SPX FLOW's (FLOW) CEO Marc Michael on Q2 2016 Results - Earnings Call Transcript

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SPX FLOW, Inc. (NASDAQ:FLOW) Q2 2016 Earnings Conference Call August 3, 2016 8:30 AM ET

Executives

Ryan Taylor - Vice President of Communications and Finance

Marc Michael - President and Chief Executive Officer

Jeremy Smeltser - Chief Financial Officer

Analysts

Shannon O'Callaghan - UBS

Mike Halloran - Robert W. Baird

Nathan Jones - Stifel

Julian Mitchell - Credit Suisse

Robert Barry - Susquehanna

Ryan Cassil - Seaport Global

Deane Dray - RBC Capital Markets

Operator

Good day, ladies and gentlemen, and welcome to the Second Quarter 2016 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to introduce your host for today’s conference, Mr. Ryan Taylor, Vice President of Communications and Finance. Sir, you may begin.

Ryan Taylor

Thank you, Liliana and good morning everyone. Thank you for joining us this morning. With me on the call are Marc Michael, our President and CEO of SPX FLOW; and Jeremy Smeltser, our Chief Financial Officer. Our Q2 earnings release was issued this morning and can be found on our website at spxflow.com. We also filed our Form 10-Q this morning along with two other news releases related to a bond offer and tender offer as we plan to refinance a portion of our debt here in the third quarter.

This call is also being webcast with a presentation located in the Investors section of our website. I encourage you to follow along with the presentation during our prepared remarks this morning. And a replay of this webcast will also be available on our website later today.

Portions of our presentation and comments are forward-looking and subject to Safe Harbor provisions. Please also note the risk factors in our most recent SEC filings. In the appendix of today's presentation, we have provided reconciliations for all non-GAAP and adjusted financial measures presented and I encourage you to study the appendix.

And with that I’ll turn the call over to Marc.

Marc Michael

Thanks Ryan. Good morning everyone and thank you for joining us on the call. Coming into this year, we were faced with the challenges of an uncertain macro environment and cyclical downturns in two of our key end markets, oil and dairy. For the first half, we saw some pockets of stabilization in order trends, most notably in aftermarket orders across our businesses, as well as component and small systems orders in our food and beverage segment.

In contrast, orders in our Power and Energy and Industrial segments declined below the run rates we experienced in the second half of 2015. Broadly speaking, customers are pushing out capital investments as they managed through a challenging an uncertain macro and geopolitical economic environment. Based on current trends, we do not anticipate any meaningful recovery to recent order trends over the balance of this year.

Given this, we are aggressively reducing cost and taking a prudent approach to managing our business over the next 18 months. At the end of Q2, we amended our credit facility and initiated plans to refinance our $600 million of senior notes due in 2017, which we announced earlier this morning. We believe these actions will give us greater financial flexibility going forward and reduce our annual interest cost.

Jeremy will provide more details on the refinancing later on in the call. As it relates to our realignment program, we are accelerating certain actions previously included in the plan and we have also identified incremental actions that we plan to initiate this year. In aggregate, over the three-year period 2015 to 2017, we now expect to invest $160 million of realignment with an annualized savings target of at least $135 million.

For 2016, we are now targeting $60 million of cost savings, up $20 million from our previous target. We expect the majority of the savings to come from actions already taken or planned. We also increased our expected restructuring expense for this year to $80 million to account for the acceleration of certain actions, as well as the incremental actions we have identified. The majority of savings from these actions are expected to be realized in 2017.

I’m confident that we are taking the necessary steps to mitigate risk in the short-term, while at the same time reducing our cost structure in improving our competitive position. I believe all the steps we are taking will establish a healthy foundation for long-term success as a high performing operating company. Despite the current demand environment, we remain confident in the long-term fundamental growth of our key end markets.

We remain disciplined in our approach to pricing, particularly on large projects. And we are focused on our growth efforts on increasing our aftermarket presence in expanding high value product lines into adjacent markets. I’m proud of our teams globally for embracing our strategic initiatives and aggressively executing our realignment program.

During the first half of the year, we made significant progress reducing our cost structure, realigning our footprint and streamlining our functional support globally. We have reduced headcount by 9% and expect to be within our target range of 10% to 15% by the end of the year. Looking at a savings progress, in Q1, we reported $7 million of year-over-year savings. In Q2, we saw a meaningful acceleration with net savings of $16 million.

