Earnings Call: Q1 2013

Oct 19, 2012

Summary

Q1 sales were flat at $3.2B, while EPS fell 18% to $1.57 amid international weakness and September order resets. FY13 EPS guidance was cut to $6.15–$6.75; management assumed subdued conditions would persist, while continuing acquisitions and cost actions.

Good day, ladies and gentlemen, and welcome to the first quarter 2013 Parker-Hannifin Corp earnings conference call. My name is Erica, and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference. If any time during the call you require assistance, please press star followed by zero, and a coordinator will be happy to assist you. I will now ask to start the presentation over to your host for today's call, Ms. Pamela Huggins, Vice President and Treasurer. Please proceed. Thanks, Erica. Good morning, everyone. As Erica just said, it is Pam Huggins speaking, and I would like to welcome you to Parker-Hannifin's first quarter fiscal year 2013 earnings release teleconference. Joining me today is Chairman, Chief Executive Officer, and President, Don Washkewicz, and Executive Vice President and Chief Financial Officer, Jon Marten. For those of you who wish to do so, you may follow today's presentation with the PowerPoint slides that have been presented on Parker's website at www.phstock.com. For those of you not on the line, the slides will remain posted on the company's investor information website at www.phstock.com one year after today's call. At this time, I would ask that you reference slide number 2 in the slide deck, which is the safe harbor disclosure statement addressing forward-looking statements. As usual, I ask, if you have not already done so, please take note of this statement in its entirety. On slide 3, this slide, as required, indicates that in cases where non-GAAP numbers have been used, they have been reconciled to the appropriate GAAP numbers and are posted on Parker's website at phstock.com. To cover the agenda for today on slide number 4, the call will be in four parts. First, Don Washkewicz, Chairman, Chief Executive Officer, and President, will provide highlights for the quarter. Second, I will provide a review, including key performance measures of the first quarter, concluding with the revised 2013 guidance. The third part of the call will consist of the standard Q&A session. For the fourth part of the call today, Don will close with some final comments. At this time, I will turn it over to Don and ask that you refer to slide number 5, titled First Quarter Fiscal Year '13 Highlights. Thanks, Pam, and welcome to everyone on the call. We certainly appreciate you joining us today. I just want to make a couple of comments, and then we'll turn it back over to Pam for some additional detail about the quarter. First of all, our results in the first quarter largely reflect the impact of the continued weakness in international markets and the softness in North America. That's particularly late in the quarter, and I'll talk about that in a minute here. We were actually ahead of plan going into September. July and August were actually fairly strong months. We were actually ahead of plan, and then we experienced in September a lot of cancellations and rescheduling of orders and so forth by many of our OEM customers as they adjusted to current economic conditions. That's really what impacted the quarter for the most part. We were ahead, and then a lot of these cancellations, rescheduling, we saw September come in weaker than what we had anticipated. Considering what happened in these conditions, we have performed well in the quarter but remain cautious about the outlook, especially going into calendar 2013. I'd just say to keep in mind that we are one of the few companies giving guidance into 2013 due to our mid-year fiscal. Our earnings guidance, therefore, reflects this caution with regard to the global economy in calendar 2013. Just a few points about the quarter, a little review of the quarter. Our sales were essentially flat with last year at $3.2 billion, and they were impacted by a 9% decline in Industrial International sales. You can see where the weakness is coming from. It's in our international segment. This is the third consecutive quarter in which we have reported a year-over-year decline in this segment, largely as a result of recessionary conditions in Europe and moderate growth in Asia. Really, Europe was impacted the most and followed by Asia. That was partially offset by a 5% growth in North America in the quarter. Currency was negative 3%, while acquisitions contributed 3%, and organic sales were essentially flat, and that combination resulted in a flat top line for us for the quarter. Total segment operating margins were 14.4%, which were actually pretty good when you look historically. They were pretty good numbers in spite of all of the negative segments that we're talking about here. We're again impacted by the Industrial International segment, which had operating margins of about 12.9%, while Industrial North American margins remained pretty strong at 17.9%. I might just point out that North America margins were better than our full-year North American margin last year, which was at 17.2%. North America performed very well in the quarter. Net income for the quarter was $239 million, or $1.57 per share, and that's a decline of 18% compared with last year's first quarter. That EPS reflects additional acquisition integration costs, and we'll talk about that in a bit, as well as Aerospace R&D expense. I might add there that the additional expense for Aerospace was required to keep pace with our customers' timelines for several of these new programs that we've been working on that we landed over the last couple of years. That's what impacted the R&D expense. Net cash from operations was slightly negative, driven by a $226 million discretionary contribution to the pension plan, and this anticipated change was announced previously. During the quarter, we also continued to execute on long-term initiatives to drive growth and profitability. Some of those are as follows. We completed five acquisitions in the quarter, which added approximately $243 million in annualized sales. Additionally, in October, we announced two more acquisitions, two filtration acquisitions, and those will add about $141 million in annualized sales. In addition, we announced the divestiture of the automotive air conditioning portion of the Climate & Industrial Controls segment, and sales for that segment that we divested was approximately $140 million in sales. That unit, by the way, was in our numbers for the entire first quarter but will not be going forward. Earlier this month in France, we celebrated the