EnPro Industries' (NPO) CEO Steve Macadam on Q2 2016 Results - Earnings Call Transcript

| About: EnPro Industries, (NPO)

EnPro Industries, Inc. (NYSE:NPO)

Q2 2016 Results Earnings Conference Call

August 03, 2016 10:00 AM ET

Executives

Chris O’Neal - VP, Strategy, Corporate Development & IR

Steve Macadam - President and CEO

Milt Childress - SVP and CFO

Ken Walker - SVP and COO

Analysts

Jeff Hammond - KeyBanc Capital Markets

Joe Mondillo - Sidoti & Company

Justin Bergner - Gabelli & Company

Operator

Good morning. My name is Kelly, and I will be your conference operator today. At this time, I would like to welcome everyone to the EnPro Industries Second Quarter 2016 Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions] Thank you.

And I will now turn the call over to Chris O’Neal. Please begin, sir.

Chris O’Neal

Thank you, Kelly. Good morning and welcome to EnPro Industries’ quarterly earnings conference call. I’ll remind you that our call is also being webcast at enproindustries.com, where you can find the slides that accompany the call.

Steve Macadam, our President and CEO; Milt Childress, our Senior Vice President and CFO will begin their review of our second quarter performance and our outlook in a moment. Also joining us on the call today is Ken Walker who is our Senior Vice President and COO.

But before we begin our discussion, I will point out that you may hear statements during the course of this call that express a belief, expectation or intention as well as those that are not historical fact. These statements are forward-looking and involve a number of risks and uncertainties that may cause actual events and results to differ materially from such forward-looking statements. These risks and uncertainties are referenced in the Safe Harbor statement included in our press release and are described in more detail along with other risks and uncertainties in our filings with the SEC, including the Form 10-K for the year ended December 31, 2015 and our Form 10-Q for the quarter ended March 31, 2016. We do not undertake to update any forward-looking statements made on this conference call to reflect any change in management’s expectations or any change in assumptions or circumstances on which such statements are based.

Our earnings release and conference call presentation materials contain additional disclosures regarding non-GAAP financial information, collective references to EnPro and our subsidiaries, the deconsolidation of Garlock Sealing Technologies or GST and pro forma illustrative financial information presented as if GST were reconsolidated for financial reporting purposes. These disclosures are important to understanding comments we will make on today’s call and we urge you to read them carefully.

Just as we did last quarter, we’re providing pro forma segment sales and pro forma segment profit information in conjunction with the ACRP settlement agreement announced on March 17th to provide investors with additional pro forma information illustrating each segment’s results as if GST has been reconsolidated with EnPro based on confirmation and consummation of the joint plan of reorganization as described in our earnings release.

Given where we are in the bankruptcy process and due to request from investors for this type of information, we believe of focus on pro forma operating results is instructive to investors as it reflects the performance of all of our subsidiaries. Until the ACRP process is completed however, our published GAAP financials and Forms 10-Q and 10-K will continue to reflect GST on a deconsolidated basis.

Also throughout this call, we will be using terms normalized sales and normalized segment profit. Normalized sales refer to consolidated or pro forma sales adjusted for year-over-year differences in foreign exchange translation and the impact of acquisitions and divestitures. Normalized segment profit refers to consolidated or pro forma segment profit adjusted for foreign exchange translation, the impact of acquisitions and divestitures, acquisition-related expenses, restructuring charges and the impact on earnings as if the multi-year EDF project or accounted for on a percentage of completion basis. The intent of providing normalized results is to provide greater clarity of results in the current period compared to the prior period.

And now, I’ll turn the call over to Steve.

Steve Macadam

Thanks, Chris and good morning, everyone. Before I begin my comments, I’d like to take this opportunity to formally introduce Chris O’Neal, whose voice you just heard at the open of the call. Chris joined in probably about eight years ago and served in a verity of corporate and divisional roles before succeeding Milt as Head of EnPro’s Strategy and Corporate Development function when Milt assumed his position as CFO about a year ago. Chris added Investor Relations to his responsibility a couple of months ago. He knows a lot about our businesses and we’re pleased to have him engaged in Investor Relations and I expect to enjoy working with Chris. I also would like to take this opportunity to formally thank Dan Grgurich, our prior Head of Investor Relations for all of his contributions to EnPro.

Now, let’s begin. As an opening comment, I want to share that I’m pleased about what our team accomplished during the second quarter despite overall market conditions that continue to be quite challenging. Our total normalized pro forma segment profit for the quarter increased by 7.8% despite a 4.3% decline in normalized pro forma sale. This improvement was driven by a combination of cost reduction, restructuring, production efficiency improvements, a record aftermarket parts sales quarter for Power Systems and lower input costs as a result of supply chain optimization. Total pro forma sales for the quarter increased by 2.8% and pro forma adjusted EBITDA increased by 3.1%.

The market environment in the second quarter as summarized on slide five can be characterized as more of the same. We’ve seen negative year-over-year trends in many of our markets. Despite some recent positive trends, commodity prices in general remained down significantly versus the second quarter of 2015. And we have yet to see an increase in demand for related products in most markets. We’re continuing to experience weakness in refining, nuclear, mining, gas turbine equipment and general industrial. Heavy-duty trucking also turned down slightly during the quarter versus last year, while aerospace was relatively flat. Notwithstanding these market challenges, we’re seeing modest positive momentum in midstream oil and gas and semiconductor, and our order patterns along with customer feedback suggest that momentum in both of those markets will continue.

