Regal Beloit's (RBC) Mark Gliebe on Q2 2016 Results - Earnings Call Transcript

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Regal Beloit Corp (NYSE:RBC)

Q2 2016 Earnings Conference Call

August 09, 2016 10:00 AM ET

Executives

Rob Cherry - Investor Relations

Mark Gliebe - Chairman & Chief Executive Officer

Jon Schlemmer - Chief Operating Officer

Chuck Hinrichs - Chief Financial Officer

Analysts

Joshua Pokrzywinski - Buckingham Research

Sam Eisner - Goldman Sachs

Jeffrey Hammond - KeyBanc Capital Markets

Ryan O'Connell - Baird

Scott Graham - BMO Capital Markets

Nigel Coe - Morgan Stanley

Operator

Good day and welcome to the Regal Beloit Second Quarter 2016 Earnings Conference Call and webcast. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded.

I would now like to turn the conference over to Mr. Rob Cherry, Vice President Investor Relations. Mr. Cherry, the floor is yours, sir.

Rob Cherry

Thank you, Operator. Good morning. And welcome to Regal Beloit's second quarter 2016 earnings conference call. Joining me today are Mark Gliebe, Chairman and Chief Executive Officer, John Schlemmer, Chief Operating Officer and Chuck Hinrichs, Vice President and Chief Financial Officer. Before turning the call over to Mark, I would 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 factors that could cause actual results to differ materially from projected results, please refer to today's earnings release and our SEC filings.

On slide three, we state that we are presenting certain non-GAAP financial measures in this presentation. We believe that these are useful financial measures to provide you with additional insight into our operating performance. And for helping investors understand and compare our operating results across accounting periods and in the same manner as management. Please read this slide for information regarding these non-GAAP financial measures and please see the appendix for reconcialtions of these measures to the most comparable measures in accordance with GAAP.

Now, I will turn the call over to Mark.

Mark Gliebe

Thanks, Rob. Welcome and thank you for joining our second quarter call and thank you for your interest in Regal. We'll follow our normal agenda. I'll make a few opening comments. Chuck will give a financial update. Jon will provide color on markets, operations and the performance of our three segments. And after that, I'll summarize and we'll move to Q&A.

Before I get into the presentation, just one opening comment. Our second quarter results were generally in lined with that we had expected. Sales came in a little lighter than we have planned primarily due to the slower start to the cooling season and further weakness in core industrial markets. Margins were up sequentially and in line with our expectations. Now, at a macro level, top line revenues challenged our results for the second quarter. Organic sales were down in all three segments. Looking across the segments, there were a few key items that put significant pressure on our top line.

First, sales into our global industrial markets including oil and gas and power gen were down roughly $50 million year-over-year. Second, the impact of two way material price formulas with our larger customers was a $70 million headwind. Next, demand from Middle East HVAC business has declined $30 million. And finally, North American residential HVAC and water heater markets were off roughly $9 million in the quarter.

From an operating proper perspective, as expected, margins improve sequentially in the quarter. The year-over-year decline in margins was driven by the overall volume decline across the segments, breaking it down to decline in our oil and gas and power gen businesses made up over 40% of the $21 million volume-related op profit decline. Fortunately, our ongoing investments in simplification and cost saving activities helped offset the impact of these headwinds.

We had another good quarter in free cash flow with free cash flow coming in at a 175% of net income. Part of the way we accomplish these results was by reducing inventories. For the quarter, we improve cash cycle by seven days and we reduced the inventory of $45 million. While the inventory reduction put pressure on our margins, we needed to improve our cash cycle and we're seeing the benefits in free cash flow.

Finally, we close down a sale Mastergear which was a non-core business for Regal. With a strong free cash flow in the sale of Mastergear we paid down $93 million of debt in the quarter. As we look forward, we expect the second half Organic growth rates to be meaningfully better than the first half. We expect organic revenues to be down low single digits versus prior year compared to first half sales that were down roughly 11% as compared to prior year. Operating margin rates are expected to improve in the second half as well.

On guidance, back in April we estimated that we would see a pickup in the back half of the year. While our second half is still estimated to be stronger than usual the demand in our industrial based business is still weak overall causing us to reduce our earnings guidance by a 3%. Even so, our guidance reflects second half earnings to be 8% to 18% stronger than the first half.

I'll now turn it over to Chuck.

