMART Service Tool Kits that we've introduced into that market segment. So very positive there. Touching back on North America oil and gas, as I mentioned in my distribution comments, we continue to see extreme weakness, double-digit declines across all of our end customers. Our customers, and I've had plenty of these conversations, are not signaling any significant improvement until the end of calendar year 2016 or early 2017. All of them have very active restructuring plans to be profitable at today's oil prices. Turning to agriculture, we continue to see top-line declines, which is consistent, I think, in contraction in production schedules at our major customers. So very weak on the agricultural equipment side. On energy, wind and energy storage business for us remains robust, with major customers maintaining a healthy backlog. The decommissioning of U.S. coal and oil-fired power plants continues at a fairly brisk pace and has brought some good opportunity for us on natural gas conversion projects. On heavy-duty truck, Class 8 truck, this market has been very good and growing for us. It was excellent. But consistent with industry forecasts, we are lowering our forecast by at least 20% from the 2015 levels going forward. On the mobile side, mobile equipment, the traditional construction equipment markets continue to be soft in North America. A highlight here has been some really nice wins in the turf business. The market is up, and has been a bright spot as we continue to win new business there. Lastly, I'll just talk about in-plant automotive. Our key North America distribution that covers in-plant automotive is up year-over-year, Q2 versus prior. But we are expecting a slowing of CapEx spending in this area, which will have an impact on the machine tool builders that cover this area. So that's North America. In Europe, I'll comment on Europe. If I talk about distribution, weak overall with Q2 down versus last year. But I think what I have to highlight here is if you pull out distribution that's tied to oil and gas, which is really U.K., Norway, it's up year-over-year. We have seen steady progress outside oil and gas-related distribution. We've continued to see strong distribution growth in emerging regions, and this is a highlight. If I look at Germany, it's ahead of last year to date. It obviously has much less oil and gas exposure than other countries. Oil and gas for the region, investment in North Sea is almost at a standstill. Looking at the U.K. capital investment, North Sea has dropped significantly. But we are still finding opportunities. We've had some nice wins in point of use for clean diesel wins into emerging markets. Really systems that eliminating high water content using our fluid conveyance and filtration technologies. Agriculture is still pretty much the same as North America. Production rate's low. Energy, very excited about some recent wins for energy grid-tie systems, and really is a complement to our growth in the renewable energy segments. Class 8 truck continues to remain strong. I was looking at this. I think this is the fifth consecutive quarter of growth in that area, so we're very positive about that. The mobile construction equipment markets, we actually have seen some stability there, with a little bit of modest growth from Q1 to Q2. Turning to Asia. Distribution. As a total, flat to moderately down year-over-year. I attribute some of that to our continued expansion, which we highlighted in our Win Strategy of expanding our distribution points around the world. We are doing that in the region. Oil and gas, again, it is a contraction across the region. It's of note that we do see some positive success with some project builds in China. I think with a lot of these state-owned oil and gas companies, they still continue to invest, maybe at somewhat of a reduced rate. On energy in the region, really, I'm speaking to China mostly. Renewable wind, solar, and hydro is growing rapidly. But traditional thermal powers, coal, gas, nuclear are still taking a major share. On rail, and this really speaks to China, we continue to be very bullish on the rail market. The Chinese government's making significant investments in this area. There's a strong focus on the export markets of high-speed rail technology to North America, Europe, Africa, and Asia, and they continue to win business there. And for us, we've had a very good market participation in that segment. We continue to have strong participation across that rail market in China. On mobile construction, I can't say anything that has progressed positively since the last time we talked. There continues to be a slowing rate of growth in China's construction industry, and really has been a key driving factor in the deceleration of many parts of Asia Pacific. But our customers there continue to have really tons of idle capacity and inventory on hand. And lastly, just talking to Latin America, it's really about Brazil. I won't go into the details. I think everybody knows, but Brazil continues to be just in very dire condition. And we've seen softness in all our end markets: mining, power gen, oil and gas, heavy-duty truck, et cetera. Okay. Thanks, Lee. That was really, really helpful. Thank you. Just one quick follow-up, if you guys don't mind. On 3Q, you're guiding for a $1.40 EPS at the midpoint. Typically, EPS steps up Q and Q. I know there