opening of our 2,000th ParkerStore. We added 1,000 stores in the past five years. We've added a store approximately every business day over the past five years, somewhere in the world. A lot of good things happening from the standpoint of acquisition activity and other growth initiatives for the company. Looking forward to our expectations for the full fiscal year, we have revised our guidance for earnings for continuing operations from the range of $7.10-$7.90 to the range of $6.15-$6.75 for diluted share. That's basically reflecting what we see right now. As the year unfolds and we get another quarter in, we'll have a better look at the next calendar year. At that time, I think the elections will be over. Maybe some of that, things will calm down a little bit, and we'll see what impact that might have going forward. But right now, we felt comfortable going with this range. We'll adjust that as we deem necessary. As a reminder, these estimates include an expected increase in pension expense of approximately $0.35 per diluted share, as a lower discount rate was required for accounting purposes. With that, I'm going to turn it back over to Pam, and she'll get into a little bit more detail for you. Thanks, Don. At this time, if we'll just take a look at slide number 6, and I'll begin by addressing earnings per share for the quarter. Fully diluted earnings per share for the first quarter came in at the low end of the guidance at $1.57. This is a decrease of $0.34 or 18% versus the $1.91 from the same quarter a year ago. Just laying out those components, the puts and takes of that $0.34 for you. Segment operating income accounted for $0.26 of the decrease, and this is mainly due to Industrial International and the continued softness that we're seeing in that region that Don just talked about. Below segment operating income, or what we refer to as below-the-line items, impacted earnings per share unfavorably by $0.09. And again, this is mainly due to the other category, and it is the result of the higher pension cost that we communicated last quarter. Higher taxes impacted earnings per share by $0.02, and this is mainly due to the expiration of the tax extenders bill for U.S. research and development credit. There also were some discrete items that were an expense this year and a benefit last year. Then less shares outstanding impacted the earnings per share favorably by $0.03. So moving to slide number 8. Looking at the top line, revenues for the quarter. They were essentially flat, decreasing $19 million or 0.6%, coming in at $3.2 billion, consistent with last year. Revenues decreased in Industrial International and Climate & Industrial Controls, offset by increases in Industrial North America and Aerospace. There was an impact to revenues as the result of acquisitions and currency in total, as acquisitions added 3% to sales, which was offset by negative currency of approximately the same amount. Segment operating margins for the quarter decreased 170 basis points from 16.1% to 14.4%, again, mainly due to Industrial International and Aerospace. Please note that acquisition expenses and integration charges are included in these numbers. Parker incurred $0.01 in restructuring charges in the quarter and plans to incur $0.05 to $0.10 in fiscal year 2013 going forward. Slide number 9, focusing on segments and commencing with Industrial North America. Organic revenues increased 2% in the quarter. Acquisitions added 3% to revenues, and currency was relatively minor in this segment. As such, reported revenues increased 5%. Operating income increased from $223 million to $227 million, a 2% increase over the prior year. Operating margins of 17.9% for the quarter decreased 60 basis points from first quarter last year. However, you should note that the first quarter of last year was an exceptional quarter with a margin of 18.5%. Continuing with the Industrial segment, moving to Industrial International. Organic revenues decreased 6% for the quarter. Currency was a deduction to revenues in the quarter of 7%, again, mainly due to the weakness of the EUR. Acquisitions added 4% to sales, and as such, reported revenues decreased 9% for the quarter. Operating margins decreased 330 basis points to 12.9%, and this is down from 16.2%, again due to reduced sales in Europe, Asia, and Latin America and the impact of acquisition-related costs and of course, currency. Then moving to slide number 11 and focusing on Aerospace for a moment. The reported and organic revenues increased 9% in the year as acquisitions and currency had minimal impact. Margins decreased 240 basis points for the quarter to 11.4% from 13.8%, and this includes the higher non-recurring engineering charges and the higher OEM business versus aftermarket. So moving to slide 12, Climate & Industrial Controls. For the quarter, core revenues were down 3%, and unfavorable currency deducted another 2%. As such, reported revenues were down 3%. Segment operating margins as a percent of sales, in spite of lower sales, increased to 9.4% from 8.2% a year ago. So now moving to orders. I will quickly run through this for you. Slide number 13 details orders by segment, and just as a reminder, these numbers represent a trailing three-month average and are reported as a percentage increase of absolute dollars year-over-year and excluding acquisitions and currency, except for Aerospace. Aerospace is reported using a 12-month rolling average because of the lumpiness of that business. As you can see from this slide, orders declined 6% for the September quarter just ended, reflecting softness in North America, continued softness in Europe, China, and Latin America, which resides in the Industrial International segment. North American orders for the quarter decreased 11%, Industrial International orders decreased 8%, and Aerospace orders increased 5% for the quarter. Climate & Industrial Controls orders increased 2% for the quarter. Moving to the balance sheet. Our balance sheet remains strong. Cash on the balance sheet at year-end was $436 million, and $35 million in commercial paper was outstanding. DSI, or days sales in inventory, remained at 62 days in fiscal year 2013 versus 2012, and this includes the inventory that we added in connection with acquisitions. Inventory to sales of 11.3% compares to 11.4% in the same quarter of fiscal year 2012. Not bad performance on the inventory side. Accounts receivable in terms of days sales outstanding closed at 51 days, 3 days higher than last year. The WADPO, or what we call weighted average days payable outstanding, increased to 55 from 54 last quarter. Operations used cash of $7 million in the quarter, mainly due to cash contributions