Chuck Hinrichs

Thank you Mark, and good morning everyone. Sales in the second quarter 2016 were $838.6 million, down 11% from the prior year.

Foreign currency translation in the quarter was a negative 1%. The sale of the Mastergear business negatively impacted the second quarter sales by $2 million or a 0.2% shown on the slide as a business divestiture. Therefore, organic sales declined 9.8% from the prior year. Our adjusted operating profit margin in the second quarter was 9.7%, a decline of 220 basis points from the prior year. The decline in sales volume pressured the operating profit margin, with partial offsets from the benefit of the simplification initiative and cost controls. Some of these cost control actions benefitted our operating expenses. Our operating expenses in the second quarter declined $16.7 million from the prior year. This decline is comprised of the $11.6 million gain on the sale of Mastergear and a $5.1 million reduction in operating expenses as a result of our cost control programs.

Our second quarter 2016 earnings per share reported on GAAP basis were a $1.26. There were two adjustments to EPS in the second quarter. The first adjustment was $1.7 million or $0.02 per share of restructuring and related costs relating to restructuring activities in all three reporting segments. The second adjustment was the $6.3 million after tax gain or $0.14 per share from the sale of our Mastergear business in the quarter.

Net of these adjustments, the adjusted EPS for the second quarter was a $1.14 per share. On the bottom of these slide, we showed the annual impact of a divestiture of the Mastergear business which will not be in the power transmission solutions segment in the future.

Now, I will summarize some key financial metrics for the second quarter 2016. Our capital expenditures in the first quarter were $17 million and our total capital expenditures in the first half were $32 million. We expect our full year 2016 capital expenditures to be $80 million compared to a $92 million in 2015.In the upper right quadrant, we show our effective tax rate information. The ETR in the second quarter was 24.9% pushed up by the higher tax rate on the gain, on the sale of the Mastergear business. Our ETR forecast for the second half 2016 remains at 23%.

In the lower left quadrant, we provide data on our second quarter 2016 balance sheet. Our total debt was $1.614 billion and our net debt was $1.343 billion. In the second quarter, we reduced our total debt by $93 million. Over the last 12 months, we have reduced our total debt by $266 million. In the lower right quadrant, we provide information on our free cash flow. We generated $99 million of free cash flow in the second quarter. Free cash flow represented a 175% of net income for the quarter. Our free cash flow was very strong in the quarter benefitting from our progress in reducing our inventory by $45 million in the period. In the first half of 2016, we have reduced our inventory by $64 million as we balance our production with the lower level of sales.

Now, I will review our full year 2016 earnings guidance. Our updated guidance for 2016 reflects our expectations that organic sales growth will be down low single-digits in the second half. This is a meaningful improvement over the organic sales growth in the first half which was down 11.3%. Sales in our North American HVAC business will benefit from the strong cooling season driven by the recent warmer temperature is in the third quarter and our assumption of a normal heating season in the fourth quarter as compared to the prior year. We expect the stabilization of sales into oil and gas end markets and easier comparisons versus the prior year. Additionally, we forecast a sequential improvement from the two-way material price formulas due to the recent inflation and steel costs. And finally, we forecast a lower negative impact on foreign currency translation in the second half as compared to the first half of this year.

Our outlook for the second half of 2016 is for sequential improvements in our adjusted operating profits and margins. We will have a favorable price cost impacts in the second half. This results from the lagging realization of lower commodity input costs benefiting the second half of 2016.

Additionally, we have momentum from the benefits of our simplification initiative and restructuring actions especially in our oil and gas businesses which will benefit the second half results. Our full year 2016 GAAP earnings per share guidance is $4.32 to $4.52 per share. Our full year 2016 adjusted earnings per share guidance is$4.35 to $4.55 and includes two adjustments. The first is the add back of the estimated restructuring charges totaling $14 million or $0.20 per share for the full year. The second is the subtraction of gains on sales of businesses of $0.17 per share. As I mentioned earlier the gain on the sale of the Mastergear business recorded in the second quarter represents $0.14 per share of this amount. The additional $0.3 per share represents the gain on the sale of the assets of our Venezuelan business to a private party in the third quarter. You will recall that in the fourth quarter of 2015 we ceased operations in our Venezuelan business.

In summary, our revised full year 2016 guidance reflects a second half improvement in adjusted earnings per share of 8% to 18% as compared to the first half of 2016.

Now, I'll turn the call over to Jon Schlemmer.