Before Milt provides detail on our financial results, I want to give updates on several of our strategic initiatives including progress on the ACRP, a major new engine program win at Power Systems, innovation programs and our latest acquisition in Sealing Products. The ACRP is proceeding towards planned confirmation according to the expected timeline we shared previously. Since March 17th of this year, when we announced the comprehensive settlement, we’ve been working on the legal and administrative steps necessary to begin planned solicitation.

During the second quarter, the parties filed all documents necessary to implement the ACRP settlement including the plan itself, plan documents, disclosure statement, voting procedures and from data. [Ph] On July 29th, so very recently, the bankruptcy judge issued an order approving the disclosure statement, solicitation confirmation procedures and schedule for confirmation. The order established several key dates including a deadline of December 9th for voting and deadline of December 30th for completion of the tabulation and certification of the voting results and the date of May 15, 2017 for the confirmation hearing to begin. The solicitation period is scheduled to being this month. So, as in appeals, we would expect the Bankruptcy Court and the District Court to enter final orders, confirming the plan and issuing the plan injunctions within the 60 days of the confirmation hearing, leading to reconsolidation under this timeline in the third quarter of next year.

As Fairbanks Morse announced on Monday of this week, Power Systems was chosen as the engine supplier for the main propulsion diesel engines on the Navy’s Lewis class of underway replenishment oiler ships referred to as T-AO 205. This is a combination of three years of intensive technical and commercial development effort, and as you know, represents typical cycle to win major Navy programs. The program has valued the Fairbanks Morse engine of approximately $240 million over the life of the program and Navy has ordered six ships that will be built over the next six years, each ship will be powered by two Fairbanks Morse MAN 4860 engines. The engines meet the latest emissions requirements with exhaust after-treatment systems. Fairbanks Morse received a $13 million order in July for the engines that will power the class’s lead ship to John Lewis.

Engine orders for additional ships are expected pending the normal preparation process. This program will provide new engine aftermarket parts and service revenue for many years into the future. It also affirms Fairbanks Morse as the ongoing key strategic engine supplier for the U.S. Navy.

Turning to slide eight. During past calls, we’ve discussed restructuring actions in both the Sealing Products and Engineered Products segments, and I am pleased to share that we have completed all of these plans major milestones. In Sealing Products, we discontinued all production and warehousing activities in Garlock’s UK facility and successfully expanded our distribution network there to support our existing sale. We also have made significant progress on our plan to exit a small facility in Brazil, which we expect to close by the end of the third quarter. These actions have already started to generate associated cost savings.

In Engineered Products, GGB completed the move of its Chicago operation to other existing GGB facilities. GGB also moved into and began production in a new owned facility in Suzhou, China. With these actions we fully completed the four-facility footprint consolidation modernization program that we began in early 2015. CPI also completed its comprehensive restructuring plan, which included the exit from nine service centers and light manufacturing facilities; five were closed, two of which were in South America, three in Canada; three were sold, one each in the United States, Canada and Thailand; and one was consolidated into another facility.

This restructuring resulted in the reduction of about 15% of the CPI workforce. This positions CPI as a much stronger company and we’ve already started to see the impact of these actions on CPI’s results.

In late June, as a result of continuing soft conditions across many of our served markets, we began the implementation of an additional initiative to reduce costs across all segments and the corporate office. Through this initiative, we expect to reduce pro forma operating costs by approximately $20 million on an annualized pro forma basis going forward.

These actions will make us leaner now and more productive when markets recover. This cost reduction effort is additive to restructuring of the past couple of years. As a point of reference, our total headcount at the end of 2014 was approximately 6,000. Excluding additions from acquisition since that time, we expect the total Company headcount to be approximately 8% lower by the end of this year. Even in the midst of challenging market conditions and cost reduction efforts, we remain committed to our new product development efforts and maintaining our leadership positions in the markets we serve. We’re also taking a long-term perspective and have increased our focus and funding for innovation. We believe this is vital to our future project.

Two exciting projects underway are the developments of the OP2.0 engine and power systems, which I have spoken about in the past, and the new next generation hydrodynamic seal and sealing products that I’ll discuss in a moment. We expect that both of these programs will create tremendous value for our customers by providing a step change in performance through both greater efficiency and lower lifecycle costs.

Fairbanks Morse is in the prototyping design and development phase of the new opposed-piston engine or OP2.0, which is a medium speed diesel engine, offers a unique combination of being fuel-efficient, highly reliable and Tier 4 emissions applied. The test results from the prototype engine have been excellent and we expect the customers will find the value proposition compelling. Fairbanks Morse has a long history of powering municipalities, hospitals, universities, which positions it a very well to serve demanding need to the distributed power applications.

