Regal Rexnord Corporation (RRX) Earnings Call Transcript & Summary

Hi, everyone. This is Joe Ritchie, head of the U.S. multi-industry for Goldman. Very happy to have Regal Beloit with us today. We have the CFO, Rob Rehard. Rob, thanks for joining us today. Really looking forward to having this discussion with you.

Hey, thanks, Joe, and thanks to the Goldman Sachs team as well.

Yes. So Rob, maybe just kind of starting off, right, and kind of thinking about your long-term targets. You guys just set pretty ambitious 3-year targets at your Investor Day just a couple of months ago, the 303 program. You guys are looking for above market organic growth, the 250 to 300 basis points in margin expansion, call it, high single-digit to low double-digit earnings growth. It's pretty incredible that was only 2 months ago, a lot has happened since then. But like, I guess, how are you kind of thinking about those targets just in the context of this backdrop? And would also love to understand maybe some investment that is necessary in order to kind of realize these?

Yes. So let me -- first of all, let me recap. The plan we outlined at Investor Day, it was to realize the $90 million to $100 million of operating income gains over the next few years, which included at that time, $29 million in 2020. Now we've raised that to $32 million this year. And those gains are being driven largely by actions under our control, including restructuring, changes to our supply chain, implementing the 80/20, which I know we've talked a lot about, in addition to some modest assumed benefits from volume and mix over that 3-year period. So that's kind of the way we laid it out initially. As you know, we've been implementing the 80/20 principles across organization. And we made great progress on this front. I'd say we're really still in the early innings on that front. I always say, we're probably in the third inning or so. So we've got some great runway here. 80/20, as you know, as talked about, is not just -- they're not just actions, just a set of actions to reduce complexity or lower cost or dedicate resources to our highest return customers or opportunities, but it's also a mindset, and that's clearly been implemented here. And I'm happy to say it's really taking hold across the organization and even gaining momentum as our associates across Regal are starting to realize the benefit of this program. And I think 80/20 has been contributing to the strong operating leverage we've been delivering over the last 4 quarters. So clearly, it came through in our first quarter results as well. And I should say that since COVID-19 has started to impact our volumes, we're staying focused on executing what's under our control. And the restructuring actions we targeted for this year are really in aggregate, still on track. In fact, as I talked about earlier in my answer, I said that we even pulled in an additional $3 million in light of things that are going on right now to ensure we can still deliver on that commitment, on our 303 initiatives that we talked about at Investor Day. So I also I want to say that while many of our end markets have weakened, we still aim to outgrow our markets, and that is a big focus internally. And I think in many cases, we're seeing success in doing that. So hopefully, that answers your question, that I sort of follow-up.

I know that's helpful, Rob. I guess maybe just one follow-up to that. When you're rolling out a new kind of like corporate-wide strategy, 80/20, can you talk us through how that actually works? Like how do you execute on that? How do you get buy in within the organization? And how do you kind of layer it across the different business segments?

Well, I'll tell you, Joe, it's a good follow-up question because we talked about -- a little bit about this at Investor Day where we said that we had trained, I believe it was over 900 of our associates, our leadership team and many of our associates across organization. We're well over 1,000 now, and we continue to make progress. So it's really about training, and it's kind of like you train the trainer and kind of -- and that kind of culminates throughout your organization. And I'll tell you, it really is taking hold. But that's really the way you roll it out. You really -- you train people on this initiative, you provide examples and models on how to implement. So for example, on the 80/20 pruning activities that we are going through right now, it could be as simple as providing scatter plots on, hey, where are the margins above 0 and below 0. What do we have to go working on? What are those specific customers or products that we need to go after? Those are the kinds of things that we're implementing in our organization. And that's how you get those sustained benefits, and it becomes part of your culture going forward.

Got it. No, that makes sense. That makes a ton of sense. And then you mentioned being able to pull forward, call it, $3 million in benefits into this year. As you're kind of thinking about structural benefits in 2021, like what's kind of the playbook for 2021? How do we kind of think about like the right number that we should -- could potentially plug into our model for 2021 in terms of the work that you're doing?

Right. So the original -- as we talked about at the end of 2019, we had $38 million of annualized benefit coming to us through both the reorganization that we talked about, which is about $15 million of that; the plant consolidations, which were about $17 million; and then there was other restructuring activities going on to about $6 million. So there's about $38 million there. We said that we would get about $29 million this year. Now we've raised that to $32 million, which brings another $6 million coming in 2021. And so you'll get $38 million of run rate going into '21, most of that will be coming into '21 on a run rate basis as we exit this year because you'll be getting $32 million of it. So that's really the way to model it. Now the $32 million we're getting this year, we said about 1/3 of it in the first half and the other 2/3 in the back half. So that's the other way to think about as you're thinking about this year. One other thing to point out on this, there was about $6 million of temporary Q2 cost actions that we took that take in the form of furloughs and salary reductions and the like, other discretionary. So there's really in 2020, we're really looking at $38 million in total. Now $6 million, that's temporary and $32 million is more structural -- sustained. But that's the way to think about it and to cadence it when you're modeling it.