With $23 million of savings realized in the first half, we are ahead of our original savings target for the year. We now expect to realize savings of approximately $60 million in 2016 and $55 million in 2017. As it relates to footprint consolidation, during Q2 we transferred the manufacturing of heat exchangers from Denmark and valves from Germany into our new factory in Poland.

Our team at Poland is aggressively ramping up production of these two product lines. As this year progresses, we expect to see improved production and reduce transition costs associated with the first phase of emigration to Poland. The next step is to transfer homogenized remanufacturing. We plan to have that completed by year end at which time we expect to be in a position to close the facilities in Germany and Denmark and initiate additional site consolidations into Poland.

During Q2, we also announced and began to execute two smaller facilities to consolidations, one in North America and one in China. These transitions are part of our overall target to reduce our manufacturing square footage by 10% to 15%. The majority of the actions we are executing are aimed at simplifying our cost structure as we transition our business to an operating company.

To that point, we estimated about 75% of the targeted savings or structure in nature and about 25% co-related to volume declines, particularly in our Power and Energy segment. As we transition to an operating company, we are aligning our segment teams to focus on developing intimate customer relationships and expanding customer relevance within each end market.

The key areas our end market teams are emphasizing include product management, channel development, engineering customer solutions, and project execution and delivery. To support our end market teams more efficiently, we are streamlining our functional support globally. We've made good progress on this front in certain areas and we have plans to streamline other functions to simplify and reduce our support structure.

Our ultimate goal is to create a more customer centric service oriented organization and deliver greater value to our customers, investors, and employees. Consistent with this approach, we've recently appointed new end market presidents to lead our Food and Beverage and Power and Energy segments. In June, we announced that Dwight Gibson joined our team as President of Food and Beverage. We’re very pleased and excited to have Dwight join our team.

He comes to us from Ingersoll-Rand with a proven track record of developing and leading growth in emerging markets and strategic product categories. Dwight’s vast experience in delivering customer value and his experience in Ingersoll-Rand’s business operating systems are key areas of strength that fit very well with our strategic initiatives in transition to an operating company.

Through his strong leadership skills, international background and nearly 20 years of business development, we expect Dwight to have a positive influence on growth and future business development of our Food and Beverage business. And in our Power and Energy segment, Tony Renzi has announced his plans to retire in August.

Throughout his 13 years of service with FLOW, Tony has brought leadership in many different capacities. Most notably, he led a successful integration of APB and ClydeUnion. We will miss Tony, and I would like to personally thank him for his dedication and contributions to the business.

We've been powerfully thoughtfully working on Tony’s succession plan and today I’m excited to share with you that we have appointed Jose Larios as President of our Power and Energy segment. Jose joined our team in July 2015 as Vice President of OE Sales for Power and Energy. In that role, Jose has strategically expanded our customer base and our presence in new markets.

He has also provided a strong leadership for our sales teams during the extremely challenging conditions we’re experiencing in the oil sector. He brings 19 years of experience in the oil and gas industry, including 15 years at GE, where he gained experience in project execution, product management, marketing, operations, and global commercial leadership. Given the market development emphasis we are placing on our end markets Jose’s experience aligns well with our strategy.

Looking now at our financial results for Q2, revenue was $529 million in line with our guidance, versus the prior year organic revenue decline 12% and currency was at 2% headwind. Segment income was $57 million or 10.7% of revenue. On an adjusted basis, operating income was $43 million and earnings per share was $0.46, above the high end of our guidance range.

Sequentially, adjusted operating income more than doubled and operating margins improved 430 points. On a GAAP basis, we recorded a $426 million impairment charge to write-down, goodwill, and certain intangible assets within our Power and Energy segment. This charge reflects the challenging environment in oil-related markets. During the quarter, we also recorded $11 million of special charges as anticipated.

Moving to orders and backlog, we ended Q2 with a total backlog of $881 million, down 7% sequentially. Backlog declined across all three segments. Orders were down 8% sequentially. Broadly speaking, we saw a very low level of order activity for medium and large Capex investment during Q2. Specifically, we did not book any large system orders in our food and beverage business as several customers delayed order placement.

In our industrial segment, we also experienced a moderate slowdown in run rate orders. Looking at the specific trends within each market, in Food and Beverage, we continue to see steady demand globally for aftermarket parts and services and demand for components has been good this year, particularly across North America and Europe.