Well, the total global addressable market for medium-speed reciprocating engines is approximately $10 billion, our initial focus will be on the 3.5 to 5 megawatt distributed power segment, which has an annual market size of approximately $1 billion. Technetics recently finalized the development of its next generation hydrodynamic seal for aerospace, main propulsion gas and main propulsion turbine engines, gear boxes, transmission and auxiliary power units. The next generation hydrodynamic seal creates real value for customers by increasing operating efficiency and lengthening maintenance cycles.

Our test data shows that our seals offer significant improvement in performance, and customer reactions have been very positive, leading to several application development projects. We believe we have achieved a competitive advantage through a unique combination of advanced design capabilities including our proprietary Finite Element Analysis to solve complex application requirements combined with highly precise manufacturing techniques. Market study suggests that the market for these seals is approximately $40 million and that the market has the potential to grow to approximately $60 million as next generation hydrodynamics displace displays legacy technology. These are two examples of the many development projects that are underway across our Company. I will continue to update you on these and others as they mature towards commercialization and we get a more refined sense of the revenue potential.

Finally, since December 14th, we’ve completed four acquisitions in our Sealing Products segment. Each of these strategic bolt-ons enhanced our position in the markets served and provides new products and capabilities. In aggregate, the companies are beating performance expectations. Of note, STEMCO’s integration of the Air Spring’s acquisition which closed in July a year ago is proceeding very well. During the second quarter, we transitioned off the sellers ERP system to a new cloud-based ERP system that STEMCO is adopting across the division. We also completed the relocation of the Air Spring’s research facility into a new location nearby. Our supply chain team has continued to negotiate new agreements with vendors to reduce costs and improve availability and costs. [Ph] We’re beginning to see the associated savings in our financial results and are expecting continuing benefits in the second half of this year.

Garlock’s acquisition of Rubber Fab is also off to a great start. While this has only been a few months since we completed the acquisition, we’re pleased with the customers’ positive reaction, how smoothly the integration has progressed and our initial financial results. We see Rubber Fab as an attractive platform for expansion in the food and pharma hygienic growth market.

Now, I will turn the call over to Milt.

Milt Childress

Thank you, Steve. As Chris mentioned in the introduction, this quarter, we will continue to focus most of our remarks on pro forma results. The pro forma segment results that I will discuss are prepared as if GST had been reconsolidated on the basis described in our earnings release. It’s important to note that the pro forma results do not represent a projection of the financials as of the future date of reconsolidation. Also as a reminder, most of the difference between consolidated and pro forma segment information is in Sealing Products with only small differences in Engineered Products and Power Systems stemming from foreign operations of those segments included in GST’s foreign subsidiaries.

Our pro forma second quarter results or sales of $352.3 million were up 2.8% from the same period of 2015. Net of divestitures, acquisitions contributed $25.3 million and foreign currency translation reduced sales by $900,000. Excluding the impact of these factors, pro forma sales for the quarter were 4.3% lower compared to a year ago. The organic sales decline was driven primarily by continued soft demand we’re facing in many of our end markets. And I will cover each segment in more detail in a moment.

Pro forma gross profit for the quarter of a $126.8 million was 2.7% higher than in the second quarter of 2015 and pro forma gross profit margins remain constant at 36% year-over-year. Excluding the impact of the acquisitions made during the last year, which in aggregate have a lower margin profile, pro forma gross profit margin was 100 basis points higher for the quarter, reflecting improved results from previously completed restructuring actions, realized gains from recent cost control initiatives and lower input costs as a result of supply chain optimization.

In total dollars, pro forma SG&A remained flat in the second quarter of 2015 at $87.2 million. As a percentage of pro forma sales, pro forma SG&A decreased in the second quarter of 2016 to 24.8% from 25.4% in the second quarter of 2015. Adjusted for the impact of acquisitions made last year, pro forma SG&A was down 3.7% year-over-year.

Corporate expenses were $6.5 million in the second quarter, compared to $3.4 million in the prior year. The year-over-year increase is primarily driven by downward $5.5 million incentive compensation accrual adjustment in the second quarter of last year. Excluding incentive compensation costs, corporate expenses declined 3% in the second quarter of 2016, compared to the same period last year.

As Steve mentioned earlier, in the second quarter, we began to implement an additional initiative to reduce costs across all segments in the corporate office. This effort is expected to reduce pro forma operating costs by approximately $20 million on an annualized pro forma basis. We did not realize any significant savings in the second quarter since we began implementation of this initiative in June. However, the majority of the actions have been taken and are complete. With this program plus restructuring efforts that we previously initiated, we incurred $3.1 million of pro forma restructuring costs in the second quarter and expect to incur total pro forma restructuring cost of $11.3 million in 2016 leaving about $4 million in restructuring cost for the second half of the year.

Pro forma adjusted net income which adjusts pro forma net income for items such as restructuring, legacy environmental reserves and normalized tax accruals, all as shown on the reconciliation table on our earnings release, was $22.9 million, up $1.5 million from a year ago. Most of the year-over-year increase is attributable to improved profitability from the previously announced restructuring plan in the Engineered Product segment, lower input costs as a result of supply chain optimization and record aftermarket parts shipments in Power Systems, all of which more than offset the effect of lower volume in the quarter.

