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Executives

John M. Perino - Vice President of Investor Relations

Mark J. Gliebe - Chairman of the Board, Chief Executive Officer and President

Charles A. Hinrichs - Chief Financial Officer and Vice President

Jonathan J. Schlemmer - Chief Operating Officer

Analysts

Julian Mitchell - Crédit Suisse AG, Research Division

Michael Halloran - Robert W. Baird & Co. Incorporated, Research Division

Jeffrey D. Hammond - KeyBanc Capital Markets Inc., Research Division

Nicole DeBlase - Morgan Stanley, Research Division

Joshua C. Pokrzywinski - MKM Partners LLC, Research Division

Christopher Glynn - Oppenheimer & Co. Inc., Research Division

Jamie Sullivan - RBC Capital Markets, LLC, Research Division

R. Scott Graham - Jefferies & Company, Inc., Research Division

Liam D. Burke - Janney Montgomery Scott LLC, Research Division

William J. Dezellem - Tieton Capital Management, LLC

Regal Beloit (RBC) Q1 2013 Earnings Call May 1, 2013 10:00 AM ET

Operator

Good morning, and welcome to the Regal Beloit First Quarter 2013 Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded.

I would now like to turn the conference over to John Perino, Vice President of Investor Relations. Please go ahead.

John M. Perino

Thank you, Laura. Good morning, and welcome to the Regal Beloit First Quarter 2013 Earnings Conference Call. Joining me today are Mark Gliebe, Chairman and CEO; Jon Schlemmer, COO; and Chuck Hinrichs, our Vice President and CFO.

Before turning the call over to Mark, I'd like to remind you that the statements made in this conference call that are not historical in nature are forward-looking statements. Forward-looking statements are not guarantees since there are inherent difficulties in predicting future results, and actual results could differ materially from those expressed or implied in forward-looking statements. For a list of those factors that could cause actual results to differ materially from projected results, please refer to today's earnings release and our filings with the SEC.

On Slide 2, we mention that we're presenting certain non-GAAP financial measures related to adjusted diluted earnings per share, adjusted gross profit, adjusted gross profit as a percentage of net sales, adjusted net income from operations and free cash flow. We believe that these are useful financial measures for providing you with additional insight into the operating performance. Please read this slide for information regarding these non-GAAP financial measures, and please see the Appendix, where you can find reconciliations of these measures to the most comparable measures in accordance with GAAP.

Now I'll turn the call over to Mark.

Mark J. Gliebe

Thanks, John. Welcome, and thank you for your joining the call and for your interest in Regal Beloit. We'll follow our normal agenda. I'll make a few opening comments, Chuck will give you a financial update and then John will provide color on our markets and operations. And then finally, I'll summarize and we'll move to Q&A.

Despite weaker than expected conditions in our commercial and industrial markets for both our motor and mechanical businesses, Regal achieved performance within our guidance range for the quarter. As we entered the first quarter, order rates in our C&I markets appeared to be strengthening, and we were feeling cautiously optimistic about our outlook. However, by mid-February, orders slowed across our C&I end markets.

In the HVAC space, it was a similar story. We started out the quarter strong, but then demand fell off in February and then picked up again in March.

Our Unico business had another quarter of strong growth, driven mostly by continued penetration into the oil and gas end markets. Free cash flow came in at 92% of net income for the quarter, reflecting our normal seasonal inventory build. We continue to make solid progress on our synergy plant consolidation programs, having now completed 3 of the 4 plant transitions in Juarez, Mexico. We are on track to complete these synergy programs by the end of the second quarter.

We continue to drive our growth. We launched 20 new products during the quarter after launching 60 new products last year. We also completed the acquisition of the RAM Motor business, a business that complements our Commercial Hermetic Motor business, with manufacturing capabilities in Pennsylvania and Brazil.

And finally, we are actively pursuing acquisition opportunities that meet both our strategic and financial hurdles, that range in size from small bolt-ons to medium and larger-sized targets. We intend to continue to be a consistent and successful acquirer.

As we look forward to the second quarter, our guidance reflects continued difficulty in our North American commercial and industrial markets. While these markets are expected to rebound in the second half, we don't yet see it in the second quarter. Weakness in our C&I markets in both our Electrical and Mechanical segments is the primary channel -- challenge we are facing in the second quarter.

In HVAC, while residential housing is supporting overall demand, we expect the combination of a cool spring and the demand for more value-oriented products to be a headwind for the quarter. You all know that HVAC market is a competitive space, with customers changing technology and changing suppliers. As an example, one of our larger residential hermetic motor customers has recently decided to cease production of certain compressor platforms and instead they will source compressors from a third-party. Therefore, this customer will not be purchasing hermetic motors from Regal, and the effect of these types of anticipated changes will result in up to a $15 million reduction in HVAC sales in the second quarter. We expect a similar but declining impact for the next 4 quarters.

We are actively pursuing new commercial opportunities that could substantially offset these expected changes. And additionally, Jon will walk you through new HVAC products that over time should position us well for the future.

With that, I will turn it over to Chuck Hinrichs.

Charles A. Hinrichs

Thank you, Mark. Good morning, everyone. Our first quarter results were in line with our earlier guidance but at the lower end of our guidance range. Net sales for the first quarter of 2013, up $778.2 million, decreased 3.7% from the prior year. As Mark stated, sales were weaker than expected as we experienced slower market demand in our C&I and Mechanical businesses.

International sales were weaker in the quarter, declining 6.8% compared to the prior year. The impact of foreign currency exchange rates reduced total sales by 0.8% in the quarter. To put a finer point on this statistic, the 0.8% is measured against total sales. Recalculating the FX impact on just the amount of international sales explains 2.4%, or 35% of the decline, in international sales in the quarter.