Jon Schlemmer

Thanks Chuck and good morning, everyone. Let's go ahead and start with segment performance, beginning with the commercial and industrial systems. Sales were 395 million, a decrease of 10% from the prior year but up approximately 4% from the first quarter. Organic sales declined by 39 million. The impact of oil and gas in the power generation end markets impacted sales by 21 million in the quarter. The two-way material price form has reduced sales by 9 million and the general industrial end markets in China impacted sales by another 8 million. We experienced strength in both the residential pool and data canter end markets.

North America commercial and industrial motors account for over 50% of this segment and in the quarter sales in these businesses were flat to prior year. With the headwinds on the top line, adjusted operating margin was 6.5% of sales down 340 basis points from prior year, but up 70 basis points from the first quarter. The decline in oil and gas and power gen accounted for approximately 50% of the margin decrease. We're starting to see the benefits of our restructuring and resizing of our oil and gas businesses, and we'll see a greater impact from these actions in the second half than we experienced in the first. We're also expecting improvements in our second half margin rates due to a more favorable price cost impact as compared to the impact we experienced in the first half of this year.

Sales in the segment increase sequentially 4%. We expect this inquiries demand level in the second quarter to hold through the remainder of the year. In addition, we'll benefit from the earlier second half comparisons in the oil and gas and power gen businesses. Sales in our climate solutions segment decreased approximately 11% from prior year up 6% from the first quarter. Organic sales declined by 30 million. This was the fourth consecutive quarter where we experience weakness in the Middle East air-conditioning market. We don't expect a major turnaround in the Middle East markets, although the comparisons will ease in the second half. The two-way material price formula has impacted our sales by 9 million, approximately 3% of sales.

In the U.S., industry data shows that combine unit shipments for residential HVAC and water heaters were down low single digits. In the HVAC after-market we experienced weakness in demand of our replacement motors due to the impact of the cool start to the summer. We experience strength in our global commercial refrigeration demand and were pleased with the opportunities we continue to see in this business, especially with energy-efficient products. North America HVAC orders picked up in June, and the strength has continued into the third quarter. In this business, we're forecasting a stronger third quarter over our second quarter which is unusual.

Adjusted operating margin was 14.4% of sales, a decline of 80 basis points from prior year, but up significantly from the first quarter. We experience improvements in our second quarter margin rates due to a more favorable price cost impact and we expect this benefit to continue in the second half. The simplification in cost reduction efforts offset the majority of the volume decline from the U.S. and Middle East markets. These benefits will only accelerate in the second half. And finally, as you recall last year, we had an unusually warm heating season. This year in the fourth quarter, we're anticipating a normal heating season.

Sales in our power transmission solution segment were a $189 million, a decrease of 12% from prior year and down 6% from the first quarter. Organic sales declined by $24 million. The decline in organic sales was driven primarily by oil and gas and continued weakness in the agriculture and metals end markets. We also experienced weakness in our distribution channel in the second quarter. These declines were partially offset by continued strength in renewable energy and unit material handling. Adjusted operating margin was 10.1% of sales, down 170 basis business points from prior year and down a 140 basis points some in the first quarter.

You will recall that in the first quarter, we call it out that operating profit benefited by approximately 90 basis points as we finalized purchase accounting in the acquired business. Synergies and cost actions help to offset the impact of lower volume. Orders weaken through the quarter and we're not anticipating any improvement in the second half, however we will have easier comparisons in the second half from oil and gas. Given the orders environment, the synergies programs remain on an accelerated schedule, and additional cross actions are being taken across the business. While the current conditions are certainly challenging in many of our end markets, we continued our efforts to develop new energy-efficient products. There's tremendous activity going on right now to increase the energy efficiency requirements on both our products and our customers' products in a number of applications. The level of legislative activity is increasing and we're being responsive to the needs of our customers to meet new imminent energy legislation.

Over a year ago we made the decision to assemble dedicated teams of engineers to develop the new products like the ones shown here. These new products are helping our customers meet these ever-increasing levels of energy efficiency. The products we are developing in our target for a wide range of applications, but they all have something very important in common. As opposed to simply providing a standard motor for the customer's application, we're developing an entire system by integrating a more efficient electric motor, a custom electronic control and application specific software to help the customer optimize performance for their needs. This is what our engineers did in residential HVAC many years ago and today we lead the industry with

our energy efficient small motor systems. We're repeating that equation over and over again in these new spaces. We believe our team is the best in doing this and our customers looked to Regal for these innovative solutions.