Pro forma sales in the Sealing Products segment were $223.3 billion in the second quarter, up about 3.1% over the second quarter of 2015. Adjusting for the impact of acquisitions and foreign exchange, pro forma sales were down 8.2%, reflecting weak demand in nuclear, gas turbine equipment, general industrial refining, and metals and mining, slightly offset by increased demand in midstream, oil and gas, and semiconductor. Aerospace was relatively flat while heavy duty trucking was slightly down.

Pro forma segment profit of $31 million was up 3.3% from the second quarter of last year. Pro forma segment margins remained constant at 13.9% year-over-year. On a normalized basis, pro forma segment margins were a 120 basis points higher compared to the second quarter of the prior year. As previously mentioned, profitability improvements were largely due to lower input costs as a result of supply chain optimization, cost reduction initiatives, and realized savings from restructuring activities in the segment.

In the Engineered Products segment, second quarter pro forma sales of $74.3 million declined by 5.7% from the second quarter of 2015. The year-over-year sales decline can be attributed to revenue reductions from restructuring activities that were completed during the past 12 months; weakness in the fluid power, oil and gas, and industrial markets; and a slight reduction in North American automotive shipments. All of these factors more than offset the growth in the European compressor parts and service.

Normalized pro forma sales declined 5.5% in the second quarter versus the same period in 2015. Pro forma segment profit of $5.6 million was up 30.2% from the second quarter of last year, despite the decline in sales, due to cost savings related to the restructuring activities that Steve described earlier. Pro forma segment margins were 7.5% in the second quarter versus 5.5% in the prior year’s second quarter. Normalized pro forma segment profit was 29.2% higher than a year ago and normalized pro forma segment margins were up 230 basis points, despite lower sales, as a result of [indiscernible] restructuring and other operational cost savings.

In the Power Systems segment, pro forma sales were $55.5 million, up 14.7% compared to the second quarter of 2015. The increase was largely due to record aftermarket parts sales slightly offset by lower engine and service revenues. Pro forma segment profit for the quarter increased to $7.3 million, up 14.1% from a year ago, primarily as a result of higher margin part sales. Pro forma segment profit in the second quarter of 2016 was unfavorably impacted by $1.7 million charge for the multi-year EDF engine contract. The charge for the quarter resulted primarily from a drop in the dollar-euro exchange rate since the end of the first quarter. Excluding the impact of restructuring and adjusting EDF engine contract loss as if it were accounting for on a percentage of completion basis, pro forma segment profit was 37.1% higher than the second quarter of 2015. And more profitable sales mix as just mixed mentioned, lower parts and services, lower work warranty costs, and relatively flat year-over-year SG&A expenses contributed to the increase profit.

We remain committed to our strategy of creating shareholder value through earnings growth and balanced capital allocation, including disciplined investments for organic growth and innovation, strategic bolt-on acquisitions and returning capital to shareholders through dividends and share repurchases. We continued to execute on this strategy in the second quarter through the acquisition of Rubber Fab and investments in innovation such as the ones Steve discussed in his comments.

We also repurchased approximately 200,000 shares for $9.5 million as part of the ongoing $50 million share repurchase program that was approved by the Board of Directors in the fourth quarter of last year. The yesterday’s market close, we spent $26.5 million on share repurchases out of the authorized $50 million program. Additionally, we paid a $0.21 per share dividend in June and last week announced the $0.21 per share dividend payable in September.

We get a lot of questions about our pro forma net debt position, particularly now we have clarity on our asbestos liability. As you can see in the table on slide 18, upon reconsolidation of GST, we anticipate using the majority of cash on hand at GST in addition to some incremental third-party debt to fund the initial ACRP trust commitment of approximately $417 million. This includes $400 million for the U.S. liability and an estimated $17 million for the Canadian liability. The final $80 million commitment for the U.S. trust will be funded within one year of the initial payment.

As shown on this slide, if the settlement payment were to have been made at the end of the second quarter of this year, EnPro’s enterprise value to net debt leverage ratio would be approximately 2.4 times in contrast, for the 4.8 times leverage ratio based on a consolidated results. This does not include approximately $163 million of tax benefits that will be realized over the three to four years following reconsolidation, as we discussed on previous calls.

Due to the unique nature of the ACRP, we also get questions about our valuation relative to industrial peers. We believe that our pro forma financials are instructive, particularly now that we have a consensual agreement on the ACRP, as they reflect the performance of all of our subsidiaries. Given our market cap of approximately $1 billion, pro forma net debt of $469 million and our trailing 12-month pro forma adjusted EBITDA of $198 million, the resulting enterprise value equates to a 7.4 times multiple of trailing 12 months pro forma EBITDA in contrast to the 10.8 times multiple indicated about our consolidated results without benefit of GST.

This pro forma multiple is well below the peer average of 12.7 times. We believe this valuation gap will adjust over time as the market gains confidence that the ACRP will be finalize per our plan, resulting in the permanent renewal of the asbestos uncertainty that has been part of EnPro since inception.

Now, I’ll turn the call back to Steve.

Steve Macadam

Thanks Milt. We’ll close with the discussion of the current market conditions and our outlook for the remainder of the year and then take questions.