Despite the decline in sales in the quarter, we increased the gross margins in both of our 2 reporting segments, the Electrical and Mechanical segments, as compared to the prior year. This reflects the benefits of our synergy program.

Our SG&A expenses increased modestly during the quarter due to inflation in our compensation and benefits. Our operating profit for the first quarter was 9.8% of sales, stable with our results in the prior year.

Free cash flow in the first quarter was $45 million, or 91.7% of net income. This is modestly below our goal of greater than 100% of net income and reflects the increase in accounts receivable and inventory as sales increased seasonally from the fourth quarter levels.

Earnings per share for the first quarter 2013 were $1.09 on a GAAP basis. In the quarter, we had restructuring charges of $900,000, or $0.01 per share. Restructuring charges were $0.03 below our forecast for the first quarter as some of these planned restructuring activities will be completed in this second quarter.

Also in the quarter, we booked the $1 million retroactive benefit of the reinstatement of the 2012 R&D tax credit. This produced a $0.02 EPS benefit in the quarter. The adjusted EPS for the first quarter was $1.08 per share.

Let me provide some additional data on our first quarter results. In the upper left quadrant, we provide data on our capital expenditures, $20.6 million in the first quarter. We still expect our full year 2013 capital expenditures to be approximately $100 million, which includes the relocation of our C&I motor factory in China and the Unico plant expansion in Wisconsin.

In the upper right quadrant, we provide income tax information. Our effective tax rate in the first quarter was 23.2%, reflecting the $1 million retroactive reinstatement of the R&D tax credit and the completion of the tax integration of the EPC acquisition in the previous quarter. This integration provides a sustainably lower level of tax expense for the future. For the second quarter of 2013, we expect our ETR to be 27%.

In the lower left quadrant, we highlight our strong free cash flow in the fourth quarter of $45 million, equal to 92% of net income for the quarter. We focus on generating free cash flow for debt reduction to improve shareholder value, to pay dividends and fund our future growth.

In the lower right quadrant, we summarize our credit metrics. At the end of the first quarter, our total debt increased $3 million to $822 million, and our cash balances increased $34 million in the quarter. This progress was achieved in the quarter in addition to the funding of the RAM Motor acquisition. We continue to drive improvement in our credit metrics with our strong free cash flow.

As we look to the second quarter of 2013, we expect earnings per share on a GAAP basis to be $1.17 to $1.25 per share. Our guidance includes $0.02 per share of restructuring charges for our synergy program.

Our adjusted EPS guidance for the second quarter is $1.19 to $1.27 per share after adding back the $0.02 of restructuring charges to the GAAP guidance.

Mark provided a summary of the market challenges we are facing in the second quarter in our North America C&I motor business, our mechanical and our HVAC businesses. Our sales volumes in these businesses will be lower in the second quarter versus the prior year and will have a significant impact on our operating profit. Other headwinds in this quarter will be inflation in our compensation and benefit costs and the impact of some negative product mix as compared to the prior year.

Now I'll turn the presentation over to Jon Schlemmer.

Jonathan J. Schlemmer

Thanks, Chuck, and good morning, everyone. Let me start by give you some color on the end markets and also on customer demand.

As I mentioned on the last call, we did see an improvement in order rates for our North America commercial and industrial motors business towards the end of the fourth quarter, and we -- as we started the first quarter, that same C&I order strength -- we saw the same C&I order strength but as we entered February, we experienced a slowing in the order rates.

For the quarter, sales in our North America commercial and industrial motors business declined 6.7% compared to the same period prior year. We saw weakness in industrial pump, equipment and machinery and overall distribution. We believe industrial equipment and machinery is being impacted by a decline in machinery exports to Europe and also small businesses holding off on making capital investments due to the general uncertainty.

Looking forward, we would expect that all the rain in the Midwest would help the pump market, and we did see strength during the quarter in a number of end markets, including commercial refrigeration, commercial HVAC, irrigation and leisure pump.

On leisure pump, we just launched another version of our high-efficiency variable speed offering for the pool market, and we're seeing very nice demand from our customers on this new product.

Sales in our North America residential HVAC business were up 3.5% compared to the prior year. March orders were stronger than January and February, and we experienced a negative mix, most likely driven by the increase in lower-cost housing units. As usual, we're ramping up production as we enter the cooling season.

Our sales to regions outside the United States declined 6.8% compared to the first quarter 2012. As Chuck mentioned, 35% of this decrease was related to currency. In addition to that, the end markets were challenging in both Europe and Asia. And in Asia, we saw this in China, India and Australia. Sales outside the United States represented approximately 34% of our total sales for the quarter.

Our Unico business delivered another strong quarter in sales. The prior year first quarter sales were up 46% compared to the same period 2011, so we're pleased to see the growth continuing in this business.

Global orders remains strong for Unico in oil and gas, as well as automotive. The Unico team also just launched a new product that was developed to control large chillers and commercial HVAC applications. They recently signed a multi-year contract with a large commercial HVAC customer for this product.

Last quarter, I mentioned that we were expanding our Unico facility in Franksville, Wisconsin. This program is on track, and it will be completed during the third quarter of this year.

As you know, we communicated that we would complete our Juarez manufacturing synergy projects by the end of the second quarter, and that's still our plan. We have just a few more EPC synergy-related manufacturing moves to make, and we will complete them as planned yet this year. From there, we'll move on to our simplification initiative. Let me touch on just a few of the simplification highlights that we've been working on.

As we wrap up the Juarez restructuring effort and look forward, we do see a lot of opportunities to further consolidate and simplify our manufacturing footprint, and we'll have more to communicate on that front in the future.