While these efforts will fuel our long-term growth, we continue to place an equal focus on simplification and cost actions. During the last quarter, we discussed a number of cost reduction programs that were under way to help us improve margins including eight production line transitions, two large warehouse consolidations, a number of ERP conversions and our fifth design platform consolidation. These programs in total will deliver $13 million in annual savings and a number of these programs are now positively impacting our results.In addition to these actions, we have also implemented further restructuring actions and resizing of our oil and gas businesses. All of these actions will help us to improve margins in the second half as compared to our first half margins and will also provide momentum as we move into 2017. There are additional simplification and synergy programs that will be initiated in the second half of this year. And finally, we are forecasting restructuring expenses related to all of these activities to be 14 million for the year.

I will now turn the call back over to Mark.

Mark Gliebe

Thanks Jon. Before I summarize, I want to take a moment and cover the Company's free cash flow performance. As you can see, Regal has consistently delivered strong free cash flow. In fact, the annual average of free cash flow to adjusted net income over the past five years is 129%. Our bias right now is to use the cash to pay down debt and over the last 12 months we have paid down $266 million in debt. The key point here is that in spite of the difficult market conditions, our business consistently delivers strong free cash flow.

Now, I would like to summarize our second quarter performance and then we will go to Q&A. For the second quarter, Organic sales were down approximately 10%. The biggest headwinds were oil and gas, power generation and the global industrial markets. The weaker volumes negatively impacted our margins with margins in our oil and gas and power gen businesses being hit especially hard. We have been restructuring and resizing these businesses and we are expecting to begin to see the benefits in the second half. Our cash flow to net income was 175%. We reduced inventory by $45 million and we closed on the sale of the noncore Mastergear business. We used a portion of the free cash flow to pay down 93 million in debt. Our guidance reflects second half Organic sales to be down low single digits. That would compare with the first half where we were down roughly 11%. On our second half sales estimate we expect to see a pickup in the third quarter HVAC demand because of the recent warmer temperatures and we expect a more normal heating season in the fourth quarter.

We expect easier comparisons in the oil and gas and power gen businesses and we forecast a sequentially improving two-way material price formula impact. Finally, we expect less of an impact in the second half from foreign currency translation. On earnings our guidance reflects earnings 8% to 18% stronger than the first half. We expect an overall favorable price cost impact as the lagging realization of lower cost commodities benefit the second half more than the first. And we expect simple feck and cost saving actions especially in the oil and gas businesses to benefit the second half. We will now take your questions.

Question-and-Answer Session

Operator

Thank you, sir. We will now begin the question and answer session. [Operator Instructions] The first question we have comes from Joshua Pokrzywinski of Buckingham Research. Please go ahead.

Joshua Pokrzywinski

Just to clarify on the guidance, I get maybe the push out or timing impact on HVAC. I think we can all appreciate the weather shift here. But if I do parse out the $0.15 is it price cost a little bit better, revenues a little bit lighter? Just trying to calibrate what's changed in the back half maybe versus the prior outlook.

Mark Gliebe

Josh, the biggest single change from the prior outlook, with the reason we reduced our guidance 3% was related to the weaker global industrial markets that's the big top line driver.

On price cost we can cover that now. I'm sure it's going to be a question from many of you so we will go into a little detail on that. There is really three drivers to the price cost equation that we discussed and the first one is related to material price formulas. So, let me remind you that since the latter part of 2014, copper, aluminum and steel spot prices have been declining and the markets as you know have been very volatile. The prices hit their low point as we entered 2016 and as a result, our material price formulas and again those are with the larger customers and impact 30% of our business, they hit their low point in the second quarter. And so, while copper and aluminum have been stable in the last few months, steel has actually started to inflate. And so, therefore, our material price formulas have started to turn as we entered the second half, turn positive. And so, the impact will be more favorable in the second half as compared to the first. Now, the second driver on the price cost equation is related to our commodity hedging program.

Chuck, why don't you touch on that?

Chuck Hinrichs

Sure, thanks, Mark. So you will recall that we have a commodity hedging program for the volumes not covered by the MPFs. So our blended costs of our copper and aluminum hedges will result in lower costs in the second half of the year as compared to the first half. As we've said in the past about our commodity hedging program, the goals are to smooth the volatility of spot prices and to provide price certainty. Now, the third driver is from the realization of lower cost inventory. In the first half of 2016 we sold inventory that was manufactured in 2015 with higher input costs. In the second half, we will be selling inventory manufactured in the first half with the lower commodity costs so.