As we’ve described in the past, we do not have much visibility to future demand for most of our businesses, and the current volatility in global markets makes the industrial demand picture extremely difficult to forecast. Most of the markets that we serve have continued to show weakness and the strong dollar continues to affect our results. Only a few markets are showing signs of modest strength. It’s also important to note that the record aftermarket parts sales that we enjoyed in Power Systems during the second quarter are not sustainable for the rest of the year. The increase in shipments in the second quarter was a result of the convergence of marine vessel maintenance schedule orders received late last year and early this year. Our current order backlog suggests that aftermarket parts sales will be approximately at historical levels for the remainder of the year.

We are now close enough [ph] to the end of the year that our backlog, order trends and customer feedback give us some level of confidence in providing the following guidance. We expect pro forma sales to be roughly flat on a currency neutral basis with the growth attributable to acquisitions completed since early 2015 offset by general market-related weakness. Excluding the cost associated with the AVL Powertrain Engineering lawsuit that we discussed last quarter, we expect flat to low single-digit decline in pro forma adjusted EBITDA compared to 2015. Both pro forma sales and pro forma adjusted EBITDA assume constant currency for the rest of the year.

I want to emphasize that market developments and company performance could cause our results to deviate either positively or negatively relative to this guidance.

Now, we will open the line for your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Ian Zaffino of Oppenheimer. Your line is now open.

Unidentified Analyst

Yes. Hi, this is Dan filling in for Ian. Thanks for giving me the opportunity to ask a question. In terms of the oiler contract, can you just give a better sense as to what that might mean for EBITDA going forward and ultimately how that will affect some defense related businesses? Thank you.

Milt Childress

Yes. Hi Dan, it’s Milt. One of the things important to note as Steve mentioned, this is a significant win for us. We’re very, very excited about it. It is spread out over a long period of time. It’s expected to be 17 ships over 17 years, so roughly one per year, if you look at it with our order -- contracts that have in hand and approximately $13 million in revenue. It will have a modest impact as we look year-to-year, but it’s a very important win as it does help solidify as evident as evident our position with the U.S. Navy. Our experience with new programs is that we typically see with a learning curve a ramp up in margins as we go from the early engines in a program to the later engines in a program, and we would expect the same to be here. So, typically would see gross margins in the half, single-digit to low double-digit range initially and then with some ramp up over time. So, that’s a little bit of guide and hopefully that helps you put this in perspective.

Unidentified Analyst

Great, thank you. And just a follow-up, given where the stock price is and clearly a good quarter, any thoughts on capital allocation and buybacks and how that might look going forward?

Milt Childress

We’re committed to continuing with our $50 million authorization that the Board placed, we’re roughly half way through with that. We think that’s working well. We’re dollar cost averaging as we go with and we’re doing it in a methodical way without we have to go and see in the market. So, we’re committed to continuing that. And then we will sit back with the Board and have discussions at the end of that program based on our balance sheet at the time and other opportunities we have for investments, keeping this balanced capital allocation strategy as our foundation and see what makes sense at that time.

Operator

Your next question comes from the line of Jeff Hammond of KeyBanc Capital Markets. Your line is open.

Jeff Hammond

So, on the sealing business and I guess just looking at the legacy sealing ex-GST, you guys put up your best margin quarter since 2013, really against the backdrop of declining sales. So, I just want to understand better what changed 1Q to 2Q to kind of drive that 500 basis points of margin improvement sequentially.

Milt Childress

So, Jeff, your question is if you look at it on a consolidated basis as opposed to pro forma basis, there are couple of things. If you look at the lines of volume, big part of the volume weakness we had in the quarter came from GST, which, so you see a more significant year-over-year change in volume when you look at pro forma than if you look at consolidated. But we had a pretty strong -- we’ve had a bright spot in the pipeline part of the Garlock, so parts business part of our consolidated results, the midstream oil and gas business, the project work has been stronger on a year-over-year basis. So, we’re benefiting from that.

Granted, we did have a reduction in overall volume. We worked hard, as you know, on cost containment. And while most of our restructuring to-date, at least until the recent initiatives were focused on Engineered Products, we have had some restructuring activities in Sealing Products. And so, we’re seeing the benefit of that. We did have one item where we benefited in the quarter this year from a settlement we received on a product patent infringement case that we were defending, we were pursuing actually, because the TrailerTail business that we acquired, we had a competitor in the marketplace who was infringing on our technology. And we did realize a settlement in conjunction with that case in the quarter. And while I don’t have the kind of the impact of what that would be on a consolidated basis on margins, if you look at the pro forma margin expansion for the quarter of about 120 basis points that affected, about a third of that pick-up in margin expansion was related to this patent infringement outcome.

Jeff Hammond

Okay. That’s helpful. And then, just back to power systems, you mentioned that the high mix of aftermarket, you kind of had a low first quarter on the margins. How should we be thinking about the margin trajectory in that business into the back half?

Milt Childress

Well, Steve mentioned we don’t expect the record parts month in quarter if we had to continue. So, we would expect the balance of the year for Power Systems on the parts side to be more in line with our typical average. So, given that, we’re not going to have the same mix in the second half of the year that we had -- certainly than we had in the second quarter. So, we would expect margins to be lower in the third and the fourth quarter than what you saw in the second quarter. So, it’s important when you’re looking at the model to keep that in mind.