On the engineering side, we're making very nice progress on 5 different design simplification programs. On each of these programs, the goal is to consolidate similar designs across the company so we have a standard platform to offer to our customers. Our teams already finished consolidating some of our high-efficiency small motor designs, as well as a few of our larger industrial motor designs. As we implement these platform consolidations, the engineering teams are also implementing lean in the office environment by standardizing a variety of design tools and engineering processes. We're only -- I would say we're only about 10% complete with the design simplification task, but we're very encouraged by the potential cost savings that we're already seeing.

Last quarter, I mentioned that we had completed a warehouse consolidation effort in the fourth quarter of 2012. That effort allowed us to exit 3 warehouses. Our logistics team is now focused on simplifying our warehouse footprint along the Texas-Mexico border. The plans are to consolidated warehouses in this region to help us improve service and reduce costs, same thing that we did with -- in the Central U.S. warehousing simplification last year. At this point, we've identified 2 warehouse consolidation opportunities, and we expect to implement both transitions by early third quarter.

On new products, Mark mentioned that last year, we launched 60 new products, a record for our company. And this past quarter, our teams launched 20 additional new products that helps us bring new technology to our customers. About 2/3 of these new products are high-efficiency products, and they cover really a wide range of applications, including HVAC, swimming pool pumps, oil and gas pumping systems and industrial motors. Sales of energy-efficient products continued to grow during the quarter and represented approximately 20% of our net sales.

I'd like to highlight just a few of the products today to give you an idea of what our engineers are up to, and I want to start with the HVAC space. We launched 2 residential and commercial blower products, helping us bring high-efficiency solutions to our HVAC customers starting in Asia.

The first is really a forward integration play. We took our ECM technology and added that to existing blower and housing technology so we can provide and assemble tested systems to our customers. This is really great for customers that want to buy solutions, and we qualified this product to introduce this in China starting this quarter.

The second launch that you see on this slide here is really a breakthrough in performance. Again, it's a system, but now we've advanced both the motor technology and the housing technology to make several improvements, including efficiency, size of the product, weight of the product, the noise performance and cost. We're calling this product HALO. This system utilizes our axial flux motor technology and completely removes the motor from the air stream to provide a really compact, lightweight, high-efficiency solution for our customers. Just compare the 2 pictures on the slide, the ECM blower system is what you would typically see in an HVAC system. This is the type of blower that you would find in really every residential gas furnace and air handler, air-conditioner in North America. You see the motor mounted on one side of the blower housing. That is a very typical motor blower design. Unfortunately, that motor blocks the airstream on one side of the blower.

On the HALO design, if you didn't know where the motor was actually located, you might actually think that the motor is not even installed on the blower. In fact, it's there. The axial footprint is a very thin motor that allows you to integrate the motor with the blower wheel itself. So it's fully integrated. It removes the motor restriction on one side of the inlet of the blower, opening up the airstream, helping to make the air system more efficient. Both of these new products take advantage of Regal's global technology expertise. We're launching HALO right now in Australia, and now we're bringing this technology, this innovative technology, to the HVAC market in North America.

Next, our Unico team has launched several new products for oil and gas applications and specifically tailored for wells located in Mexico and Latin America. Many of these wells are located in remote areas, so there's no utility power available. The Unico provides a gas-powered lift system along with their innovative progressing cavity or PCP pump systems. The gas-powered lift system uses gas from the well combined with the Unico drive to provide power to the pump itself. And we're finding a lot of opportunities for Regal technology in these systems from the generators, to the Unico drives, high-efficiency HERA gearboxes and the new SyMAX permanent magnet industrial motors. And you can see many of those on this picture of this particular application.

Unico's innovative PCP design also eliminates the need for a lot of hardware like belts and clutches and brakes that are commonly found on other pumping systems. Unico developed a new series of remote process control systems as well to help monitor and control oil field pumping units that are manufactured by a wide range of oil field equipment companies. These new units are being installed in Mexico to operate hydraulic PCP systems.

We're really excited to see the team continuing to bring out new innovative products for the oil and gas market. And so far, we continue to see this product be well received by our customers.

And the last example I want to talk about today is the success we're having with one of the new products launched actually a little over a year ago by our HVAC team. In late 2011, our team developed a high-efficiency ECM motor that was designed specifically for retrofits in commercial buildings and in large hotels. In late March of this year, I had the opportunity to visit the Westin Hotel in downtown Boston where our motors were just recently installed in over 800 of the guestrooms. The retrofit has gone very well. The whole project will save the hotel over 400,000-kilowatt hours of electricity. That's just a little over a 2-year payback for the hotel operator.

The whole story itself was highlighted on The Green Room, a show that was aired on the Fox Business channel on April 20, and we've included a link here for the video. It's a short 5-minute video that gives a very good overview of the benefits of retrofits in hotels like the Westin. And I'd encourage you to take some time to watch the video because it describes the benefits of energy-efficient motor retrofits very well.

This is really an exciting area for Regal because there's a lot more hotels like the Westin that will and can provide a significant opportunity for our products going forward.

With that, I'd like to turn it back over to Mark. Thank you.

Mark J. Gliebe

Thanks, Jon. So to summarize, we finished the quarter within our guidance but near the lower end. We did experience modest growth in HVAC, but those gains were offset by weakness in North American C&I markets. Our synergy programs and our simplification initiative remain on track, and we continue to launch new products to drive future growth.

With our second quarter guidance, we expect typical seasonal order improvement in HVAC. However, some of these gains are expected to be offset by the headwinds I described earlier in residential HVAC, as well as by the weakness in the North American C&I markets.

Finally, we continue to actively seek acquisition candidates that meet both our strategic objectives and financial criteria.

We will now entertain your questions.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question is from Julian Mitchell of Crédit Suisse.