were some below line puts and takes within the second quarter that are, they're probably messing up that seasonality a bit. I'm just curious, are you guys embedding a deterioration in organic growth in 3Q compared to 2Q? Yeah, let me start, Nicole. This is Tom, and I'll let Jon add on. What we did for the second half is basically we took the order entry that we saw, that Lee described, all the regions and markets in the second quarter, which really, Aerospace orders got better, less negative, and in Industrial, North America got worse by 3 points and internationally got worse by 2. So we took that order entry and basically translated that into the second half from an organic growth standpoint. Our second half organic growth from our previous guide used to be minus 5%, and now is minus 7.5%. So we dropped 2.5 points organically, and then we have the second half coming in at a minus 15% decremental MROS, and that's how you get the second half EPS numbers. Okay, that's really helpful. Thanks, Tom. I'll pass it on. Thank you. Our next question comes from the line of Eli Lustgarten with Longbow Research. Your line is open. Good morning, everyone. Morning. Okay, let me just follow up Nicole's question and just clarify. As a clarification, what was the adjusted tax rate in the second quarter, and is the big difference between the third and fourth quarter, third and second quarter, is it a little bit of seasonality upturn and being offset by a 28% tax rate assumption? Well, first of all, the effective tax rate for the 3 months in Q2 was 20.3%, and that's related to the passage of the tax extenders. Going forward into Q3, our run rate, going forward is a 28%, although it's just slightly higher in our Q3 that we've built in here due to a couple of items that we will account for in the quarter, Eli. Yeah, but that 28% versus a 20.3% is sort of like $0.12-$0.15 or some number like that of difference. Yeah in earnings, and that almost accounts the difference between the 152 and the 140 that you're sort of forecasting for us. Yeah. We are down in the top line versus our old guidance in Q3, and we're also down commensurately at the operating income. But I've got a, like I said, a slightly higher rate in Q3 due to some discrete items that we're accounting for in our tax rate there. All right. Can we talk a little bit about the profitability, the lower profitability that you're forecasting for the year? Most of that, I assume, is volume. Is there any changes in pricing going on in the marketplace? You'll be able to hold pricing? I mean, we assume costs will continue to trend downward, just because of the lower input costs. But can you talk a little bit about what's going on in, I assume the drop in margins that sort of are embedded, the slight drop is low volume related and that pricing looks like it's relatively stable in the industry? Eli, this is Lee. I think the drop is all volume related. Pricing has been flat. We forecast it to be flat going forward. Input costs are still trending downward? They've been favorable. Yeah. Oh, yeah. All right. Thank you very much. Thank you. Our next question comes from the line of Andy Casey with Wells Fargo. Your line is open. Thanks a lot. Good morning, everybody. Morning, Andy. Couple questions related to your guidance. First, if we look back on Q2, can you give us the components of, there was quite a bit of difference between the initial $1.16 midpoint guidance and the reported $1.52. Understand tax was part of it, but what else changed? Yeah, I think at the SG&A level for the quarter, as Tom Williams said, we've got some positive variance in the corporate G&A of about $18 million versus the prior guide. That's due to the simplification efforts and a couple one-time adjustments that won't repeat. We've also got, as compared to the prior guide, a small settlement of about $4 million for a contractual issue that we had in the other expense. That's about $4 million, and that accounts for about $0.02. Of course, Eli Lustgarten talked about the tax rate, and we had guided to a higher tax rate. Again, we did not know that the extenders was going to pass, so of course, that turned out to be good news for us, and that gave us $0.15 versus the prior guide. At the operating income level, even with the projected reduced revenues, we were able to get approximately $15 million in additional operating income versus the prior guide on a slight beat in revenues. Okay, thanks, Jon. On that $15 million, is that repeatable? That should carry through going forward? Well, that is built into our guidance going forward, and we feel very good about our cost structure and what the simplification efforts and our restructuring efforts are bringing for us. Built into our guidance is additional savings that we're going to get from the restructuring efforts that we've been going through here in the first half of this year and at the end of last year. Okay, thanks. A couple detail, I guess. First, on North American Industrial, did you see inventory destocking change during the quarter, meaning did it intensify, moderate, or kind of stay the same versus the prior quarter? Andy, it's Lee. I would say it just stayed about the same. At the end of the day, it's really hard for us to get a gauge on that. It certainly didn't increase. It certainly didn't get worse. Okay. Thanks, Lee. Then real quick on the last one, Aerospace