to the pension plans, $226 million. Other major uses of cash in the quarter are as follows: $169 million returned to the shareholders by a share repurchase, $108 million in dividend payments of $61 million, $195 million in cash utilized in connection with acquisitions, and then $77 million, or 2.4% of revenues, was used in connection with capital expenditures. We've been saying for some time that it would get up to the 2.4% level, and we're seeing exactly what we've been talking about for a while. Net of these uses of cash, there was a positive FX impact of $39 million. Cash decreased $402 million in the quarter. On slide 16, here we have the debt-to-total Cap ratio, 25.7%, and on a net basis, 20.7%. We have lots of room to grow through acquisitions and organically. Now we'll move to the guidance, which is illustrated on pages 17 through 19. On slide 17, the guidance for revenues and operating margins by segment, they've been provided there. I'm not going to read through those here on the call, but they've been detailed on the slide for your convenience. On slide 18, guidance has been provided in total for items below segment operating income, and that's $480 million at the midpoint. The amount is higher than the prior year, but it's due to the pension costs that we talked about on the last call. Slide 19 summarizes the guidance on a diluted earnings per share basis, and as you can see from this slide, the guidance for fiscal year 2013 for earnings per share is projected to be $6.15 to $6.75, just as Don had mentioned earlier. The components of the changes in guidance have been detailed on the waterfall chart on this slide that you see now, and this is reconciling the previous guidance of $7.50 to the revised guidance using the midpoints of each. So what you can easily determine is that segment operating income on a per share basis decreases by $1.09, and that is mainly due to the Industrial segment of our business. Below-the-line items adds $0.05. Tax is a deduction of $0.05. Less shares outstanding is a result of share repurchase and adds $0.04. Just as a reminder, the forecast does not include any acquisitions that we may make in the next three quarters of this year. The guidance assumes the following at the midpoint: decreased revenue year-over-year, -2%, or decreased revenue, I should say. Segment operating margins of 14.5%. Expenses below segment operating income, including corporate admin, interest, and other, at the midpoint of $480 million, with a band of ±2.4%. And a projected full-year tax rate of 28.5%, and this is up from 28% in the previous guidance, and I will talk about that in a minute. Then the guidance includes $0.05 to $0.10 for restructuring, expected to be on the high end. We talked about $0.05 to $0.10 last quarter, and we are now expecting the restructuring to be at the high end of that amount. But a couple of salient points with respect to the guidance. Sales first half, second half are divided 48%, 52%. Segment operating income, the first half to second half is divided 44% to 56%. Now getting back to the tax rate and why it is going to be higher. The company will recognize a gain in the second quarter from the sale of the automotive portion of the Climate & Industrial Controls segment. We have excluded that from the guidance due to planned offsets that will occur in the second quarter. However, the tax rate is higher in the second quarter because we needed to add the taxes related to that gain, as we do not see an offset in the tax line in the second quarter as a result of the offset. So you will see in the second quarter that the tax rate is about 200 basis points higher than it is in the third and fourth quarters. Again, just to reiterate, that is the tax on the gain from the sale of the portion of the Climate & Industrial Controls business that we sold. Earnings per share will be lower in the second quarter as revenues are lower. Again, this is consistent with the natural cycle of our business. We have more holidays in the second quarter, and so our second quarter is, I would say, our worst quarter of the year. That is consistent from year to year for the most part, and so do not forget that as you are working your model. The second half of the fiscal year is higher than the first half, and again, this is due to the natural cycle of the business. We have a 48%-52% split. So at this time, I think that pretty much covers the guidance, and we will open it up to the standard Q&A. Ladies and gentlemen, at this time, if you wish to ask a question, please press *1 on your touchtone telephone. If your question has been answered or you wish to withdraw your question, please press star followed by 2. Please press *1 at this time to begin. Our first question comes from the line of Joel Tiss with BMO. Please proceed. Wow, I finally made it. Just two quick questions. One is a clarification, I guess. Can you be more specific on the accretion or dilution from the sale of the CIC business? Yeah. The auto part? Yes, I can. It's about $0.04. Okay, thanks. I just wanted to ask Don, he's probably the guy with the most experience on the call unless Alex Blanton is on. I just wondered, you've been through three or four recessions or whatever, and you've seen how they developed and all that. I just wondered, what do you see for the next year? What are your customers saying? Are we going into another recession? Are we just slowing down or correcting inventories? Can you just take your years of wisdom and help us out a little bit? Well, thanks, Joel. Basically, if you think back to the end of last fiscal, when we started talking about this fiscal year, which takes us halfway into 2013. What we were hearing on the street at the time and from our customers and all that. Keep in mind that, for instance, Latin America was pretty flat and had been flat for quite some time. We started hearing, "Well, we're going to start seeing a little bit of a pickup there because we've been down on a month-over-month, quarter-over-quarter basis. We're going to start seeing some pickup." We didn't see any of that. Next thing we heard was that Europe's in the tank, which we knew. Last year, of course, the whole Greece thing just continues on. I don't know if that'll ever be resolved, but it was all that malaise about what's happening in Europe and how they're going to get their financial things in order. We heard that there's probably going to be some improvement there. We haven't seen any improvement. We've seen, actually, it's gone the opposite direction. Lastly, as you'll recall, we talked about Asia, and we said stimulus is coming in China. The rail project's going to come back on. Construction is going to probably