Yes. That's right. And I guess, as you kind of think about the next year's number, then you still would have kind of like that run rate coming through, call it, that extra $6 million is structural, but that's probably going to be offset largely by the temporary actions that you've now indicated for 2020. Is that a fair statement?

I think that's a fair statement. Yes, you would -- because those are temporary. And of course, as we exit -- as we end Q2 and get closer to Q3 and have a better -- a clearer picture on -- hopefully on kind of what -- when this thing is going to turn back on us or the order rates improving, hopefully, as we exit Q2, then we'll make the determination as to whether we want to continue on that plan to implement those temporary cost reductions further through the year.

Got it. Yes. No, that works. And so I guess, if you kind of think about -- you think about that kind of buildup that you were talking about earlier in terms of the dollars and margins that you expect over the next 3 years, there's a portion of it that is also coming from the -- just the volume environment. And so talk a little bit about that. So in a -- let's say, a volume environment that stays lower for longer, what can you do kind of within the portfolio today, either to try to increase structural opportunities? Or should we kind of be thinking about this as like you can really kind of flex your temporary costs for the time being, and then we'll kind of -- we'll see how it goes and depending on where the demand environment is?

Well, I think, our -- first of all, our through-cycle margins that we've historically shown have not been stellar. But we do think that we'll -- we're definitely going to need to flex more of those variables, the variable cost side, in order to hit those decrementals that we've laid out when we talked about that in our scenario analysis coming out of the first quarter. Now those actions kind of -- they take the place of mostly discretionary, but we can flex our labor workforce and we can also produce anywhere in the world if it makes sense to produce elsewhere. So those are the kinds of things that we're looking at in order to get through this very tough period of time, in addition to those structural changes that we're talking about.

Okay. Fair enough. Yes. And so maybe just talking about this through-the-cycle margins, right? The one that really stands out and where you probably have the most -- not probably, but where you have the most wood to chop is really the industrial business, given it's at breakeven today, and you're hoping to get to, call it, high single digits, maybe low double digits through the cycle. Maybe talk through some of the value engineering work and footprint work that can be done there. And is it possible to get close to a double-digit margin in a -- if the backdrop is kind of flattish over the next 3 years?

Yes. So you're correct, this is a challenged segment. That's for sure. So the nature -- specifically for industrial, the nature of the actions in industrial are similar to those that we have in the other segments and involve supply chain, footprint rationalization, the benefits from 80/20 that we're talking about, such as pruning the low-margin business and SKU reductions. And I've talked about that in the past in terms of how we're also consolidating platforms, product platforms and that sort of thing. As you saw in the first quarter, we're heading in the right direction on this front. Margins in that segment were up 230 basis points. On a top line, that was down 4.5% on an organic basis. And so we're confident that we'll make further progress. We laid out at Investor Day a plan where we said we do not need top line help in industrial in order to deliver the performance on the bottom line. And that goes for this year as well, obviously. And we do expect to make meaningful improvement throughout the year to the profitability of that business and expect it to be profitable on a business that was essentially breakeven last year. And so that's the way we're thinking about it.

Okay. Good. No, fair enough. And I guess, on the most recent earnings call, you did talk about decrementals by business. It's interesting to note, like the climate op margins are pretty comparable to PTS, but you expected a decremental PTS to be about 10 points higher. Can you walk maybe through some of the dynamics on why PTS would kind of delever at a higher rate than the climate business would?

Yes. It's pretty straightforward in that. It really just reflects the mix of fixed versus variable costs in our PTS business. As you know, that business is already nicely profitable and with low teens operating margin and -- which we think we can get to a mid- to high-teens level in that segment. And we think getting those margins up, we can reduce some of that level of fixed cost that has impacted that business? But as it stands today, the business does delever at a somewhat higher rate, given the higher fixed cost nature of its operations. The good news is that in a recovery, it also expected to see above-average incrementals in our PTS business, all else being equal. But the PTS business, as we talked about at Investor Day again is one where we didn't do a lot of plant rationalization or consolidation in the past and those sorts of things. It's a great story for us going forward in terms of our ability to improve margins in that business, that being one of the contributors.