outlook, are you embedding the same sort of fourth quarter bump up that you've seen in the last couple of years? Andy, we really are not. What we've embedded in there is the continuation of the 35% MRO, 65% OEM at around the same relative profitability that we see right now. The last couple of years, we've seen these one-time settlements get agreed to, and they have impacted the numbers, so I understand completely your question. That's not something that we would project in our guidance going forward here. I don't really have any context for you on that point. Okay. Thank you very much. Okay. Thank you. Our next question comes from the line of Ann Duignan with J.P. Morgan. Your line is open. Hi, good morning, everyone. Morning, Ann. Morning. Don used to talk about the 3-12 and the 12-12. I'm just curious about the end markets that are really weak. Are you seeing any kind of an inflection point looking at your 3-12s and your 12-12s? Anything bottoming out there, particularly in North America? Anne, in all candor, I don't have my 3-12 and 12-12s in front of me. I can bring those back in the future. I would say the comps are going to start getting easier in some of those numbers, so it's just a matter of time. Obviously, oil and gas, just from memory, is still decelerating. I would just be winging it here if I tried to give you any more context on that. Anne, it's Tom. I think our assumption is there's really no meaningful recovery in the second half, and what you see, you do the comparables, it's just really easier comparables for us in the second half. Okay, that's helpful. I appreciate it. Then you did comment on customers, talking about how weak the end markets are. Were you talking about distribution customers, particularly in oil and gas, or were you talking about OEMs? If you just could tell us what are the conversations like between OEMs versus your distribution? They're the same, quite frankly. Our distribution is involved with MRO, but also with some projects and handling it, and it's very much the same. It's the same conversation. Okay. I'll leave it there and let somebody else take it over. Thanks. Thank you. Thank you. Our next question comes from the line of Jamie Cook with Credit Suisse. Your line is open. Hi, good morning. I guess a couple questions. One, I know someone asked before on material costs, and you said it was a benefit, but could you quantify what you're assuming for material costs in your guidance versus when you initially guided? Because I'm just trying to understand the decrementals that you guys are putting up, which have been much better than expected. I get that it's the simplification initiatives and restructuring as well. Then also, Tom, if you could just comment on the sustainability of mid to high teen decremental margins. We haven't seen that before from Parker. Then my last question is just balance sheet. Given the depressed markets you're seeing, I know when we spoke last, you said valuations on acquisitions were still quite elevated. Has there been any change in the market? Thank you. Okay, Jamie, it's Tom. I'll start with the material cost side. I would say compared to our previous guidance, we're seeing a consistent gap between pricing and the material side, that our ability to maintain the decrementals is driven by the simplification and the restructuring actions. Remember that the bulk of our savings is in the second half, so that is going to help carry us. We feel good about this fiscal year. I'm not going to go beyond this fiscal year trying to tell you what the margin return on sales are going to be, but for this fiscal year, we feel very good about sustainability. We've done it three quarters in a row, and I think for everybody on the phone, to help remind everybody, the way we achieved that is it was prior year restructuring that we did. All the teams moved out very rapidly to get on top of the market adjustment. Then we launched a simplification plan, which really was more strategic restructuring in addition to the footprint restructuring we were doing. That enabled us to keep these very nice, basically half of what we historically have done. As a bit of a history lesson, if you go back to the 2001 recession, it was a -60% MROS. The Great Recession was around -40. Here we are, in that -15% to -20% range on an adjusted basis, and low 20s even reported all in. I think it's sustainable, and that's what we have in the plan for the next two quarters. On the balance sheet, the pipeline's active. But valuations are still high, and I think what you're seeing is a delay in the reality from sellers' expectations to buyers like us as far as setting a new revenue target as far as what they think for the business. That's the key valuation difference. I think everybody knows we're disciplined buyers and we buy things that are in our space, so we understand what the growth rates are. I think the time's on our side with that. I think as time goes on and people see the new reality that, hey, it's maybe not going to grow what they thought it was the previous decade, that those valuations will come in more line, and I think our pipeline will become more actionable at that point. It's lumpy. It's hard for us to predict output. But we're still working on it. Sorry, Tom, one just quick follow-up on the simplification initiatives. Because as you look to 2017, there could be very