pick up a little bit. In fact, if you look at our China activity, it really hasn't materialized. Matter of fact, the GDP over there is more like in the low 7s now as opposed to what they were looking at before. As I look forward, do I see a cliff coming? I don't see a cliff. It just seems like a flatlining, if you will, waiting for something to happen. It's not like what happened a couple of years back in 2009 when we had the housing crisis and all the subprime crisis and so forth going on. I don't see that happening, but I just don't see any more right now as we were hoping to see some positive movement in any of these markets overseas, and that's any of these regions around the world. What we decided to do here is just say, "Hey, let's not assume anything at this point. Let's just assume this current situation continues as is." We don't see anything where it's going to be a cliff going forward. At least for the rest of our fiscal year, I haven't heard anything that would change my opinion that we're going to change the current picture all that dramatically. Something might happen after the election. Who knows? I mean, it's anyone's guess as to what might happen after November. We're just assuming that it's kind of flatlined from here the rest of the way out, and that's kind of the way we're playing it here. We're taking a number of actions internally to adjust to that reality. We're doing all the prudent things that we've done in the past with respect to our workforce adjustments and CapEx rebalancing and things like that. We'll continue to look at that. We'll get another look at the end of the calendar year, probably have a better vision of the third quarter and fourth quarter then. I would say, based on what we're seeing right now, at this point, I don't think there'll be much change unless something dramatically happens in one of these regions. All right. Thank you very much. Sure. Thanks, Joel. Our next question comes from the line of Stephen Volkmann with Jefferies. Please proceed. Hi, good morning. Good morning. Well, I was wondering if you could just give us a little more color, I guess, on the North American orders. That was the one that was kind of surprising for me. Don, you sometimes have your 312, 1212 commentary that you do by end market, and I'm wondering if maybe that might help us understand that. Well, let's talk a little bit first about just a couple of other indicators. One thing, when you look, and I like to look at the PMI indices, because that's kind of telling as to what's happening there. First of all of the PMIs, pretty much globally, have been going up, interestingly enough, in spite of what we've been just talking about here. Only North America is greater than 50%. So that's kind of telling as well. Everything seems to be moving a little bit in the right direction, but nothing other than North America is really in a positive territory with respect to the PMI. When we look at the specific market segments and what's happening there as far as order trends, which ones are doing better and not as good, pretty much all of the Aerospace markets, both military OEM and aftermarket segments, are all looking good on a quarter-to-quarter comparison. That's what I'm going to kind of give you here is kind of the overall trend. Some of the other ones that are looking good, power gen, process markets, farm and ag has been positive, and I think that'll continue. Oil and gas has been positive, and commercial refrigeration. If we look at our trends, those would be the positive ones. The ones that are kind of flattening out for the most part, but not necessarily terrible, but it's just that they're not growing at the same rate they had been in the past, would be cars and light trucks, distribution, semiconductor, life science, and heavy-duty truck. This is not to say those are doing real bad, it's just that the trends are actually flattening out on those. Regionally, we look at the regions as well as far as the trends, both the 312 cyclical and the 1212 cyclicals. Right now in North America, the 312 is a little bit below 100%, which would mean that the North American markets are coming in for a soft landing, kind of flattening out, which we kind of have been seeing here. The 1212 is still north of 100, but heading toward 100% on a year-to-year basis. Europe is running around mid-90s on a 312, which is basically pulling the 1212 down into the mid-90s. That would be the worst region for us worldwide. That's real weak. Asia, we have basically a 312 and 1212 that's just slightly below 100%, so pretty flat. Asia pretty flat at this level. Flat to slightly negative. Latin America, the 1212 is running just under 100%. Again, it's still weak as well. Really, with the exception of North America, the rest of these regions are weak, Europe being the weakest for us. I could go into specific end markets, but I just wanted to give you that basic color there. One other thing, just to give you maybe another bit of information. Our backlog, this would be our total backlog for the company, in the first quarter decreased 2.5% year on year. That's for the total company. That includes Aerospace. If you look just at the industrial part of the business, the backlog decreased by 8%. That'll kind of give you an indication. Again, that activity or those numbers, Pam already covered as to where that was coming from. Hopefully, that helps you a little bit. Great. I appreciate that. And maybe just quickly, your thoughts on share repurchase, given the liquidity you have on the balance sheet and the cash flow that you seem to be doing this year. Well, share buyback. Currently, just to kind of remind everybody, we increased our 10b about a year ago, 10b5-1, from about $50 million a year to $200 million. So we're on a $200 million a year, about $50 million a quarter pace right now. So that will continue. We bought in the first quarter, I believe, somewhere around $57 million shares back in the first quarter. And that would give you about $107 million in the first quarter total for the company. What I have been doing, not just I, but what we have been doing, is really focusing primarily right now on trying to keep enough dry powder to go after some of these acquisitions that are in the pipeline. You can see that we picked up five. We got a couple more coming through in this quarter. So we've been just kind of paying close attention as to, are these going to make it to the finish line or not? If they are, we'd like to have some capacity to do some of these acquisitions. Not all of them, we realize, are going to make it to the finish line. And after that, if in fact they don't, we'll buy back more shares. But I don't want to