Steve Macadam

I think there is also -- Jeff, we have really talked about this, so there is no way you would know or anybody. And it’s kind of so difficult to quantify, we really haven’t talked about it much. But the EDF contract is extremely demanding. They are the most demanding customer we’d ever serve. And as you know, we’ve sold a lot of engines over the years, both to the U.S. Navy and to the domestic nuclear power industry but EDF really sets the global standard, to be honest with you, for rigor around the procedures and inspections and all the documentation required to put together in engine reliably, far exceeded our organizational capability to do that in the beginning. And so, as we have been working hard to deliver the first actual production unit for EDF, it has really been a significant drain on the organizational resource at Fairbanks. Probably -- I would take it back to the second half of last year and really through the first half of this year, and it’s kind of -- we’re now looking where that engine has either shipped or is going to shift in another day or two, but it’s ready to go, EDF has approved it so forth and so on.

So, we have been really climbing up a very steep learning curve at Fairbanks. And that has -- while again it’s not necessarily -- it kind of affects the whole the shop because it affects the organization and puts stress on the organization. So, I am really hopeful that -- and then of course on top of that -- actually do know about which is we’ve made all this currency issue with respect to EDF and having to do the full contract accounting with any time the damn currency exchanges or our projection of the cost frankly to do the engine changes, we got to look forward through the multi-year contract and bring that all back and book it now because we’re in a loss position really because of the currency dropped so dramatically.

So, it’s a challenge for the organization and it’s my view and hope that we’re pretty much -- we’ve broken the back of that product. As I said, we shipped the first engine or it’s being shipped this week. And from this point, all we’ve got 20 some odd engines more to build there, and they are all exactly the same. And I think we’re going to benefit from the learning curve going forward, hopefully; I’m certainly not counting on this but hopefully we might get a little bit of strengthening in the euro which would obviously unwind some of that loss provision that we’ve taken because the quarter ended at 1.11 I think it’s what we finally booked the decrement or incremental loss at. So, anything over 1.11, euro to the dollar, that provision would unwind a little bit.

That’s kind of might help you get a little bit more color on what’s going on in Power Systems. But, I got tell you that the EDF win was huge for us; it was a very big high profile contract. And like many things in life and in business, when really attack a very, very difficult problem, it really makes you better, is made our organization at Fairbanks so much better and more capable, I can’t even describe, which will position us very well for deeper penetration into the commercial market as the OP2 engine is beginning to hit the market. While I’m on the OP2, nobody has probably kind of asked me question about that but I’m going to talk about it. We had -- actually we were up there last week, we had our Board meeting in Beloit last week and saw the new engine running and heard that R&D team up there report on results. It’s going to be a winner. I’m just very excited about it, the Board excited about it. This is going to really reshape the competitive profile of Fairbanks going forward into the future. And as we’ve talked to everyone about in the past, our intention in Power Systems is to strengthen our position with the U.S. Navy and Coast Guard with the U.S. government marine market which has been our legacy business and I think the TAO program really solidifies that even further. There is other major programs that we’re looking on winning as well.

But we want to supplement that base, expand our addressable market with aggressive pursuit of the commercial distributed power market. And we believe now we’re gaining more confidence all the time. We’re actually going to have a product that is unique and highly, highly competitive in that space. So, when you combine that with what we’ve learned organizationally and productivity improvements that the workforce has been able to put in place, they’re really driven by the EDF requirements, pretty excited about the future of Fairbanks. And that’s not new; that’s been a consistent team I’ve been talking about for months now, so.

Operator

And your next question comes from the line of Joe Mondillo of Sidoti & Company. Your line is open.

Joe Mondillo

My first question, I just wanted to ask you relative to some of your comments, Milt, regarding the multiple that you’re getting on the stock and relative to sort of your thinking on the consolidation with GST over the next year and such. Just wondering what if at all risks are there with ACRP?

Steve Macadam

Well, let me address that Joe, I’m closer to Milt. Now that the judge has issued the order approving the disclosure statement, the voting procedures and so forth and setting the date, at this point, the major risk would be, if we had a third-party that came out of somewhere and tried to enter this case as an objector and they would have to do that also by the end of the year essentially to be valid. Now nobody’s done that yet. We’ve gotten no indication that anyone would do that. And in past cases, W.R. Grace is the perfect example; there were a number of legitimate objectors in that final confirmation including us, including Garlock as well as the city of Libby, Montana and many, many others that were impacted by the Grace settlement. And during that time, the District Court essentially through all those objectors out basically said were confirm this plan, including us that said Garlock didn’t have standing in the case. And so, our view, our legal team view is at this point for an objector to come in -- first of all, we don’t see where they would come -- a lot of time, an insurance company that comes in and objects to these things but in our case, we don’t anticipate that based on where we stand with our insurance companies. And there is really no other debtors involved in this thing, or there is no other -- we don’t owe anybody else anything. So, there is no -- it’s really not, there is no other contingent party I guess I should say. And if somebody did come in, they would be coming in so late in the game, there has been so much work done on case as you know, it’s been going on for years that it would be surprising if they were given much legitimacy in the process to be honest with you.