Mark Gliebe

So, Josh, I'm glad you asked about price cost. I know that's a rather thorough answer, but hopefully that answers your question.

Joshua Pokrzywinski

That is actually very helpful. And I guess maybe just to continue with that thread, when does the increase in steel pricing start to flow through? Is that a first, just in terms of inventory sold, is that a first half 2017 element where we are hearing more companies talk about steel inflation maybe being a second half risk but sounds like you guys might be a six month delay from that?

Mark Gliebe

Good question. So we will start to see it in the fourth quarter from our cost perspective and then more so in the first quarter.

Joshua Pokrzywinski

Got you. And then, just one last one from me. You talked about the inventory liquidation being a headwind to margins in CNI, can you quantify what that was?

Mark Gliebe

Sure. You know, we estimate that we, as you mentioned we took $45 million of inventory out in the second quarter $65 million year-to-date. It's probably somewhere between a 25 to 50 basis point headwind on a year-to-date basis.

Operator

Next we have Sam Eisner of Goldman Sachs.

Sam Eisner

Thanks, good morning, everyone.

Mark Gliebe

Good morning, Sam.

Sam Eisner

So just sticking with Josh's question there, maybe the forward look on the inventory liquidation, if it was 25 to 50 bps in the first half of the year, are you continuing to expect to reduce inventory in the back half of the year and did you throw out any free cash flow targets for 2016?

Mark Gliebe

So we do plan on continuing to reduce inventory to right-size our inventory with our business, probably not to the same degree that you saw on the first half but we think it will run out by the end of the year. Chuck, do you want to handle the second question?

Chuck Hinrichs

Sure. Sam, you asked about the estimate for full year free cash flow. On page 15 in the slide deck we have an estimated number of free cash flow at 150% of net income for the full year and that number will be approaching $300 million in free cash flow.

Sam Eisner

Understood. That's helpful there. And then when I look at your organic growth comps there does seem to be obviously the fourth quarter you have a pretty easy come of here, not a major change in the third quarter. So outside of the improving or maybe the timing mechanism with our HVAC exposure what's giving you confidence for a sequentially acceleration in your business.

Mark Gliebe

Well, I think you hit on the first one was as Jon Schlemmer mentioned we're expecting a third quarter in our climate business to be up versus our second quarter which is somewhat unusual. And then we have the easier comps kick really in this both the CNI and the PTS businesses those are the key drivers overall to the difference between the first half and the second half.

Sam Eisner

We also know that there will about he a sequential improvement as you mentioned Mark on the material price formulas as we enter the third quarter. So the lesser degree than the other two you mentioned but there's also a help as we enter Q3.

Mark Gliebe

Right. Material price formulas have been a drag on the top line as you know. And as we went through they are actually starting to turn positive in the back half of the year so those are the drivers.

Sam Eisner

OK. And then, one last question. When you guys called out implication or cost headwinds, these are $5.1 million that you guys referred to on slide seven. I'm curious, one, is that correct? And then two, how are you thinking about kind of simplification or overall cost out in the back half of the year for overall 2016? Thanks.

Mark Gliebe

Well, I'll take it and pass at that one to Sam, and I'll pass it off to Jon or Chuck. The $5.1 million that Chuck mentioned was an SG&A benefit. Some of that benefit comes from simplification and some of it just comes from good solid cost controls. Jon talked about simplification and he sized the benefit up over the year. Why don't you just talk a little bit about that, Jon.

Jon Schlemmer

Yes. So the active programs, the programs that are currently under way are sized up to be on an annualized benefit of $13 million. They kick in at different points in time, of course. We will see that benefit impact start to impact our results, some of those programs are starting to impact our results now. We will see that benefit impacting our second half and then carrying over into 2017. So there is, you know, part of that impact hits us in the second half and the other part will impact us in the first half of 2017. And the way I would think about the simplification and cost actions there is a part that impacts SG&A, and as Mark mentioned the 5 million is partly impacted by simplification and the general cost actions but also the other part that impacts largely our cogs so that would show up in our gross margin range.

Sam Eisner

Got it. Thanks so much.

Operator

Next, we have Jeff Hammond of KeyBanc.