predict at this point just what we're going to do. I'd say the preference right now, because we've been working on some of these acquisitions, is to try to get some of these closed in the balance of this fiscal year. The other things that we're going to do, of course, we're going to continue to do, would be the dividend payout. We want to continue that. We have an increased record that goes for 56 years now, and we're pretty happy about the yield, where it's at. We're approximately at the median of our peer group, around 2% yield. And we might need to tweak that a little bit. Of course, if the stock drops further, we'll have to worry it'll be higher than 2% yield, but we hope that doesn't happen. And acquisition, not acquisitions, but then other growth areas like supporting capital expenditures, we're still looking at around 2.5%. I think Pam mentioned 2.5%, and we're still looking at that as far as capital allocation. So hopefully that answers it. I can't give you a hard number on share repurchase, of course. We'll look at share repurchase in light of the acquisitions that we're looking at, and if we have capacity there and the shares are suppressed, we'll definitely do more share repurchase. That's great. I don't want to put words in your mouth, Don, but it sounds like what you're saying is the acquisition pipeline is fuller than it's been for a while. Is that accurate, or am I reading too much? I think that's very accurate. It seems like it took a longer time to fill it this time around because we've been talking about it for a long time, that we were looking at a lot of things. It seems like the fluid's moving a little slower through the pipe, but they're starting to come out the other end, so that's good. It's encouraging because we've picked up some very nice acquisitions of late. Thank you very much. Yeah. Thank you. Our next question comes from the line of Eli Lustgarten with Longbow Securities. Please proceed. Good morning, everyone. Hi, Eli. How are you? I'm good. Just a clarification. Your EPS guidance assumes what share count for the year? Because that's probably the easiest way for us to do it. About 154. About 154. So you actually don't expect to net your- I'm sorry, 153. I apologize. 53, which is just about 152.6, I think, for the quarter. So you are assuming there is no net share reduction for the rest of the year? That is right. It was brought to the guidance. Okay, and the guidance for revenue includes the $380 million of annual sales that you have announced? That is right. Within the first quarter, so it's all in there. That's right. Just so you know, though, let me just give you some numbers here in terms of the acquisitions. It's about 2.5%, 2.4%, 2.5% of the sales amount. Okay? Okay. All right. Don, you're indicating that profitability, I guess as the volume comes down, you're going to be able to hold profitability in Industrial North America for last year. In other words, you don't expect it to go much under 17%, I would suspect, for the rest of the quarter, despite the lower volumes. In Aerospace, the increase of profitability comes from lower R&D or a bit of volume, a bit of mix of which? Well, in terms of the Aerospace, Eli, it is really both. It's the R&D that Don talked about earlier and just us trying to react to some of the programs that we've won over the last five years, and a little bit of a change there in terms of our forecast going forward. Also as- How much was the R&D increase in the quarter, unexpectedly for us? 5 mil, about $0.02. Okay. The other part of the change in the guidance is in the mix, and it has to do with the commercial MRO business here. It's not quite as robust as we had planned, slightly down. Versus the OEM. Okay. The profitability in both Industrial North America and Industrial International going forward, I guess you're saying it's going to come down to like 17% operating margin in North America and stay the same in International from where we are today? That's what you're- I would say North America's staying Industrial, staying north of 17%, and International gradually improving throughout the year. Right. Eli, one thing to be aware of is the way that the currency impacts, it gets more favorable as we go throughout the year. Okay. One final question. We talked about the drop in orders and stuff. Can you talk about inventory liquidation at distributors? Are we seeing our contacts saying that we're starting to hear or talk about it? Particularly, as construction equipment, I'm surprised heavy truck is flat because the production's down 20% in the fourth quarter. But is construction equipment taking down their orders also across the board? Yes. That's the segment that we've seen the most adjustment in, is the construction equipment, the OEM segment, a lot of the OEMs readjusting there. I think that's pretty much globally too, by the way. It's not just North America. It's pretty much globally that what we're seeing in the construction segment of the part of the business. Distributor inventories are- Yeah, the distributors. I would say distributors, Eli, probably reacting from what input we're getting, pretty much like they have in the past. Pretty much haven't been building a lot of inventory to begin with. So they're basically adjusting to reality like we are. I don't see any huge material changes one way or the other. I think they're going to be gradually making adjustments as time goes forward. Keep in mind that there's no cliff that we see on the distribution part of the business either. That's still a pretty solid segment for us. Eli, we need to be cognizant of time to give other people a chance. Okay. Thank you very much. Thank you. Our next question comes from the line of Rob McCarthy with Robert W. Baird. Please proceed. Hello, this is Mircea Dobre for Rob McCarthy. Good morning. Good morning. First, a quick question on Industrial International. Can you give us a little more color on the integration and acquisition costs in the quarter? Well, for the Industrial International segment, we are saying $0.03 for the integration and acquisition costs. This relates to deals that we have announced and completed in Q1. This also relates to deals that are unannounced and that are in the pipeline that Don has been referring to. Okay, great. Thank you. Then switching back to Industrial North America, and you commented a little about ParkerStores, but I am wondering, are you seeing going forward any sort of mix shift in the way your revenues are generated in that segment? What sort of impact did you bake into your margin assumption? Because from what I can tell, your incremental margin embedded in the guidance is something north of 35% in North America. So