Julian Mitchell - Crédit Suisse AG, Research Division

Just a quick question on the Motors business. I mean, I just wondered if there was anything structural that you're seeing in terms of a price down effect or, as you said, in terms of a sort of supply chain discombobulation in HVAC. Is there some risk that the motors problems you have persist beyond just this one customer moving away? And then how does that pertain to the acquisition strategy? A lot of M&As you put into motors. If you're starting to maybe see some slightly strange things happening in terms of procuring and the end market dynamics, how urgently are you going to allocate capital to non-motors M&A for the balance of the year?

Mark J. Gliebe

Yes. Thanks, Julian. I don't think there's a major structural change happening. In this particular situation, there was something we could quantify that we thought was significant, and we wanted to communicate it so we could put a quantifiable number around it, what we expect to happen and put a time line around it. In fact, our price in the quarter basically was in -- there was a wash between price and materials. So there was no negative effect of that for the quarter, and we wouldn't expect a substantial change going forward. Relative to our M&A strategy, we have said in the past and that -- we are looking at all 4 of the kind of product areas that we participate in, electric motors, our mechanical -- products in our mechanical division, our generator division, as well as custom electronic drives. So that's -- we're going to continue down that path.

Julian Mitchell - Crédit Suisse AG, Research Division

Got it, thanks. And then just when you're looking at kind of the second quarter guidance on the top line specifically, if you strip out this customer walking away effect in HVAC motors, how are you thinking about the organic sort of end market trends, excluding that? I mean, do you think that the end markets will be down around the same as they were in Q1? And also, just if you could give a little bit more clarity on your comments on the HVAC end market itself, you said March was a little bit better. Maybe that's just seasonal. How are you thinking about the end market growth trends in HVAC for Q2?

Mark J. Gliebe

Yes. No problem, Julian. So in terms of the HVAC space, we always see a seasonal build at this time of the year. We're seeing it now. In terms of what we would anticipate in terms of the market itself, we -- our best indicator is what our customers are saying. And our -- it depends on the customer you speak to, but that ranges today to kind of low-single digit to mid-single digit on a go-forward basis. So that's the way we are thinking about it in terms of a growth rate. That's the way we are thinking about it. But quite honestly, our challenge for the quarter is not -- I mean, HVAC is a part of it. It explains part of the lower number for the second quarter, but our bigger challenge is on the commercial and industrial side. You saw that -- if you recall, up until third quarter of 2012, we had 6 straight quarters in a row of double-digit growth in that -- or nearly double-digit growth in that space. And starting in the third quarter, we started to see a decline in that space. It's got better in the fourth quarter than the third quarter, and we were expecting improvement in the first quarter of 2013. That didn't happen. And as we look to the second quarter, we're not seeing an improvement. There's a lot of people talking about improvement in the back half, but we don't yet see it in the second quarter.

Julian Mitchell - Crédit Suisse AG, Research Division

And then just lastly, you mentioned some reasons around the SG&A expense moving up. I think OpEx was up about 8% year-on-year. How quickly does that kind of normalize from this point?

Charles A. Hinrichs

Well, it's hard to tell, Julian. A portion of it would be your normal inflation in salaries, and that is predictable and measurable. But then some of the other benefits around insurance costs, medical insurance costs, and other related benefit costs can be a little bit lumpy and difficult to forecast.

Operator

And our next question is from Mike Halloran of Robert Baird.

Michael Halloran - Robert W. Baird & Co. Incorporated, Research Division

So could you give us the -- for the customer on the hermetic side that's moving away from you, could you just give us the annualized run rate for the revenue that they would have had, either last year or what you guys were expecting?

Mark J. Gliebe

Well, what that particular customer is doing again is they were making their own compressors using our motors in their compressors. And now they are -- have decided to go to a third-party and actually purchase the compressor itself. So that's how that particular situation is unfolding. And in terms of quantifying that, we have laid it out there for you, Mike. We kind of talked about it being a $15 million impact for those types of changes, and that's going to happen in this quarter and then on a declining basis over the next 4 quarters.

Michael Halloran - Robert W. Baird & Co. Incorporated, Research Division

Right. No. So what I was trying to drive at, because this is the seasonally strongest quarter, I would suspect that's an outsized gains based on your comments. Are we looking at something like a $40 million impact on an annualized basis in that piece? Just trying to frame it up and put that in the context of what are otherwise going to be, at least it seems like, positive HVAC trends that you're seeing in the other pieces of the portfolio.

Mark J. Gliebe

Yes, maybe slightly higher than $40 million, but not much higher than $40 million.

Michael Halloran - Robert W. Baird & Co. Incorporated, Research Division

Okay, great. That makes sense. And then kind of building off of one of Julian's questions there, just want to get your sense on the puts and takes when we move beyond the second quarter here. If we take the midpoint of your guidance range, how good of a run rate do you think 2Q represents for the earnings beyond that? And what are the puts and takes there? Meaning, how do you expect commodities to track out here? You still have the restructuring benefits coming in. I know you're not assuming a lot of improvement on the C&I side, or really the HVAC side at this point, and so I'm just trying to get those puts and takes on a forward basis to figure out how representative you feel that 2Q run rate is.