In our systems business, timing of order placement can vary quarter-to-quarter, particularly on large projects. In contrast to Q1, where we were awarded $55 million of large dairy projects, we did not book any large orders in Q2. On a positive note, however small to medium system orders were up both sequentially and year-over-year. And quoting activity remains encouraging. Our front log of systems opportunities continues to grow during the quarter with new projects concentrated on nutritious product categories and fresh dairy, nondairy alternatives, and nutritional beverages.

In the milk powder market, the global surplus of skim and whole milk powders continues to delay customer investment for new capacity. At this time, given what we are hearing from our customers we do not expect this part of the market to recover until 2017. In our Power and Energy segment, total Q2 orders increased 2% sequentially of a low base. Aftermarket orders were also up 2% quarter-to-quarter driven by spares and services.

In Power, we continue to see positive developments, particularly in nuclear. During the quarter, we awarded an $8 million order to provide safety pumps on an existing nuclear plant in France. And we continue to monitor the progress on plans of new nuclear bills in the UK, India, and China, which represent very good future opportunities for our high value safety pumps and valve products.

In all related markets, OE order activity remains stable at very low levels and the overall environment continues to be very competitive. In the midstream, we have an active front log off opportunities to supply pipeline valves on approved projects. However, timing of order placement is difficult to predict as several of these products continue to be delayed.

Our focus on Power and Energy is on increasing aftermarket sales and remaining disciplined on OE orders. Profitability in this segment improved nicely from Q1 to Q2 and we expect to see continued recovery and profitability as the year progresses, driven largely by our restructuring actions and cost savings initiatives.

In our industrial markets, orders in Q2, declined 5% sequentially. From a product line perspective, order run rates for hydraulic tools, industrial mixtures and dehydration products slowed during Q2. We also experienced a lower level of capital spending broadly across all the product offerings in this segment.

On a year-over-year basis, orders in this segment were down 10% reflecting general weakness across industrial and process markets. For the full year, our updated guidance reflects the first half results and our revised expectations for the second half. Based on the ending Q2 backlog in current trends in our run rate business, we now expect revenue to be down 12% to 15% year-over-year. This includes a 2% headwind from currents currency.

As compared to the midpoint of our prior guidance, we reduced our revenue target by $85 million to just under $2.1 billion. We expect to offset a large portion of the volume decline primarily through the increased cost savings, as well as other cost measures. On an adjusted basis, we narrowed our targets for adjusted operating income, EPS, and EBITDA to the bottom end of our previous targets. At the midpoint, we are targeting $240 million of EBITDA that’s a 2% below our prior guidance.

At this time, I will turn the call over to Jeremy to review our Q2 financial performance and 2016 guidance in more detail.

Jeremy Smeltser

Thanks Marc, good morning everyone. I’ll begin with earnings per share. On an adjusted basis, EPS was $0.46 in the quarter, above our guidance range. As compared to our guidance, lower corporate expense was a $0.04 benefit and segment income was a $0.03 benefit. On a GAAP basis, we reported a loss of $8.52 per share. This included a non-cash impairment charge of $8.77 per share or $426 million before taxes to reduce the goodwill and certain intangible assets within our Power and Energy segment.

In the 10-K we filed in February, we indicated that a further decline in order rates during the first half of this year would require us to retest the segment for impairment. Quarterly order rates in this segment moved lower over the past six to eight quarters, including a 12% decline in the quarterly run rate from the second half of 2015 to the first half of 2016.

The impairment charge reflects the impact of lower oil prices and the resulting decline in capital spending across the energy industry that had on the revenue and profitability of our Power and Energy segments. During the quarter, we also recorded $0.21 as special charges related to our realignment program.

Moving on to the segment results, beginning with Food and Beverage, revenue was $188 million, down 20% versus the prior year. Currency was a 1% headwind. Organic revenue was down 19%, due primarily to lower revenue from large dry milk projects. Segment income was $20 million or about 10.5% of revenue. As compared to last year, the decline in profitability was due to the organic revenue decline, partially offset by solid execution on SG&A and cost reduction initiatives.

In our Power and Energy segment, revenue was $156 million down 15% versus the prior year. Currency had a 3% impact and organic revenue was down 12%, due to lower OE sales in the upstream and midstream. We also recorded revenue on a nuclear project in Q2 2015, which did not repeat this year.

Segment income was $10 million, as compared to $23 million last year. The sharp decline in profitability versus the prior year was due largely to the revenue decline, as well as shipment of lower margin backlog and low utilization rates at some of our larger manufacturing sites. These declines were partially offset by savings from restructuring actions. We are encouraged with the increase in profitability from Q1 to Q2.