I am kind of wondering, is it that you are sort of seeing a more pronounced shift on the distributor side, or is it that its OEM business that potentially carries higher margin there? I just would like to make a comment about these marginal return on sales at this point. There are certain points in the cycle when you don't have a lot of acquisitions, you can look at these marginal return on sales numbers, and they make a lot of sense. But then there's points in the cycle, and especially a period like this, when we're doing a lot of acquisitions, these marginal return on sales numbers, there's the law of small numbers, number one, and then also, due to the acquisitions, they can become a little distorted. If you look at North America, just to give you an example, the marginal return on sales in the first half is, you're right north of 35%, but if you look at the first quarter and the second quarter, you have a favorable 6% and then an unfavorable 24% in the second quarter. It's just the way the numbers are working out. For North America, quite frankly, we're right in line where we think we should be. Okay, thank you. Next question comes from the line of Alex Blanton with Clear Harbor Asset. Please proceed. Hello. Hi. Can you hear me? Yes. Good morning, Alex. Thank you. Hi, Joel. You asked the question I was going to ask, and I want to go back to that for a minute. No one has really focused on the 11% decline in North American orders in the quarter, and that apparently really started in September. Was the first 2 months up in September more than offsetting? What does this mean in terms of the economy for the fourth quarter? What do you think? Well, let me just give you a little color on how things played out through the quarter. As we went into July and then August, we were feeling pretty good because we were right on pace with what we had told you previously. Yeah. It's the month of September that really did take a big decline. So it was more than offsetting? In other words, it was down more than the first two months were up? Yes. Okay. For the quarter, you can actually look at the miss. We did $1.57 for the quarter. We thought we were going to do around $1.66. It really was attributable to the really tough September month. Well, now, doesn't this sort of indicate we might be entering a recession here, a big fall-off in orders in September and the weakness overall in other companies' results that are coming along here as we go through the earnings season? I'm just wondering why you're assuming it's going to be flat for the year when you're starting the next nine months with a big downturn in your orders. Secondly, on that question, how do you think the election is going to affect you? Depending on who's elected, you might have a big increase in business in the second half or a big decline. Are you just waiting to see what happens, or do you think it doesn't matter? Well, maybe, Alex, I'll just touch on. This is Don. I'll touch on the second part. We can't predict what's going to happen, frankly. Right. No. We have our own opinions as to what would be best for the economy and best for our business, certainly as to outcomes. But I don't want to go online and predict anything. I think, instead of doing that, we just decided not to predict anything. Okay. Just say, "Hey, we're going to get another look at this after the beginning of the year. We're going to know a lot more then." We feel pretty comfortable with our second quarter. You can back into our second quarter numbers. We've given you enough information, so you can back into that, and we feel pretty confident of those. When you look at October, the way it's coming in right now, October is usually a pretty good month, and it's shaping up to be a reasonably good month. That's going to carry a big portion of the second quarter because remember, November, December are the weakest months in the quarter. Had we not had indication of a reasonable October, we would be telling a different story right here. Okay. Okay? Yeah. I got that. Okay, listen, I do not want to take too much time, but I got another question on your international business. You had a 50% decremental margin. Operating earnings were down $56 million and sales were down $112 million. Why was it so large on the decremental side? Alex, Jon here. Just to try to help you with that internationally first. We talked about the acquisition integration and acquisition costs. That $0.03 that we have talked about are baked into those MROs here for Q1. In addition to that, as you know, we try to manage to negative 30. That is historically, in the best times when we are actually going down, we are able to manage to negative 30. That provides a very good result from us from a marginal return on sales. When we first start turning, though, as we are turning right now, we cannot react instantaneously. We are furiously, throughout all of our operations, specifically in this case, internationally, that we are talking about working to try to take the actions that are necessary in order to adjust to the new reality that we are seeing here in terms of the recession in Europe and most countries there, as well as the reduced industrial production indexes that we are seeing from Asia, primarily in China. You try to get a 30% decremental margin, but you cannot react that fast, right? Right. We don't expect that 50 to continue, and we are determined to get to no worse than negative 30. Yeah. That 30 would be lower, but you don't want to cut out all of the SG&A that you built up necessarily, right? Well, we've got a certain base that we will continue to maintain, and we will continue to try to structure all of our operating divisions in a way that is going to make us also able to react as things go back up. We'll be mindful of the long term. We're not going to be totally short-term focused. Okay, thanks. Our next question comes from the line of Andrew Casey with Wells Fargo. Please proceed. Thanks, and good morning, everyone. Good morning. At the risk of beating a dead horse, I just wanted to ask Joel and Alex's question a little bit differently from a historical context. Could you discuss whatever differences you may be seeing between what happened in September in Industrial North America, the order drop-off from what you historically saw back in fiscal Q2 2009? Andy, John here. One thing that we've been looking at very closely is, and talking about is, of course, as we're putting the guidance together here, how does this situation compare to prior years? We're very intensely looking at the data in each one of our groups, in each one of our segments. One of the things that Don talked about earlier, I think is very