Charles A. Hinrichs

Mike, this is Chuck. I'll try to take a few of those points. But as you can imagine, those are all variables that will affect our future run rate and earnings. The volume -- the sales volume in the second quarter will still be higher on a sequential basis, but we expect a decrease on the year-over-year basis as Mark talked about. So a lot of it has to do with how our C&I markets will come back in the second half of the year and into 2014. We think we have a better feel on the HVAC market, adjusting for the impact on the market dynamics. International markets I think are stabilizing, and we may see increases in that as we go through 2013 and '14, particularly as it relates to some of the Asian businesses. The volumes certainly has a big driver on our operating profit basis as we're a manufacturer. And as we've shown over the years, we're quite good at controlling our SG&A expenses and getting the benefit of that operating leverage as sales start to recover. In terms of the input costs, as you know, as we are benefiting from some lower copper and expected lower steel prices, many of those commodity cost changes are then adjusted in sales price to our customers, particularly with our larger OEMs. So over time, those things tend to normalize, at least on the larger customers. We also hedge, of course, our costs. So that takes some of the volatility out of those periodic spikes, whether they be decreases or increases.

Operator

And the next question comes from Jeff Hammond of KeyBanc Capital Markets.

Jeffrey D. Hammond - KeyBanc Capital Markets Inc., Research Division

Just on this hermetic share shift, did that impact you in the first quarter? Because it still seems like the OEMs and the tone was better than the kind of plus 3.5 versus down 30. I'm just wondering if something else was going on there in the first quarter.

Mark J. Gliebe

No. The hermetic situation did not happen in the first quarter. The bigger issue for the first quarter was mix. That was probably the biggest contributor for the quarter. As you know, there's -- new homes that are being built tend to be more value-oriented homes and are -- we're putting the -- the OEMs are putting in value-oriented equipment.

Jeffrey D. Hammond - KeyBanc Capital Markets Inc., Research Division

Okay. And then do you have any line of sight near term to -- you said you were looking to replace the lost business. Is there anything kind of closer in the pipeline that would replace that over the next 6, 9 months?

Mark J. Gliebe

Well, I mean, the answer is yes, but I can't sit here and tell you that it's all going to happen. But we are not sitting still. We're very quite active with pursuing alternate pieces of business on a variety of fronts to make up for that issue. So yes, we're very active; and yes, it could happen within the next 6 to 9 months.

Jeffrey D. Hammond - KeyBanc Capital Markets Inc., Research Division

Okay. And then just back to this commercial and industrial weakness into 2Q, I mean, it seems like most other industrial companies are kind of saying kind of moderate improvement as we move through the early part of the year, and you seem to be indicating otherwise. And I think you mentioned one being distribution. It seems like de-stocking is more closer to abating than accelerating. Just kind of correlate what you're seeing to maybe what people are more broadly talking about.

Mark J. Gliebe

Well, at least with the competitors that we have that comment on this space in this area are more direct competitors as opposed to other general -- other companies that compete in and around the industrial space. We feel like what we're seeing, our competitors are seeing. So I don't think there's any major structural change happening on the C&I side. We feel like we're right in the ZIP code relative to what the rest of our competitors are saying in the North American space.

Jeffrey D. Hammond - KeyBanc Capital Markets Inc., Research Division

Okay. And then just last one, the decremental margins in the first quarter were very good. What was kind of impacting that? Because you seem to be indicating much more pronounced decremental margins into 2Q.

Charles A. Hinrichs

Well, I think on a year-over-year basis, Jeff, we were benefiting from the EPC synergies that have come over on a year-over-year basis. And those, while they will continue in the second quarter and grow in the second half of the year, the volume change on a year-over-year basis in the second quarter is greater than we experienced in the first quarter.

Operator

And our next question is from Nicole DeBlase of Morgan Stanley.

Nicole DeBlase - Morgan Stanley, Research Division

So just -- it would be great to get some additional detail on what you're seeing within HVACs. So can you talk a little bit about any major OEM inventory changes that you're seeing, what you anticipate on that front into 2Q? And also, have you noticed any big changes in market share?

Jonathan J. Schlemmer

Nicole, this is Jon. So I'll just make a couple of comments on that. On the inventory side, I'd say we've not seen anything that unusual on the inventory side with our customers and through the channel. We have the opportunity to listen in, as I'm sure a lot of folks did on the HARDI webcast the other day where it was reported that there was a feeling that inventories were slightly up in the channel. That would not be inconsistent with overall what we've seen and heard as well. And if you go back and you look at our first quarter on HVAC, with overall HVAC being up 3.5%, what we saw from customers, besides the mix that Mark talked about, what we also saw was that pretty varied reports from customers in terms of what individual customers experienced in the first quarter from low-single digit growth to -- at least one customer talked about low to mid-teens growth. So it was quite varied customer to customer, and that also impacted us in terms of where we have stronger positions on a customer-by-customer basis.

Nicole DeBlase - Morgan Stanley, Research Division

Okay, got it. But any comments on like broader market share changes?

Mark J. Gliebe

So Nicole, we're not going to comment on our customers' positions in the market, obviously. So no, we won't comment on that.

Nicole DeBlase - Morgan Stanley, Research Division

Oh, no. Sorry. I meant your own personal market share.

Mark J. Gliebe

No, no. We addressed that already in the comments we made. We quantified it for you in indicating that it was $15 million in the second quarter. We expect that -- a declining impact like that over the next 4 quarters.

Nicole DeBlase - Morgan Stanley, Research Division

Okay, got it. I mean, given where the share price is today, how does that change your evaluation of repurchases versus M&A?

Mark J. Gliebe

Well, we have not been a company that tends to repurchase shares over time. We try to put the capital to work the best way we can, so -- but we'll watch what happens here, and we'll make an assessment over the -- what's the right decision going forward. But like I mentioned earlier, our intention right now is to remain active on the M&A front.

Nicole DeBlase - Morgan Stanley, Research Division

And one more if I could squeeze it in. Can you talk a little bit about how April trended versus your expectations?