Jeffrey Hammond

Just staying on I think you said 13 million was the simplification savings number. Can you just speak to what the savings are on your separate restructuring programs? I think the $0.20 or did some of that get commingled?

Mark Gliebe

Yes. I think it's a good point. The $13 million is related to our synergy -- I'm sorry our simplification across the company. Now, on synergies that's related to the acquisition and we are on accelerated timeline of accomplishing our goal in three years versus four. And the, you guys got to help me with the exact number on the synergy benefit in the second year. It was $9 million I believe, $18 million over the last two years and $9 million in this year. I believe that was the number.

Chuck Hinrichs

That's correct. And Jeff, one more thing I would point out the restructuring expenses the $14 million that includes both the programs that are active, the programs that delivered $13 million in savings but also is a forecast for yet to be announced programs that we would be talking about on later calls as we form, as we announce those projects internally in our business.

Jeffrey Hammond

Okay. So just to close out, like the oil and gas restructuring, for those businesses that are weaker, is that a separate bucket of savings or is that in the synergy and simplification numbers.

Mark Gliebe

That's in the $13.1 million that Jon mentioned.

Jeffrey Hammond

Okay, helpful. Just to go back to material price formulas. So you said I think $17 million drag this quarter. Can you give us a sense of what it looks like in 3Q, 4Q and when we kind of shift from negative to positive?

Jon Schlemmer

Good morning, Jeff. I will try to handle that. Yes, we certainly have that number, but it's part of our guidance on second half revenue and part of our earnings guidance, but we are not giving that exact number in the second half for MPFs.

Chuck Hinrichs

We will still have the way to think about it, Jeff, is we will still have a year-over-year headwind on price as we enter the third quarter, but it turns sequentially better as some of those formulas start to kick in and start to increase prices.

Jeffrey Hammond

So what is the time frame where the material price formula actually goes positive? In early 2017?

Chuck Hinrichs

It's going depend overall, there's different contracts, different languages around timing of the actions and of course a lot of that also depends on what happens, how copper behaves over the next six month. But I think we would see that as we enter the fourth quarter it's going to be relatively neutral when you think about it on year-over-year basis, not a big help but no longer a hurt.

Operator

The next question we have comes from Ryan O'Connell of Baird.

Ryan O'Connell

Good morning, guys. Thanks for taking my question.

Mark Gliebe

Good morning, Ryan.

Ryan O'Connell

So just curious, how did you guys see the business track month to month through the quarter. As you look at kind of July and August have you seen the expected improvement towards the low single-digits declines you are looking for in the back half or is that more of a 4Q event as the comp really start to ease?

Mark Gliebe

So I will take a pass at it and Jon can add any color. So, I'll start in the climate business. Clearly, there was a slow start to the cooling season. I think everybody saw that and it warmed up nicely in June and carried right through into July and we're still seeing that strength in our HVAC business as we enter August. So that's kind of the climate space. Jon made a comment on our CNI motors business was flat on a revenue perspective in the quarter. That was positive from our perspective. I hate to say it, but flat was good in the quarter. And right now our order rates in that business are holding up. And then we mentioned in our PTF business the takeaway on the slide was that, weak markets and industrial markets persist and that is what we are seeing in the PTF business kind are very weak order rate this that business.

Ryan O'Connell

All right, great. And then on the margin side is there any way to quantify the price costs I think we can get to it but on the incremental savings is there a way to kind of bucket out how much we are looking for in the second half versus the first half or even on a year-over-year basis?

Mark Gliebe

Well, Ryan, it is all baked into our guidance for the second half where we are seeing an improvement of 8% to 18% in the second half versus the first half in our adjusted EPS.

Ryan O'Connell

Okay. And then I guess lastly, just on capital deployment, is there a target level that you guys are looking to get these debt levels down toward before you kind of shift gears to other areas? Just curious on the kind of the timeline here as we look at the great free cash flow and where that's going to go over the next couple of years.

Chuck Hinrichs

Yes, Ryan. Thanks for your question. Our near term target would be to get our debt to EBITDA, that would be total debt to EBITDA down to the 2.5% to two times range and we would expect to be approaching that number in 2017.

Mark Gliebe

Thanks, Ryan.

Operator

Thank you, sir. The next question we have will come from Scott Graham of BMO Capital.

Scott Graham

I just really have two questions. First of all, at what point do you think we are going to have to start to increase prices to sort of stave off some of the steel headwind. Looks like you are being able to delay that into '17 which is great but then '17 the bell will kind of toll there. So when do you start to think about increasing prices of products?