high probability that things don't improve or that sales could decline. Based on what you're seeing with sort of the simplification initiatives, do you feel like you guys, perhaps there's more there to do or you're realizing greater savings than you initially thought that, again, the sustainability of the decrementals could be better than what you originally thought? Well, I think that is possible. I don't want to get above my skis for 2017. We'll talk about that in August. Yes, what we've seen with sustainability for simplification so far is that the payback is more rapid. It has a better payback than traditional restructuring. The good thing about it, just to remind people, there's four areas we're looking at. Revenue profile complexity, so that's that tail of the revenue, and looking at the bottom tail, that density of part numbers and quote activity, just the cost to sustain that. We're very early days of getting into that. That's a little more difficult for us to work, but very early days of that. Then the whole organization and process optimization is the second part. We still see lots of opportunities on that. So that's more strategic restructuring geared at the overhead structure of the company. The division consolidations was the third leg of it. So we're at 28 divisions so far that we're working on. We'll do more. I don't think you'll see another 28 in the next fiscal year, but you'll see us continue to work that. Then just good old-fashioned bureaucracy. We're looking at our planning process, approvals, reports, you name it, all the things that just slows things down, and that obviously carries costs and creates better service opportunities for our customers. So early days, and I feel very good about what this could mean for us. I think most everybody's seen the walk on taking us to 17% operating margins. Simplification is the biggest bar on the walk, and so we clearly think there's more there. Alrighty. Thanks. I'll get back in queue. Thank you. Our next question comes from the line of Joseph Ritchie with Goldman Sachs. Your line is open. Thanks. Good morning, everyone. Morning, Joe. Tom, maybe staying on the simplification and restructuring spend for a second. It looks like the first couple quarters, the spend has come in a little bit lighter than we anticipated. I guess my question is really just around your confidence on your ability to complete the actions this year and to get the roughly $70 million in benefits that you're expecting to receive from those actions. Any color there would be great. Yeah, Joe, it's Tom. Our restructuring year to date is right on the money. We had forecasted 60% of the $100 million, and we're at $57 million, so we're very close to that number, and our savings are tracking. I'm very confident we're going to deliver both the cost that we had planned, the $100 million of cost, and deliver the savings. The savings, what is indicative of that is the margin return on sales. We could not be delivering these kind of returns without the actions that we've taken, simplification being one of them that's helping us. Got it. Maybe my numbers are off a little bit in the first half. We can follow up after the call. But maybe one other key point is that I noticed the free cash flow thus far has been pretty impressive, and it looks like this quarter, working capital was a source of cash. I was wondering, was there anything one time, anything special? Because I saw both the receivables and the inventory line down. Just curious what's driving the strong free cash flow. Well, Jon here. Joe, we are very much focused on cash flow every single day here in the company and watching as the top line moves, what's going on there. All of our operating metrics are very good. Nothing is deteriorating. We remain focused on the simplification efforts, and our company is doing everything we can from a lean standpoint to improve every single process that we've got throughout the company. And we're seeing it in the cash flow statement, so we're very proud of that. Okay, great. Thanks, guys. I'll get back in queue. Thank you. Our next question comes from the line of Nathan Jones. Steve Fuller, your line is open. Good morning, Tom, Jon, Lee. Morning, Nathan. Lee, in some of your comments about the end markets, you said that North American distribution was positive ex oil and gas. I think our checks had indicated North American distribution overall was down about 3%. Is that pretty close to right? Total North American distribution? Yeah. Yeah, it would be down single digits year-over-year. I think that implies that the direct channel from 1Q to 2Q saw a fairly significant decline in the comp. Can you talk about any specific end markets that might have driven that? I want to make sure I understand your question. You are talking about our direct customers? Direct or OEM, the non-distribution channel. Nathan, it's Tom. I'll chime in. What we saw in distribution in Q2 was primarily in North America, took a step down. Outside of North America, it held up pretty well. Europe, Asia, held up pretty nicely. The step down in North America really was indicative of the same step down we saw OEMs, which was the natural resource markets, a little bit of a knock-on into the general industrial space, that knocked both distribution and the OEMs down. But in general, OEMs have been down about two times what distribution's