Yes. No, that's well noted. Obviously, margins were up in both PTS and also climate just despite negative organic growth in the quarter. So definitely saw some of that coming through as well. I guess in kind of talking about the quarter ending, maybe more recent trends, like you mentioned April order stabilizing at close to down 30%. I mean I know it's only been a week since you guys reported. But has there been any kind of rate of change in those trends just based on any of the quoting activity or leading indicators that you're looking at?

Well, I'll tell you, I think it's a little early to comment beyond what we said on the call, which was only about 6 days ago, business days ago. But just as a reminder, we did say that the orders for a total company were down 30% in April, and the rate of decline in orders we saw in the early part of the month or April appears to stabilize and the month actually finished a bit stronger. So we did start to see that tick up towards the end of the month. So that's what we said on the call and really don't have much more to add beyond that today.

Yes. Fair enough. It's only been 6 business days, so quite a figure I'd ask from you. You laid out a few scenarios around -- what you would delever at. I thought that the scenarios that you laid out were pretty impressive in the kind of down 20% or down 35% environment. I guess, the question I really have is like whether you think -- if we stay at like a sharp decline through the rest of the year, how do you kind of maybe guard against maybe cutting too much across your businesses and sustaining those type of decrementals? And I'm just curious like whether at some point, you just kind of have to pull back from cutting because you want to make sure that you have a -- your employee retention is strong and that you have everything you need once the cycle does recover?

Sure. So first of all, a couple of dynamics are at play here. One, the restructuring actions we identified for this year are weighted to the second half. So we get some additional benefits from cost out in the third and fourth quarter. Now that said, the compares on decrementals also get harder since we did ramp-up in cost actions and an improvement in our deleverage in the back half of last year. So we think these dynamics could roughly net out. We'd also indicated, as part of our scenario analysis, that additional cost actions would likely be required beyond those that we've currently disclosed at those higher ranges, especially at the down 35% scenario. So here, we're looking at a range of options, including extending some of the temporary actions we took in the second quarter, like I talked about earlier, and potentially pulling forward additional permit restructuring savings above and beyond the $3 million we've already pulled. And we're looking at other actions as well. But at this point, we're not announcing anything further on the cost front. Now one other assumption we made as part of our scenario planning is that we see no material degradation in our supply chain. And overall, I can tell you, our global supply chain is running well. Though the principal risk we see on this front, as we highlighted on our first quarter call, is Mexico. And we have many plants in Mexico, and most are running well. And in the facilities where we did have some operational challenges, I can tell you that those challenges do continue, but we're actively working towards stabilization. And we've had good success here in our other facilities within that region. So we're winning back our ability to implement our workforce effectively. Now the one thing I want to make sure that I'm clear on, you asked about when do you cut too far? And when does that get into -- where you get the dangers in terms of resources and things like that when the economy does come back. Well, that's why in the second quarter, that $6 million of furloughs and pay reductions was implemented as opposed to just a reduction of force. We want to hold on to our employees as we believe that when this economy comes back, we need these employees and our resources. So those are the kinds of things you do in these times to protect against that risk.

Yes, for sure. No, no, that makes sense. And yes, all of that color was helpful. I think maybe just kind of switching gears a little bit and just diving into the segments a little bit. Maybe just kind of starting off with PTS. You mentioned that in the quarter, a lot of the decline was driven by oil and gas. I guess, maybe just remind us within the segment, how much is your exposure to upstream versus, call it, mid or down? And then specifically, like, this is an area where you have been pruning your portfolio. Is there additional opportunity to potentially cut just given the state of the oil and gas markets?

Okay. So the -- 2 parts to your question. So first of all, our exposure to oil and gas has been coming down in recent years, in part due to our proactive pruning efforts, which you just mentioned. So oil and gas in the -- for total Regal is about 2% direct exposure, while it's 8% in our PTS business. And within PTS, the weighting is about 3/4 midstream and about 1/4 upstream. I'll remind you that there is obviously -- there's a second and third derivative impact through the sales chain that we don't quite have as great a visibility to. So the numbers I'm talking about are direct sales there. Now talking about the pruning that's going on, hey, you're right, we divested about $270 million over the last couple of years. A lot of that, most of that is really tied into the oil and gas markets. And we're continuing to look at pruning opportunities across our businesses and end markets, including oil and gas. But I'd note that part of that process involves working with our customers to identify our value-add and making sure we're getting compensated for it. And if we can't get to a mutually beneficial place, then we explore other options. And we believe we can make really very nice margins on sales in the oil and gas market. But if it turns out not to be the case, we're willing to walk away from that business where we can't make an acceptable return. So the pruning takes place in terms of selling the businesses in the past that we're really more direct -- tied to oil and gas, and then this pruning of customers and products that don't fit our margin profile that we're looking for today.