Jonathan J. Schlemmer

Yes, I would say, Nicole, on April, we didn't see really a -- other than the seasonal step-up in HVAC that we mentioned, specifically on the commercial and industrial end markets, what we saw in April was pretty much in line with how we exited the first quarter. So not good from a standpoint that we didn't see a lot of strength, but pretty much what we expected. In terms of as we look forward to this second quarter forecast, I'd say April has been in line with our expectations.

Operator

And our next question is from Joshua Pokrzywinski of MKM Partners.

Joshua C. Pokrzywinski - MKM Partners LLC, Research Division

So if I just think about the year-over-year guidance bridge and add up the customer kind of pursuing a different manufacturing strategy and the change in share count, you're really only down $0.09 year-over-year, which, I guess, given what you're seeing in C&I, sounds about right. It's really not that much volume if you back into it. So I guess my broader question on the heels of that is that when you talk about the customer decision, it has the ring of maybe they were going to do this anyway and had nothing to do with where you were in the marketplace. But I keep hearing how mix in the market doesn't really support your product offering. And obviously, high efficiency and new construction don't gel well together. What is your view that perhaps this is kind of the first of other shifts and that maybe the ones going forward have more structurally to do with where you're in the marketplace? I mean -- because I appreciate the color on the $15 million, but it also doesn't really seem like it was something that you could have controlled, whereas the stuff going further is much -- would be much more directed at your product offering.

Mark J. Gliebe

Yes, the -- in terms of what's happened with the mix of the product, I don't think that it's a forever. I mean, I think that energy efficiency is still a long-term secular trend on a global basis. And as you know, there's still legislation out there that at some point will -- the courts will settle on, and there'll be more wind in our sail when all of that settles out related to regional efficiency standards, just as an example. And there's other things beyond that in this space. I just believe long term that energy efficiency is the place to go, and we -- the place that industry goes long term. Our customers will continue to get ratcheted up on the targets over time, and we will continue to be a leader on the innovation side, having products that can meet those kind of challenges. Now in the near term, we have to have products that are value-oriented products. And we do, and we make them in low-cost regions so that we can compete. So we're going to be a competitive player in this space for, well, many, many years to come.

Joshua C. Pokrzywinski - MKM Partners LLC, Research Division

But are you finding that you're needing to make either pricing concessions or you're seeing OEMs get more aggressive, knowing that your strong suit is in high-efficiency where the market really isn't, at least for the time being? I guess that was kind of my initial question, is that this hermetic thing, these things happen, and it could have happened even in a different market environment. But this notion of, well, efficiency being the market and you guys still having a lot of business for that even -- in that, even if your focus is on the high end, I guess what's to say that OEMs don't continue to get aggressive on pricing or on share?

Mark J. Gliebe

Yes. Josh, we've been in this business for many, many years, and there's never one year when OEMs get more aggressive than the next. They are always aggressive. And we have dealt with that successfully in years past, and I think we can continue to deal with that on a go-forward basis. As we've mentioned before, we tend to have a stronger product offering in the high efficiency and more competition in the lower efficiency. So naturally, it's going to be tougher sliding during those times when it's less value-oriented products. But we have a competitive offering in that space, and we'll continue to compete and be okay.

Joshua C. Pokrzywinski - MKM Partners LLC, Research Division

Okay, that's helpful. And then just one last one. It just looks like Mechanical, being pretty challenged there, I'd have to imagine that given some of the commentary in the oil and gas space that Unico was pretty -- I'm sorry, not Unico, Milwaukee Gear was pretty challenged if -- is there any color you can provide around that or kind of how that business has trended?

Mark J. Gliebe

Yes, that's a fair read, Josh. Milwaukee Gear, as you know, a large portion of their products are into the frac-ing space, and that business has been quite challenged. And that is the single largest contributor to our mechanical downside in the quarter.

Jonathan J. Schlemmer

Yes. I would add, Josh, the end markets that we talked about for C&I, in fact not only the electric motor space in C&I but also the mechanical products that go into a lot of those same end markets, and then in addition to what Mark just mentioned on frac-ing, was Milwaukee Gear. Those 2 are the contributors.

Joshua C. Pokrzywinski - MKM Partners LLC, Research Division

Does that change the way you guys look at wanting to get into some of those oil and gas adjacencies going forward?

Jonathan J. Schlemmer

Well, I would say, on oil and gas, the challenge is, is do you have a technology, do you have a product that allows you to penetrate the space? And if you think about what Unico is doing, oil and gas as an end market can be challenging from quarter to quarter. But Unico continues to grow because they're coming out with more innovative solutions to offer customers something that's better than what they have today. So that's how we're thinking about it, is how can we take that Unico model and apply that across more of our products?

Operator

And the next question comes from Christopher Glynn of Oppenheimer.

Christopher Glynn - Oppenheimer & Co. Inc., Research Division

So in terms of the low efficiency mix, I hear you on the value housing stock and the newbuilds. But I think the strong majority of sales is in retrofit. And in the wake of dry ship, that kind of down shift in the mix had sort of stabilized. Are you seeing that start to kind of devolve again as well?

Mark J. Gliebe

No, no. You're right in your assessment that as the whole R22 thing came unwound, that tended to have a weaker mix. So you're right to think about it that way. I think our customers are reporting that their mix was challenged in the quarter, and I got to believe that, that's related to mostly housing, but probably was offset by the R22 phenomena. That's my sense.

Christopher Glynn - Oppenheimer & Co. Inc., Research Division

Okay. And then in terms of a reversion to high-efficiency mix, I fully appreciate the long-term backdrop there. But are you seeing what the pathway and the pieces are where perhaps this could trigger the market back to 2010 mix over the next 6 to 12 months?