So, our view is that at this point, we feel pretty darn confident that we will are going to be able to march through this. The date has been set. We’ve been ordered by the court to start the confirmation hearing and as I said in May next year. So that should be relatively straightforward. And once we get that, then the district judge has to overall approve the whole thing. But I think we’re going to get it done. There is no other bankruptcy case that we can point to, asbestos related bankruptcy case that we can point to that got brought down at this stage other than Grace who is the most brought down all of them. It took more time to march through it but it still got done.

So, we have a high degree of confidence that it is going to get done. That’s why we’ve really shifted all of our tone in reporting and communication to be around pro forma numbers because we believe that that’s -- I know that’s the company we’ve got right, and there will be rounding in terms of what the final -- what we did in terms of Canadian thing, is not a 100% set yet and different things, but that’s going to be rounding at the edges. So we know what we are facing here. So, I feel as confident as I could be at this stage, particularly with the judge’s order essentially last Friday. Took us a little bit longer to get that over the goal line than we had hoped, but now that that’s in and the scheduling order has been issued, I think we’re pretty much locked and loaded.

Joe Mondillo

Okay, great. Thanks. That’s very helpful. Thanks. Regarding the $20 million of restructuring, I was just wondering if you could -- if you could quantify, that’d be great, but at least may be you could steer some in the right direction of the weighting of where that’s hitting amongst the three segments and the corporate line?

Steve Macadam

Hold on, let’s get it. That’s a good question. We hadn’t anticipated that Josh.

Milt Childress

We’ve -- I can give you kind of a rough approximation.

Joe Mondillo

And while you’re looking for that, was there any restructuring being done in the second quarter that you didn’t realize fully the benefit from other than this new $20 million of…

Steve Macadam

No, I think the vast majority of restructuring from programs that we’ve been working on like the CPI deal, the DGP deal we talked about, other ongoing cost reductions in Garlock, and so forth and so on. You would see pretty much the full benefit of that in Q2. So that’s been likewise on the $20 million, we actually implemented the actions. Our goal was to get as much of it done and in place by the end of June as we could. And so, the lion’s shares of the action by far are in place. But the benefits didn’t have been and frankly won’t be fully in place even in Q3; that will be through the end of Q4. As you know, when we do restructuring in the European markets and other locations where we operate, A, it’s more expensive and B, it takes a longer time, there is more of the legal process to go through, it takes more time to get it done in Europe. And so that’s really what will cause it to spill into Q3 and to Q4 in terms of the restructuring charge that Milt indicated.

Joe Mondillo

Right.

Steve Macadam

Yes. So none of the 20 event but -- and that 20 is on a run rate basis, in Q3 I would guess we’ll see 70%, is that Ken?

Ken Walker

70% to 80%

Steve Macadam

70% to 80% of it, and in Q4 probably 90% or maybe higher in Q4.

Ken Walker

But what remains -- this is Ken, Joe, what remains is really the European piece. All the other actions have been completed. So, it’s really just working through the European parts of our business, which is GGB and CPI most part.

Joe Mondillo

Okay, assuming you’re still…

Milt Childress

I can give it to you kind of roughly. This is directional. Now, we’ll see a big chunk of it, 45% roughly somewhere in that range in sealing and engineered roughly 20%, roughly 20% in Power Systems, a little bit more than that; and there is 14% or 15% of that amount corporate office.

Joe Mondillo

Okay.

Milt Childress

So, that’s 100 but that’s almost [multiple speakers] good number.

Joe Mondillo

It’s good enough. Thank you. Lastly, I wanted to ask you regarding sort of the year-over-year comps in terms of revenue for the Sealing and Engineered Products segment. Just wondering, I mean, I know the comps do get a little easier in the back half of the year but then you’re also talking about how maybe heavy duty trucking, it seems like a little weaker sequentially in sealing. So, I’m just trying to get an idea of how you’re thinking about revenue in the back half of the year in terms of the year-over-year comps, mainly at the sealing Segment and Engineered Products segment. Because it seemed like in the Sealing segment, things did get worse sequentially year-over-year at sealing as well as I guess Engineered Products. But do they get better, do the year-over-year comps get better in the back half or how are you thinking about that?

Milt Childress

Well, this is all on a pro forma basis. I think if you look in the second half of the year what we expect to see this year, compared to the second half of last year, we’re going to be down; our volume is going to be down. It will be some of the same factors that we’ve discussed this year. Because remember the second quarter of last year, we were starting to see weakness in our markets. And so, in the second quarter this year, even though Q2 we saw some further deterioration, as we’ve been talking about throughout this year. So, I expect we’re going to see that. And I believe a chunk of it will be in heavy duty, because some of the trends we’re seeing there, but we’ll see. So that’s Sealing.

And then Engineered, we believe we will be maybe flat to slightly down compared to the year ago. And the dynamics are just a little bit different in that segment versus Sealing. So, that’s general direction there.

Joe Mondillo

Okay. That’s exactly what I was wondering. Thank you. Appreciate it for taking my questions.

Operator

Your next question comes from the line of Justin Bergner of Gabelli & Company. Your line is open.