important for you, Alex, and Joel, and everybody to remember is that we did experience several cancellations from some of our OEM customers. Those cancellations, of course, are one-time events. They're not a general pattern. They were enough for us to mention in our comments going forward. As we experience those cancellations, they'll have a one-time impact on our order rates for a quarter. But we don't see, especially given the detail that we know behind the order reductions, we don't see that impacting us going forward at the same rate. What we do, as you know, is we took our bottoms-up approach in our forecast when we put our guidance together. We feel very good about our Q2 and our balance of the fiscal year based on what we know right now, and that is how we basically have looked at this question of the orders in the month of September and the impact on North America for the quarter. Thank you for that, John. If I could take a stab at recharacterizing what you just said, is your view that the OEM customers in particular who made those cancellations are just taking the production cuts right now to true up their order boards? Is that? Yes. I think that they're resetting. There's no doubt that they are resetting, and we are reflecting that in our results. Keep in mind that, as Don talked about, the PMI moving up in North America, many of our customers that reset their orders in the quarter are also resetting their look to react to the international situation. Sometimes those orders are going to our OEM customers in North America, but ultimately destined for final demand that is international related. Okay. Thank you very much. Thank you. Our next question comes from the line of Jamie Cook with Credit Suisse. Please proceed. Good morning, Jamie. How are you doing? Oh, this is actually Linda in for Jamie. Oh, how's Jamie doing, by the way? She's doing well. Good. I mean- She just had a baby, by the way. So, kind of going with what everyone else has been asking with those orders in the U.S., those cancellations, how is that making calendar year 2013 looking for you guys? Is that like the OEMs, are they looking at still a growth year? Is that going to be more flat looking or down? What's sort of your expectations with your orders? Well, I think this is Don again. I think if we see that happening on an ongoing basis, then it's going to bode not so well for 2013. But like we said earlier, we're seeing this adjustment, and I think this is just adjusting like we're adjusting to the current reality. I don't see it continuing, at least at this point. Now, if the global condition worsens, then I think maybe there's going to be another readjustment. But I think that's how it would affect us over the long period. I don't see any sustaining effect of what we saw in September above and beyond what we've already indicated in our guidance. Okay. Then switching over to international then. China seems like it's kind of an important part of the international recovery. What are your thoughts on China? Is growth going to come back there next year, or is that pushed out to your fiscal year 2014? Or how is that looking? It's Pam Huggins speaking. Really, we've become, I don't want to say negative, but versus what we were thinking even three months ago, our view is somewhat different. We were probably a little exuberant in what we thought might happen in China, but we were right in line with what everybody else was thinking at the time, too. We thought we would see more of an uptick there. Actually, now, we do have a little bit of growth baked in, but it's very minor, 1%-2% in the second half. I would call that probably more in line with the natural cycle of our business than really seeing any true uptick that's going to take place there. Okay, great. Thanks, guys. Thank you. Our next question comes from the line of Nathan Jones with Stifel Nicolaus. Please proceed. Morning, everyone. Hi, Nathan. Can we just talk a little bit about Europe and kind of the sequential progression there of things? Still deteriorating sequentially, stable, or getting any better? Well, I think if you look at what's happening from some of the PMIs that I had mentioned earlier, which is probably the best indicator overall, we can talk about our own numbers and all that. Europe is negative to 50%. They're down around 45%, 46%. It creeped up a little bit in September. Germany actually bounced up about three points, so they're around 47, which is a good indicator. I don't think deterioration from this point is what I'm seeing here. I just don't see a tremendous uptick either. I just see more of a steady as she goes. Could you talk about specifically your own business over there and how that progressed through the quarter? Nathan, as the quarter went on, it was obvious to us that in Europe, we were bouncing along a low level, so we don't see further deterioration through the quarter. Our projections through the balance of the year are that we are basically flatlining, and flatlining in terms of the growth that we had projected in the first cut of the guidance at the rate that we're now seeing. Nathan, we are at a low level there. We've never gotten to the point that we really have been able to see a huge growth in the different end markets that we're in there that are opposed to some of the other end markets around the world. We are really focusing in on some of the growth opportunities that are in very strong end markets that are in Europe right now. One of them being oil and gas, process, a few other chemical industries that are really very promising for us. But the short answer to your question, we're at a low level, but we're not deteriorating further. Okay That's what our guidance indicates. Okay. It sounds to me a little bit like the drop-off in orders in Industrial North America might be primarily driven by end market weakness in Asia. Is that a fair statement? I think that certainly some part of that is attributable to that. It's really hard for me to tell you what part of it. But that is certainly a material portion of the answer. Again, we're looking at it as a reset, and we're looking at our customers reacting to their ultimate demand levels, and many of our customers are multinationals, too, as you well know. If I could just slip one more in on Aerospace. Are you expecting the OE versus MRO mix in the balance of the year to be the same, more heavily skewed to original equipment or more heavily skewed to MRO? As time goes on through the year, it's going to be more heavily skewed to OEM. Great. Thank you very much. Our next question comes from the line of Jeff Hammond with KeyBanc Capital Markets. Please proceed. Hey, guys. You mentioned a