Jonathan J. Schlemmer

Well, in 2010, we had a couple of things that were really helping with that. And we saw a big step-up, as you recall that year, with energy efficiency tax credits for homeowners. So without that in place, certainly, we saw a bit of a -- what I would -- that could also be related to the energy costs today, natural gas prices being very low, for example. And then as Mark mentioned, we had the delay in the regional efficiency standards. So I think those combinations of some of the factors, we're just feeling that right now. But longer term, I think we feel very good about the energy efficiency space and our product technology that we have there, as well as some of the new products we're coming out with.

Operator

The next question is from Jamie Sullivan of RBC Capital Markets.

Jamie Sullivan - RBC Capital Markets, LLC, Research Division

Can you give us your perspective on the mix? You talked about that being -- and HVAC being a headwind in 1Q? When do you feel like that -- you lap that headwind where kind of revenues and volumes sort of grow in tandem?

Mark J. Gliebe

Well, the -- certainly, we'll have this headwind that we laid out today, which is -- we'll have -- we said $15 million in the second quarter and then on a declining basis for the next 4 quarters. So we're going to have that challenge with us for a little -- for the next 4 quarters for sure. And then in terms of mix, and I -- it's tough for me to say. I think the -- my sense is that the housing build that we'll see right now, that will continue for some time. And that will continue to have demand for value-oriented products. And so it's tough for me to say when that switch is over.

Jonathan J. Schlemmer

The housing demand increase would be a mixed headwind. However, the conversion away from R22 dry ship should be nothing but a positive. To question how much, as I explained earlier, but should be a positive. So those 2 will somewhat work to offset each other.

Jamie Sullivan - RBC Capital Markets, LLC, Research Division

Right. And if the housing cycle kind of continues as it is, are you willing to ride that out with your current mix? Or do you feel like you need to be more aggressive in changing the way that your offering is into that market?

Mark J. Gliebe

Well, like we mentioned in the past, we're aggressive in terms of the value-oriented products we're offering. We launched a few new products on the value side just in the last 6 months. So we certainly have positioned ourselves to compete in that space, and we'll continue to do so.

Jamie Sullivan - RBC Capital Markets, LLC, Research Division

All right. Then one quick last one. On the acquisition front, maybe you can talk about just sort of the maturation of the pipeline at this point? You also mentioned that you're casting kind of a wide net in terms of product exposure. But are you thinking any differently about the portfolio additions in terms of types of businesses, competitive differentiation, things like that going forward?

Mark J. Gliebe

We've been consistent in that we would have looked for energy efficiency products, number one; number two, we would look for businesses that expanded our footprint; number three, businesses that improved our margin in our portfolio. So that is our strategic thoughts. And then from a product standpoint, we talked about electric motors, mechanical gear products, our custom electronic drives and in electric generators, and we'll continue to look in those 4 spaces. Now it doesn't say that we wouldn't look outside those 4 product platforms, but our primary focus will be those 4 spaces.

Operator

And next we have a question from Scott Graham of Jefferies.

R. Scott Graham - Jefferies & Company, Inc., Research Division

So if we were to look at what you were maybe thinking about the second quarter, even in December versus kind of what you're thinking now, pushing aside the shift of the customer, would you say that the difference between then and now is maybe 2/3 North American C&I, 1/3 HVAC mix in that territory?

Mark J. Gliebe

Well, I'll just comment on what we knew coming through January. We were -- as you recall, our C&I markets were down 6% in the third quarter and down 1.5% in the fourth quarter. We came through December and into January feeling cautiously optimistic because of the order rates. And by February, that fell off and has been the big challenge for both Q1 and Q2. So that to me was the biggest change in our thinking. Certainly, between the 2 challenges, HVAC and C&I is more primary challenged and then in HVAC to a lesser extent.

R. Scott Graham - Jefferies & Company, Inc., Research Division

The other question I have maybe is more for Jon. Over the last couple of years, the organization has had a significant emphasis on new products. And I guess 2 questions on that, #1 is are placements of new products tracking in line with your expectations? And secondly, is this -- are such placements or hoped-for placements part of your -- Mark's optimism that you can make some of that up with the lost customer?

Jonathan J. Schlemmer

Yes, thanks for the question, Scott. Absolutely. We've been -- as you said, we've been very focused on new product development over the past 3 years, and we've seen a nice ramp up in terms of number of new products launched, and a nice mix between the businesses as well. It's not all in one of our business segments. So we're seeing better new products generation, if you will, in the pipeline across multiple businesses and geographies. So we have -- the pipeline has really been strengthened as well on new products in Asia, as well as in North America. We're just -- it's interesting, we're just getting ready to enter our long-range planning process where we look at our 3-year product plans in all of the businesses. And we look to each of our businesses to understand what is the new product technologies and products that are being planned and developed to help us offset some of these challenges. My feeling is we're right on track with what we're doing. We're putting more focus on the growth expectations of the new products. So not just number of launches but the growth expectations from each of the products. So just in general, I feel very good about what we're doing on the new product development side and the impact that those programs can have. I mean, the 2 that I showed here today -- HALO will take some time to get the penetration in the customer base. But it is such a different technology than what's out there today and offers a lot of benefits for newer design platforms for our customers. And then the retrofit opportunity is one where we can go right in once you identify the space, like we have done over the years on commercial refrigeration and now start doing this in premium hotels. So yes, overall, I feel very good about the direction we're going on the new products side.

R. Scott Graham - Jefferies & Company, Inc., Research Division

Then if that's the case, then maybe you can just connect some dots here from me, because -- I'm going to put aside resi because that's kind of a market that's maybe more linked with what's going on out there in the marketplace. But commercial and industrial and mechanical organic sales in the first half of '12 were up really only modestly and have been declining since that time. And I know a lot of these new product launches are in fact in those businesses. And when I look at some of the pictures that you represent, it looks like there's a significant change in the format of a product involving significant OE participation on that product, which would imply a placement as a solution. Maybe I just am -- I'm just having trouble connecting those dots. And if that's the case and if you're on track with new products -- and some of these products are very specific for a solution and would seem to have a placement set before it's even come out -- why have the sales in those businesses been lagging for so long?