And my second question is really at Jon. Jon, about a year would I asked a question, maybe longer about how you are looking at your new product pipeline and how you are measuring that internally in terms of effectiveness and projects that you fund versus those that you don't and sort of measuring the top line impact. I was hoping you could give us some of the internal thinking on that. Thanks.

Mark Gliebe

Good morning, Scott, thanks for the questions. As a practice we don't comment on the timing of pricing activity. But certainly we are analyzing the impact of steel on our total costs. So I will leave it there. Jon, do you want to try to cover the…

Jon Schlemmer

Just one thing I would add on the steel cost. As you mentioned, Early remark on the business with the large customers where we have material price formulas it takes care of itself, just a matter of timing on both when we realize the cost and implement the increases in the prices and on the rest of the business we are analyzing that right now and deciding what we need to do.

On the new products, yes, I remember that discussion. We absolutely continued to look at prioritizing the growth programs that we want to resource in the company. The two examples that I showed are two where we actually have large teams of dedicated engineers focused on those because we know that there is a long-term, a material impact from those programs. One as it relates to the climate business. There is quite a bit of legislative activity going on right now in the climate space and while one of the larger changes is a little farther out there in 2019, our customers engineers are currently looking at their platforms today and they are actively engaged with us on that product as well as a couple other new products that we're focused on for that particular application. And then, the same thing with the larger axial product, the CNI product very targeted on specific customer applications where there is a benefit for the energy efficiency and the smaller footprint. So we continued with putting, prioritizing the new product development program, Scott, so that rather than just looking at a count of new products and how many new products we release what is the impact of those programs.

Scott Graham

Right. That is exactly as you know what I was getting at because you had a very strong pipeline for several years and now you're trying to work this towards more of an effective pipeline. Would you say, Jon, that we are maybe at 1%, 1.5%, 2% organic increment from new products the last three years that the point?

Jon Schlemmer

You know, it is, I would say it's difficult, it's difficult for me to put an exact number on it. You know, some of these programs take, they do take longer even though I think we are doing a much better job of prioritizing. They have a little bit longer term benefit stream. But I think if you look at our organic while it is always challenging when you look at our organic sales being down 10% in a particular quarter it's hard for me to sit here and feel great about what we are doing on new products when overall organic sales are down 10% but we know that new products are absolutely delivering benefit on organic sales. There's no question about that. I would say on a year-to-date basis it's probably in the neighborhood of low single digits in terms of the impact but it is a positive impact.

Operator

Next we have Nigel Coe of Morgan Stanley.

Nigel Coe

Thanks, good morning. Just wanted to say, I just wanted to turn to the MPF bridge, I understand it turns positive and you get a revenue impact a positive revenue impact as opposed to a head winds. But my assumption was that the MPFs are basically a wash at the EBIT line. Obviously there is some timing differences. But why does it benefit earnings when fuel prices go higher?

Chuck Hinrichs

Nigel, this is Chuck. That is a very good question. It doesn't impact EBIT. As you said, it is neutral to the EBIT line. We do call it out because it is an impact on our top line and because it has turned. We have always said it would. But the impact on our price cost is going to be on the other 70% of our revenue that's not subject to the MPFs. And so we have as I describe whether it be the impact of the commodity hedges or the lagging effect of lower costs that will drive the improvement in the second half on the EBIT or our profit line.

Nigel Coe

Okay. That is very clear. And then I mean maybe I'm just digging into a little bit too deep here but the impact of the lower hedge prices for copper and then the inventory issue obviously you talked about I guess the higher cost inventory flush through in the first half of the year and lower cost inventory in the second half of the year. Is the lower hedge prices on copper is that double counting that or is that the same issue i.e. the lower hedge prices on copper get used for inventory that I guess, so I'll say, the lower hedge prices on copper, the raw material copper does that get put into inventory for sale in 2017?

Chuck Hinrichs

Yes, so in the second half of this year will he converting and selling and running through the P&L the hedged cost of copper in the first half. And we will see a lower second half cost of copper because of our hedges than we did in the first half. That will set up and contribute towards second half -- first half of 2017 as well. So you're right in your thinking. There is a lagged effect that applies both to our normal inventory as well as to our commodities that we have under the hedging program.

Nigel Coe

Okay so a two-step impact there. And based on your hedging program is 3Q the low point for your hedge prices?