lot of acquisition integration costs, but clearly, you are bringing in some good businesses. Do these start to become accretive pretty quickly? Or maybe if we look at the whole year, how should we think about accretion from these deals? All of these deals that we announced in Q4 last year and in Q1 this year have been accretive to the bottom line. And are performing very well for us. We are very excited about the prospects. And, of course, we have got integration costs and things, but even given that, these deals have been accretive. Okay. But your bridge does not really call out any acquisition positives or negatives. No. We just do not get to that level of detail, and we normally do not go deal by deal and explain exactly what the performance has been by quarter. But in general, we wanted to make sure that we explained to you and anybody else that called, that these deals have been accretive for us, and we are happy with the results that we are seeing. Okay. Don, I just want to understand the capital allocation dynamics a little bit better, because I think what you are saying today is acquisition pipeline is pretty full, and we are going to focus more on deals. Yet, the last two quarters, your comments were, "I want to buy back my stock, I want to buy back my stock." And now the stock is down 7% today and looks like maybe a better buy than the previous quarter. So, what is really changing here? Nothing's changing. It's a timing thing. Like I said, this pipeline takes a while to fill. Once you get things going down through the pipeline, it's a timing issue. When those start coming out the other end, I have to have money to pay for them. If they're not going to come out the other end, or if they're going to come through slow, then I can maybe do some share buyback and replenish my dry powder in the interim. It's really a matter of timing as far as what I can do and how much I can do when I can do it. We've done a lot of share buyback in the last couple of years. $1 billion type numbers. It's not like we've been sitting here doing nothing. We weren't able to do as many deals in the last couple of years because we were filling the pipeline. We were looking at things. We were turning some away. We're looking more seriously at some. I think it's really a timing issue, and we look at this kind of real time all the time. Like, okay, how much money do we have? What's our leverage? We're not going to let our leverage go above 37%. We're going to maintain our A ratings on our debt. So what can we do and how much can we do? When can we do it? Of course, if I knew that the stock was going to drop $7 today, of course this would be a great buying opportunity and is a great buying opportunity. I'm not going to predict anything here, but I say that we're certainly looking at that in light of everything else we've got coming through the pipeline. But once I get things going through the pipeline and I get them going through a due diligence process, I can't just shut that off. It would be silly to do that. We spent a lot of money to get them to that point. So we've got to continue through with the ones that we're looking at seriously, and we're always looking at Parker stock as a good potential acquisition for us. Certainly at these levels that it's at now, it's a tremendous opportunity. Okay, thanks. Okay, we'll take one more call or one more question at this time, please. Our last question comes from the line of Henry Kirn with UBS. Please proceed. Hey. Good morning, guys. Hi, Henry. How quickly can you flex production? Could you discuss a little bit the changes to your headcount plans over the last quarter? Then maybe if the OEMs were to switch back to a more positive view, how quickly could you shift the production back up? That's a good question, Henry. I think one thing that we are doing is adjusting the workforces globally. It's slower in Europe. Probably the slowest of any region around the world is Europe because of all the Works Council negotiations and the government negotiations that go on when you're trying to reduce workforce or adjust it down. What we've done over time is we've built up a layer of what we call associates, part-time employees, and so forth, so that we could flex better. That's what we're kind of working into right now, is these associates where you can take actions a little bit quicker and adjust a little bit faster and yet not eat into your core workforce. So that's kind of what we're working on. The other thing that we've done is we've gotten some locations, we have shortened work weeks. Again, every facility, we have 350 facilities, so every one is in a different state as far as demand and order trends and so forth. So they're adjusting with short workweeks, part-timers, and associate workers, and so forth. Those are the kind of things we're doing in the workplace. I think we're going to be in a tremendously good position to rebound whenever there happens to be a rebound, and hopefully that's soon here. There's certainly a possibility it could be soon. So we're ready. We can add people back. We've got the core workforce still there so that we can respond quickly to any changes in demand. Okay. At this time, we'd like to end the formal Q&A session, and I'm going to turn it over to Don, who just has a few closing comments. But for those of you on the call, I just want to say thank you. I know that you guys have had a very busy day today. A lot of people are releasing earnings this morning. So, thank you for taking the time to attend our call. With that, I'll turn it over to Don. Well, I want to once again, thank everyone on the call for joining us this morning. I also want to take the opportunity to thank all of our employees, as I have in the past, for their continued commitment and our success. The team continues to execute on our Win strategy, and they continue to outperform and perform extremely well vis-à-vis our peer group. Throughout this period of uncertainty, we're going to continue to manage our costs. As we've said on this call, we're going to maintain our strong financial position, as I stated, with our leverage. We're going to continue to pursue our long-term growth strategy, and we talked about all of those issues today. I want to thank you again for your participation on the call and for your continued interest in Parker. As we've said in the past, Pam will be here the balance of the day, and she'll be taking calls. If you have anything that we haven't answered, feel free to give her a call today. Thank you very much and have a good day. Thank you for your participation in today's conference. This concludes the presentation. Everyone may now disconnect and have a great day.