Jonathan J. Schlemmer

Well, I would say, in C&I, that we did have growth in the first half last year, and that was on a year-over-year basis comparing to quarters the prior here that had growth over the prior year 2011. So we've had -- I think Mark mentioned 6. I think we actually had 8 quarters in a row of year-over-year for the growth in the C&I segment. So we were coming off some pretty -- if you think about our first quarter performance this year, that's coming off a pretty tough comparison to the first quarter of last year. Now that's no excuse, and we need to find a way to keep growing. But I think we have seen good growth in the C&I business. One -- no question about it. One of the challenges that we have with our new product strategy in the C&I businesses is you have a much more diverse customer base, smaller customers, a balance between distribution and OEM. And so it is a little more difficult to develop one product and get a big hit from that out of the gate. But if we develop the right products over time, they become adopted and we'll see the benefit. But there's no question, it is a different challenge than you have, say, on the HVAC side with large OEMs. If they develop their new platform and use one of our products, you can see a -- just like when SEER 13 happened in 2006, you could see a big takeoff in a new product. You won't see that on the C&I side. You have to do a lot more products for a lot more customers.

Operator

And the next question comes from Liam Burke of Janney Capital Markets.

Liam D. Burke - Janney Montgomery Scott LLC, Research Division

Mark, how did the aftermarket business perform during the quarter?

Mark J. Gliebe

We have aftermarket business both on the HVAC side as well as on the commercial and industrial side. I would say, on the commercial and industrial side, it was down a little bit. And on the HVAC side, it was up a little bit.

Liam D. Burke - Janney Montgomery Scott LLC, Research Division

Okay. And are you seeing any pricing? Or are you being able to get any better margin on energy-efficient products to that channel?

Mark J. Gliebe

Sure. We have -- and certainly, in both cases, we have a variety of products that are energy-efficiency oriented. In fact, on the resi HVAC side, where there are replacement opportunities, we now have a number of new products that allow consumers to replace their standard motor with an ECM-type motor that provide them energy efficiency. So yes, we are seeing growth with those kind of products as an example.

Operator

And next we have a question from Bill Dezellem of Tieton Capital Management.

William J. Dezellem - Tieton Capital Management, LLC

It's Tieton Capital, and I'm hoping that you will allow me to be a slow pony here. Relative to the C&I business, would you give us your perspective as to what was behind the strengthening in orders that you saw in terms of -- maybe customers who were looking to build inventory or whether they thought markets were improving, et cetera? So I'm trying to understand that. And then conversely, what led to the reversal?

Mark J. Gliebe

Boy, that's a tough one. I could just speak to the general trends in that space as I had mentioned before. We started to see an improvement in the fourth quarter, and we came through January feeling that same level of improvement in our order rate. And as you know, this is a very diversified customer base. Thousands and thousands of customers. So hard to pinpoint what was behind it all. But we were feeling -- we did see kind of a change in tone in our order rate sometime in mid-February.

William J. Dezellem - Tieton Capital Management, LLC

So in terms of your ability to understand the why, it's pretty limited and not a lot of color you can provide there then?

Mark J. Gliebe

Not really. I mean, Jon provided a little bit of color about those particular areas that were up and down. Jon, if you want, you can just repeat them.

Jonathan J. Schlemmer

Well, one for sure was in -- towards the tail end of the fourth quarter, we did see what seemed like growing confidence in the distributor base and an uptick in orders, and particularly in distribution. And it felt like -- a lot of anecdotal information, but it felt like there were customers that were feeling a little bit more confident towards the tail end of the quarter, and they had been holding off on purchasing prior to that, and we'd seen that in the slower order rates. And it felt like that was an improvement. And there's always a question of how much of that's stocking? How much of that is actually end market demand? But that was what we were seeing on the distribution side at least, and also with some of the OEMs as well in C&I. And as Mark said, the order rates were pretty consistent coming into the first of the year from what we experienced at the end of the fourth quarter until we hit February.

William J. Dezellem - Tieton Capital Management, LLC

And I guess that leads to the second question is, is this ongoing choppiness in the marketplace, is that leading to more acquisition opportunities because some of your prospective targets, they're just getting tired of the back and forth? Or does that not really enter into the equation?

Mark J. Gliebe

Well, certainly, in the case of private owners, you have that fatigue. So I think that's a fair characterization. And we are certainly talking to some of those kind of people.

William J. Dezellem - Tieton Capital Management, LLC

And is that more of a factor today than it, say, would have been 1 or 2 years ago?

Mark J. Gliebe

We had different factors 1 or 2 years ago. We had the kind of a tax threat 1 or 2 years ago that was driving activity then. So I would say it's similar but just for different reasons.

Operator

And that will conclude our question-and-answer session. I'd like to turn the conference back over to Mark Gliebe for any closing remarks.

Mark J. Gliebe

Thank you for joining the call today. We appreciate all your questions today. Obviously, the second quarter is certainly a challenge, the primary issue for the quarter being in our C&I markets. To a lesser extent, the market dynamics that we explained on our second -- that we quantified for you and put a time horizon around in the HVAC space.

The company, I want to assure you, is doing -- aggressively pursuing alternatives, commercial alternatives in the HVAC space to offset that challenge, something that could happen in the next 3, 6 to 9 months. And the company continues to execute on simplification and new products. And as you know, we are going to remain active in the M&A space.

So again, thank you for joining the call and for your interest in Regal.

Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.

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