been down, if you were to characterize the difference. Okay. That helps. With nine months to go on the original plan for $2 billion to $3 billion of share repurchase, it looks like you're kind of gliding into more of the low end of that. Is that keeping powder dry for some expected correction in the pricing in the M&A market for you, with an eye to getting perhaps more aggressive as we go forward on M&A? Yeah, Nathan, it's Tom. Good question. I'm sure this is on top of everybody's mind. We feel very good about what we've done so far. We're 87% of the way through to the low end of the $2 billion to $3 billion range. Maybe if I could just give a little color into the process that we use. Every quarter, we sit down, and it's really a cash allocation discussion. We look at cash generation capabilities. What do we think we're going to generate, a closed-loop model, taking a look at that. Where is the cash generated? What access do we have to the cash? Also with our goal that we'd like to maintain an A rating as we go through this, for a lot of good reasons. Then on the deployment side, we look at the best opportunities to yield the best long-term value for our shareholders, comparing, recognizing, hey, we're going to do the dividends first. We're not going to move off of that. We're going to fund organic growth. Then we're going to look at the balance of share repurchase versus acquisitions to try to make that best decision. It's hard for me to give you a specific number that will land on the share repurchase, because it's really an opportunistic look, weighing those various tugs and pulls, every quarter as we go through that closed-loop model. Fair enough. If I could just go off the beaten path a little bit here. You talked about 2Q developing a comprehensive e-business plan, and also talked a little bit more about development of the Internet of Things plan. Can you give us a little bit more color on where you are with that, how long the rollout looks to take, and where the benefits come from that? Okay. Well, Nathan, it's Tom again. I'm going to start on e-business, and I'm going to be a little bit coy with you here because I'm not going to give you the kind of color that I might normally would because I would be giving competitively sensitive information to our competitors and trying to help them be successful. Let me just suffice it to say that what we want on the e-business side is we want a Google-like experience for our customers and for our distributors when they come to that website. We've launched a number of things that we think will get us there. It's not going to happen overnight. We've made progress, we think, over the last couple of years, and as we talk to our customers and distributors, they see that, but we clearly recognize we're not there. We see this as a potential additional growth channel, leveraging the great distribution channel that we have already. Just remember that about 60% of the relationship between a customer and supplier nowadays happens via that website and happens before they even talk to you. That's why we want this to be so important. We're investing in it. We made some organization design changes to add some resources and add leadership to that. That was the change we made in August last year. On the Internet of Things, that Connectathon, in case people are not familiar with what that is, it's basically an ideation process where you gather ideas from around the company. That, coupled with the fact that we made that equity investment in Exosite, which gives us a software backbone to help all the applications throughout the company, has really given us fertile ground for ideas. We've taken that ideation process, the Connectathon, we've narrowed it down to about 10 of what we think are the best, most commercial, actionable projects. We think that's got multimillion-dollar type of look, tens of millions of dollars of revenue over the next 3 years. Most of that's not going to cut into probably towards the end of FY 2017 into FY 2018. It's probably going to take a year and a half incubation here. We do have two good examples, and Lee highlighted one of them, the SMART Service Tool Kit, which is helping us in refrigeration, primarily the air conditioning market. So if you take an air conditioning contractor today, they have a lot of mechanical tools they have to utilize to measure pressure, humidity, temperatures. This is a patented sensor that we have, allows you to diagnose and troubleshoot the conditions of that air conditioning unit much more rapid. So the value for the contractor is many more calls happens during the day. They can get a printout right on their smartphone or a visual on their smartphones and print it out if they wanted for the customer so they can see what is going on with their unit. So we launched that. We have been very pleased with the initial sales. That is a really good example of taking a traditional market and using Internet of Things to make it even better. It makes our expansion valves and the things we go in, our check valves, very sticky. But then our contractors absolutely love the new toolkit. I think if you go to our website, you can probably find a video of one of our contractors' testimonial talking about it as well. Great. That is helpful. Thanks very much. Thank you. Our next question comes from the line of Andrew Obin with BofA. Your line is