Yes. No, that makes sense. I guess, maybe just staying with PTS for a second. One area that's been good for you guys is, a, in PTS, that's been renewables. We're hearing that across some of the companies that supply into that end market. Did you have any other areas, I think, within PTS you think could hold up well? And is it -- is that a fair statement that renewables should kind of remain strong for you guys in 2020?

Yes. So in the first quarter, renewables was a real bright spot for us, and solar in particular. We think there's a lot of opportunities for us in that end market, including in 2020. But I'll tell you that, that business can be lumpy. So the growth is not always a straight line. Now the other area that -- you asked about other areas that we're seeing nice traction, is in our conveying business where we're selling our advanced ModSort conveyor system, often to distribution centers. And we've been talking about that as a growing opportunity funnel in conveying at the end of 2019. And now that's starting to convert into orders, one of which, a large order we talked about at our first quarter call. So -- and there's -- in addition, there's other opportunities that continue to grow in that funnel. So yes, we see some great opportunity here in PTS in both the renewable and the ModSort technologies moving forward.

That's good to hear. I guess, just shifting gears to climate. Here, your orders were down 40% in April on the climate side. I think maybe just talk through a little bit, just for the -- for everybody who's listening in, like why that trend was worse than many of the OEMs that kind of reported somewhere down between, call it, like 15% to 20%?

Yes. So Joe, I'm actually glad you asked that because we've got a lot of questions on that topic. And there were a few dynamics that impacted our climate business orders in the first quarter and in April. So I'll give you a few of those here. So first of all, as most are aware, it was historically very warm weather, record-setting warm winter. So OEM customers didn't sell as many furnaces. That's part. Now the second is that we were comping against a prior year period that saw significant tailwinds from pre-building ahead of the FER regulatory change that was implemented mid-2019. I'll remind you, we were selling a lot of standard motors, standard PSC motors, a lot of units, higher sales volume there last year. Now we're selling the higher -- better-margin products, fewer units, especially with the warm weather, but we're selling a few of those today. So from a comp perspective, year-over-year, you've got that hangover going as well. And finally, there's just caution in the channel given the COVID-related uncertainty. So the inventory build that typically happens as we head into the peak summer season hasn't happened yet, or at least to a much lesser degree. But one thing I want to make clear, just really quick, Joe, is one thing that's not occurring, and we discussed this very candidly with our OEM customers, is share. It's not that we're losing share. It's really those 3 dynamics. And so that's really what's going on, those 3 things that I talked about. But it's not a share issue with the OEMs.

Okay. No, that's super helpful. And I guess just -- I mean, just from an end market perspective, do you have any kind of -- any color on like -- on the verticals that are potentially driving some of the order declines? I know that's kind of 3-pronged dynamic right now. But I was wondering if there was any more like end market-specific commentary?

Well, regarding the verticals, so the headwinds are pretty broad-based. But we did see pressure on our residential HVAC business and our commercial refrigeration business, in particular. So hopefully, that helps.

Yes. Okay. Cool. And then just, again, you guys kind of talked about being able to lever this business at 20% to 25%. It's pretty good like in this type of an environment. So like what specifically are you guys kind of focused on here on this segment to be able to kind of hit those numbers?

Yes. So our scenario analysis that you're talking about contemplated a deleverage rate of about 18% to 22% when you were at top line decline of 20%, and about 26% to 32% with a top line down about 35%. So we didn't outline a scenario for 40%. But at this point, we don't think it's likely that our climate business will be down 40%, but you can extrapolate based on the scenarios what a down 40% would look like. But we're -- the cost savings that we're implementing across our organization in every segment should help to -- us to delever at below historical rates in every segment. So that's really the way to think about it and -- even in these very extreme situations that we've laid out in our scenario planning.

Got it. No, that's a fair statement. Sure. Maybe switching to commercial. Just -- that's an area where you've got some pretty high exposure to Asia. Would you expect to see this business start to kind of pick up? Or are you seeing any pickup as China start to show signs of improvement?

Yes. So that's a good question. And we mentioned on our call that we're starting to see improving demand in our China business. Now some of which we think might be spurred by the government stimulus programs around infrastructure investments that are starting to pick up again or appear to be picking up again. We also highlighted some of the work our team is doing there around 80/20. And there's been a lot of effort made to focus on our high-value add customers in that area and reallocate sales resources accordingly. And I'll tell you, it's starting to pay off, as we talked about on the call.