Chuck Hinrichs

Well, it is different for different commodities. We don't hedge steel. We do hedge copper. So we will still see deflation in copper in the second half on the commodity hedges.

Nigel Coe

Okay, okay, great. And then just a final one on the commentary about 3Q pickup in the HVAC, North American HVAC, which we've heard from the OEMs. You said -- I think you said sequentially higher in 3Q than 2Q, which obviously is unusual but makes sense given the weather patterns. I just want to confirm that. And then maybe just clarify would you expect that business to be up year-over-year as well?

Mark Gliebe

So the answer on the first part is yes. As Jon mentioned, we are expecting the third quarter in our HVAC business to be up versus the second quarter which is unusual and that is usually -- unusual, it usually is down 1% or 2%. I didn't catch the second part.

Jon Schlemmer

Whether it would be up year over year. And Nigel, looking at our current demand levels in our HVAC business on unit basis, yes, and as I mentioned earlier while we see sequential improvement in the material price formulas price is still a headwind on a year-over-year basis in the third quarter but on a unit basis we are seeing demand growth in the third quarter for our North America residential HVAC business.

Nigel Coe

Okay. That is very helpful. Thank you very much.

Operator

Sam Eisner, Goldman Sachs.

Sam Eisner

Sorry. Just one quick follow up. On your implied $2.36 midpoint for the back half of the year what is the weighting that you guys are considering for 3Q and 4Q?

Jon Schlemmer

Well, Sam, the third quarter will be better than the fourth from seasonal factors, but I -- I don't have at my fingertips what the percentage of that earnings guidance would be third quarter versus fourth quarter.

Sam Eisner

Okay.

Jon Schlemmer

But you would expect third quarter to be heavier?

Sam Eisner

Yes. I just didn't know if there was anything because of the very easy comps that you guys have in the fourth quarter if you were anticipating that seasonality being offset by the easier comps.

Mark Gliebe

The only comment we made is that we are expecting a more normal heating season versus prior year but that gets back into the comp.

Sam Eisner

Right.

Jon Schlemmer

Sam, I would also point out on the comparisons in the fourth quarter of 2015 we also had a sizeable LIFO benefit in our results in that period.

Sam Eisner

Got it. Thanks.

Operator

Joshua Pokrzywinski of Buckingham Research.

Joshua Pokrzywinski

Hi guys, appreciate the follow up question here. Just to be clear on climate, I think Nigel touched on it a little bit. But how should we think about the second half between comps and the improvement in volume. Obviously the Middle East price impact or Middle East market impact starts to go away. Does that business grow at all in the second half and is it fourth quarter only, second half on average? Just maybe help us calibrate that given all of the moving pieces going on there.

Chuck Hinrichs

Well, Josh, I would just say that in general where no question we are looking at a better organic sales performance in the second half than we experienced in the first half. So I will start there. We are expecting that in the second half. We will still have price as a headwind to a lesser degree than we had in the first half. Comps will get easier in the Middle East. But we are really not forecasting much recovery there. We are not seeing it get sequentially worse and we will just simply have easier comparisons in the second half. And then we've already talked about the third quarter air conditioning season being quite strong for us and expecting a more normal heating season in the fourth quarter. So I think that is just the way you should think about the second, the overall second half performance.

Joshua Pokrzywinski

I would imagine by the time you get to the fourth quarter, growth is unavoidable regardless of the price environment.

Chuck Hinrichs

Well, there's no question we had a very unseasonable heating season in the fourth quarter of 2015 that carried into the first quarter of this year. No question about that. What we are forecasting is just a more normal heating season. If we get really cold weather like we are seeing the hot summer, then the comparisons will get quite favorable in the fourth quarter. We are not predicting it to be unusually good, just the normal heating season.

Joshua Pokrzywinski

Okay. I will follow up offline. Thanks.

Chuck Hinrichs

Thanks, Josh.

Mark Gliebe

Thanks, Josh.

Operator

Well, at this time we are showing no further questions. We’ll then conclude our question and answer session. I will now like to turn the conference call back over to Mr. Mark Gliebe for any closing remarks. Sir?

Mark Gliebe

Thank you, everyone, for your questions and for your interest in Regal. Have a great day.

Operator

And we thank you sir for your time today and also to the rest of the management team. Again, the conference call is now concluded. At this time you may disconnect your lines. Again, we thank you all for attending today's presentation. Take care.

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