open. Good morning, guys. Morning, Andrew. Hi. Can I just ask first just a very simple question? Did I hear it right that you highlighted automotive slowing, or did I mishear that? Andrew, I was talking about in-plant automotive, so CapEx going into the plants. Is that related to new platforms at OEs? I'm not going to be that specific, but what I've noticed that there's been a lot of retooling activity with a lot of plants and some of that we're being told is going to start to slow down. Got you. Let's not count this question. Are you guys getting any transaction benefit? I think a year ago you were talking about that it takes about a year to recertify some of the plants to ship stuff from Europe to the U.S. Are you doing it? Are you being able to do it? Are we seeing any benefit from this? Well, Andrew, we are constantly trying to make sure that we're producing the right parts at the right locations in the right plants. We are not, from a transactional standpoint, getting hurt as bad as we would've been, say, this time last year, in terms of the margins. That is one piece of progress that we've been making. That's one of about 10 or 15 things that are going our way, that are helping us with our margins and our decrementals. We don't see that getting bad. We're adjusting. It was this time last year where the euro and the Swiss franc decoupled and also when the dollar was really getting stronger. We have adjusted to that, where we stand right now today, and that's what's built into our guidance going forward. And just a question on capital allocation. Given where the high yield markets are, given that PE can no longer play, given where the stock prices are, how do you guys feel about your M&A funnel? Yeah, Andrew, it's Tom again. Same comments that I mentioned earlier about acquisitions. The valuations right now are still a little bit high. I think it's a little bit of a delayed effect as the sellers' expectations on revenue hasn't come down to earth yet. But time's on our side. They will come down, and we continue those discussions. And what we've seen over time is eventually, we come to terms with a better revenue forecast. We haven't taken action on some deals in the past, mainly because of the difference in pricing, and that pricing difference was primarily geared by differences in what we thought the revenue expectations was going to be for that business. Abigail, if I could ask you, please, if we could just have one more question. I see we're getting ready to run out of time here, so thank you. Certainly. Our last question comes from the line of Joel Tiss with BMO. Your line is open. Hi, how's it going? Good, Joel. That's good. I'll make it quick. Is the run rate in your corporate G&A, is that the new level that we should be using going forward, or is that a moving target that either got a benefit this quarter and is going to rise again, or is it going to continue to structurally lower as we go forward? We're structurally going to be down slightly from our past run rate, but it was more of a couple one-time things in the corporate G&A. We're focused on about between $45 million to $48 million going forward here in the corporate G&A going forward as compared to in the mid-50s in Q1 and in prior years. This has some structural benefits from the simplification, but it would be wrong for me to not mention that there were some one-time items in Q2 for our G&A expense. Okay. Is there a big target on the business simplification? I think you used to have 240 divisions, and now you mentioned it is down by 28. Is there any sort of a goal, or is it just, it is going to end up where it naturally ought to be? Joel, it is Tom, just to clarify, the number of divisions that we have, operating divisions, is 115. The 20 is in that 115. Both Lee and I, the message we have left with the group presidents is we are looking for natural combinations that helps us just be more efficient, give us the scale that we need to better gross synergies and better cost synergies. We have some divisions that I think if we looked at it in hindsight, had too much technology or product charter overlap, it made more sense to put them together. So, it is not going to be one division. We still believe in a decentralized model. We still believe in driving that P&L ownership closest to our team members. But I think you will continue to see us do more in 2017, not at the rate that you saw us do in 2016, though. This is the last one. Sorry to take so long. Is there a lot of product line simplification underneath those business combinations, or is that the next stage that you have not dug into as deeply yet? Yeah, that is what I was referring to. Again, it is Tom. That revenue profile complexity. That is where we are very, very early days, and I think that is where the real juice in the tank here is. That will help us in multi-years going forward. All right, great. Thank you so much. Thank you. I'd like to turn the call back to management for closing remarks. Abigail, I made my closing remarks already, so I think we can conclude the call. Yep, this concludes our call. Thank you, everybody, for joining us today. Robin's going to be available throughout the day to take your calls should you have any further questions. Thanks again, and have a good day. Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. You may all disconnect. Everyone have a great day.