Justin Bergner

Good morning and thank you all for taking my questions following a pretty good quarter. First question, I have a couple of quick questions here. Within your pro forma Sealing Products business, it might be helpful just to remind us the breakdown within oil and gas between upstream, midstream and downstream?

Steve Macadam

There is not much upstream and there is certainly not much left I mean. We had some product lines that we sold into upstream that I mean is off over 50% from its peak year and a half ago. So, I think the amount that we have left in upstream has got to be fairly negligible for the segment. And then I would say kind midstream and versus downstream, I would still say it’s kind of 50-50.

Milt Childress

Our overall direct oil and gas exposure for the company is roughly 12% or 13%. And I don’t Ken or Steve, I don’t have a data in front of me at it. Justin, you can follow-up with either me or Chris after the call and we can give you what that percentage of exposure is specifically for the Sealing Products segment. I just don’t have it front of me right now.

Steve Macadam

Yes, I have given you my estimate Justin for Sealing Products because in Engineered Products, it’s call CPI and that is probably more 40% midstream and 80% downstream.

Justin Bergner

Okay. That’s helpful. Thank you. Different dynamics for different parts of the oil and gas market these days.

Steve Macadam

No question.

Justin Bergner

I know that you don’t want to specifically quantify what the raw material sort of benefit was to the second quarter Sealing Products margins. But when we look at sort of the first quarter and the second quarter combined on a first half basis, is it sort of safe to assume that the margin level in Sealing Products will look similar in the second half to the first half?

Steve Macadam

Yes, it’s a reasonable; I think that’s a reasonable estimate.

Justin Bergner

Okay, great. And then switching to Power Systems, do any of the businesses in this new contract plan existing business in your Fairbanks Morse business or is this all incremental?

Steve Macadam

You’re talking about the new engine, the T-AO program?

Justin Bergner

Yes, the new engine contract.

Steve Macadam

No, it’s all replaced. I mean we benefited in -- if you go back to the period of let’s call it 2008, 2009, 2010, 2011, 2012 we benefitted by large wave of engines, new engine builds for the Navy. They were building a lot of ships, and then we I think we shared with folks that have been following us for over -- consistently over a long period of time that kind of -- we were going to have a loll and a significant loll in new ship for the Navy engines in the 2015, 2016, 2017 kind of window, really 2016 and 2017 primarily. And that in fact -- I mean we saw that coming because of the next wave of new engine -- new ship programs that the Navy was working on like the T-AO program, like the LXR program and others. And the new offshore control [ph] covers with the Coast Guard and so forth, are all things we’re working on, we obviously won the T-AO program. But those -- that’s the next wave of government shifts that will happen beginning kind of in 2017, 2018, 2019 in that time period.

So, it’s important for us to win these programs, to have that base of that we have enjoyed in the past. Obviously, we have the aftermarket parts benefit for all the engines that we put in the field in the earlier in the timeframe that I mentioned right. But the way, the nature of this business works in the government is we get on a work, and how remaining -- typically, how remaining ships are built in that program, they don’t redesign the ship and engine and power propulsion system for everyday, just build multiple ships that are the same configuration.

So, once you are in the program, you pretty much stay on the program through the life of it. But once the program is over, that’s it, the volume’s gone and you’ve got to win the next one that follows on behind it. And that of course is lumpy; it’s not a constant that Navy is going to spend so much on -- the Navy budget remains relatively constant. But how much of that money is on new ships and what of ships and whether the ships take our engines or not at all up in the air. So, I would say all of the Navy stuff will be replacement, depending on what periods you look at. Obviously, it’s new and incremental relative to last year and where we are today.

Milt Childress

I think Steve said this, but I want to reiterate one point, it goes back to Dan’s comment earlier, question earlier about the profitability impact. When we win the programs, we are really seeding the future aftermarket and that is -- that mark will have in future years a significant impact on our business and profitability.

Justin Bergner

Great. Thank you for that perspective. One more, which I think will be a benefit to people on the call, and then I’ll follow-up offline with respect to other questions. But you mentioned that the guidance for 2016 excludes the legal costs associated with the Power Systems lawsuit. I just want to verify that was the case and understand where those costs show up in your financial reporting?

Milt Childress

Yes. That was in our segment results in Q1 and it was about $2.7 million charge that we recognized in conjunction with that, and that was in Power Systems.

Justin Bergner

Okay. And there won’t be further charges as the year progresses?

Milt Childress

Not related to that, none that we know about, Justin. There is always the stuff that we don’t know about but that we don’t see anything on the horizon.

Steve Macadam

And the reason we separated that out is because we are referring to adjusted EBITDA. And as you know, we don’t just out for these legal things, even though that was a big one, we know from what we see things of that size. But we wanted to stay consistent with how we’ve always reported adjusted EBITDA, which only adjusts really for restructuring and the legacy environmental stuff and discontinued ops related things. So that’s why we called that out special to be consistent, because it’s not normally in the adjustments we make.

Operator

And there are no further questions at this time. I’ll turn the call back over to Mr. O’Neal.

Chris O’Neal

Thank you, Kelly. And thank you all for joining us this morning. If you have any additional questions, please give me a call at 704-731-1527. Have a good day.

Operator

This concludes today’s conference call. You may now disconnect.

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