Got it. And I know within this end market, like commercial HVAC is about 1/3 of your business. Do you have like any outsized exposure to any particular end market within commercial HVAC? Just curious like how you're thinking about that specific kind of cycle over the next 18 months?

Yes. So to the best of our knowledge, our exposure reflect the exposure of our customers, which are the large commercial HVAC players you're familiar with. And our sense is their exposure by vertical is pretty diverse. We'd also have some nonresidential exposure in our hermetic motors business, where our products are used more in industrial applications such as chemical and metals, manufacturing plants, or in municipal applications, such as building or upgrading wastewater treatment facilities. So in terms of the cycle, we do not -- we don't have a strong view. I'd say we look at some of the same data you do, such as ABI and Dodge. There are projects in process that we think will continue to be completed, which should help in the near term, maybe near to mid term. And then beyond that, our visibility is fairly low. We are a fairly short-cycled business here, which you're aware. It likely -- it just depends on the course the virus takes. But as you know, coming into the pandemic, there was a view that the non-res cycle could be protracted due to labor availability constraint. So we think it's possible there's some pent-up demand out there. But of course, now it's hard -- it's really hard to say how long it takes to get unleashed. But if it does, in fact -- or if it does, in fact, exists at all.

Got it. And then we're -- you've got a few minutes left. I just want to quickly kind of touch on the Industrial Systems business and maybe the balance sheet. But the Industrial Systems business, obviously, we talked about it a little bit. It's typically been your kind of most challenged business. Like what does this business need longer-term to be successful?

Yes. So we -- hey, we see a path to material -- materially higher margins in the industrial business, and we think a lot of that's under our control. And I talked about it earlier, we don't need the top line in order to get there. And as we've been discussing, this includes things like footprint rationalization, changes to our supply chain, simplified -- simplifying our product portfolio and focusing on our high-value customers. And you started to see the progress of all these fronts over the last several quarters, which were also evident in our first quarter results. And we think there's a lot of room for further improvement here even without the top line help.

Yes. And then just -- I'll ask you the question also on the commercial side, but even on the Industrial Systems side, like this is a segment that has the greatest exposure to Asia, it's roughly 31% of the business. Like is it reasonable to believe that this segment can kind of benefit the earliest then from a recovery, call it, first in, first out?

Yes. I would say that the early indications around China infrastructure coming back online I talked about a minute ago are promising. But it's still too early to draw any real conclusions around sustainability on that front.

Got it. And I guess maybe kind of switching gears. And like lastly, just talking about just capital allocation. You temporarily suspended the buyback. I guess, what would take it to get it going again? And then also just from an M&A perspective, it seems like you're still evaluating some opportunities out there. So maybe just kind of touch on that as well.

Yes. So we think in this environment, it certainly makes sense to conserve cash. So as you noted, we've taken actions such as maintaining versus raising our dividends, suspending repurchases and drawing down our revolver. And we do want to return to a balanced capital allocation strategy, and we'll look to do that when we have better visibility and the recovery actually starting to take hold. From an M&A standpoint, the second part to your question, that's right. We wouldn't rule out M&A in this environment, but we do think the bar is higher, and it's -- quite frankly, it's harder to execute a transaction with travel restrictions and lockdown, making activities such as due diligence and things more difficult. Now that said, where we're most focused on M&A at this point is really within our climate and PTS segments. And on the latter, PTS, we'd like to explore opportunities, maybe bolt-ons to drive more product through a very -- our very robust distribution channels, and that would be a great fit for us moving forward. So it's not off the table, but it's a little more difficult right now.

Got it. Okay. Great. And then just maybe lastly on free cash flow. You still have expectations to be above 100% for the year as a percentage of net income. I think you mentioned building inventories in 2Q to help with any supply chain disruption. So should we be expecting negative free cash flow in 2Q for you guys, with an improvement as we progress through the year? Or how should we be thinking about it?

Yes. Well, we didn't provide guidance by quarter, but we do -- I will tell you, we do expect our free cash flow conversion to be north of 100% for this year. And we've said that we see lower working capital as a meaningful contributor to that performance. We expected trade working capital to be a source of cash, is what we said. But that said, we said that in the first quarter, certain pockets of our business, we are building inventory, largely as a precaution against potential supply chain disruptions. But those are really isolated actions. And overall, we do see inventory coming down in 2020 and contributing to our lower working capital. It is one of the primary drivers of that source of cash through the year.

Got it. Rob, thank you so much for your time today. It was great talking to you, and I hope you have a great week.

Thanks, Joe. I always appreciate the time, and look forward to the next meeting.

Take care.

Take care.