We expect to see continued restructuring benefits in the second half. That said, given the lower level of orders in the first half, we continue to evaluate additional restructuring actions in this segment. And at our industrial segment, revenue was $185 million in Q2, down 6% versus the prior year. Currency had a 2% impact. Organic revenue declined 4%, due to lower sales of hydraulic tools, heat exchangers, and dehydration equipment.

Segment income was $27 million, down $1 million versus the prior year, due primarily to the organic revenue decline. These declines were largely offset by restructuring savings and cost reduction initiatives. This is reflected in the margin, which improved to 14.5%, 30 points above the prior year period an 310 points better than Q1.

Looking at our third-quarter modeling targets on a consolidated basis, we expect revenue of about $500 million, down about 5% sequentially, due primarily to lower shippable backlog in our Power and Energy and industrial segments. We expect segment income to be between $50 million and $60 million with margins at approximately 11%. This is relatively flat to Q2 as we believe we will offset the headwinds on the topline with incremental cost savings quarter-to-quarter.

Corporate expense is also expected to be flat to Q2. On an adjusted basis we are targeting between $0.35 million and $0.45 of operating income and earnings per share of $0.45 at the midpoint. In our adjusted guidance, we are modeling a tax rate of 28% and 41.5 million shares outstanding.

In our GAAP model, we are targeting $10 million to $20 million of special charges related to the realignment actions Marc discussed earlier. With respect to the debt refinancing, we expect to record a charge of about $38 million, related to the early retirement of the bonds. From a cash flow perspective, payments related to the debt refinancing are estimated to be approximately $50 million in Q3.

On a GAAP basis, we expect to report a loss per share of about $0.60. Note that our GAAP tax rate is expected to be around 10% in Q3. Note that the GAAP tax rate is significantly lower than the rate in our adjusted earnings, as a result of the impact of the impairment charge on our full year blended tax rate.

Looking now at our revenue and segment income on a sequential basis, we expect the fourth quarter results to benefit sequentially from timing of revenue recognition on food and beverage projects and backlog, primarily related to the large projects we announced that we had won in Q1. In our Power and Energy Group, we also have a modest increase in OE orders scheduled to ship in the fourth quarter, including a few nuclear orders.

In those two segments, we also expect to see a modest seasonal uptick in aftermarket spares and replacement components. For industrial, we have assumed revenue was flat from Q3 to Q4, and consistent with the order rates we experienced exiting Q2. We think this is prudent given the short cycle nature of this segment and the low level of capital orders we have seen over the past few quarters.

As it relates to segment income, in addition to leverage on the higher revenue we also expect to see strong sequential improvement from our cost savings initiatives. In addition, we expect transition costs on the manufacturing consolidation in Poland to decline in Q4. And we are forecasting a modest improvement in absorption. On a full-year basis, we have revised our segment targets to reflect our first half results and revised outlook for the second half.

For Food and Beverage, we narrowed our revenue target to a range of $745 million to $765 million. We increased our margin target for Food and Beverage to approximately 11.5% with the expectation of incremental cost savings in the second half of the year and better leverage on the revenue increase in the fourth quarter. In Power and Energy, we lowered our revenue target to a range of $590 million to $610 million.

Given the first half order rates, we expect revenue to be down in the second half. Our revised margin target for Power and Energy is 7% to 8%. This assumes incremental cost savings in the second half of the year and a higher mix of nuclear and aftermarket revenue in Q4. And for industrial, we have lowered our full-year revenue target to between $700 million and $720 million with margins between 14% and 15%.

On a consolidated basis, we are now targeting just under $2.1 billion of revenue with segment income margins between 11% and 20%. Looking at our full year model, first on a GAAP bass basis, as Marc mentioned we increased special charges to $80 million for the year, up from $60 million in our previous guidance. We expect the majority of these savings from the incremental and restructuring actions to benefit 2017.

The GAAP guidance also includes the Q2 impairment charge, the net pension funding to retirees, the debt refinancing in Q3 and a $22 million tax credit in Q4, which is the incentive from Poland for the manufacturing expansion investments. Excluding all of these items, our adjusted EPS guidance for 2016 is $1.85 per share to $2.05 per share. And we expect to generate about $150 million of adjusted free cash flow for the year, the majority of which is expected in Q4.

Moving on now to our financial position, free cash flow in the second quarter was $26 million. During the quarter, we invested $16 million in restructuring. We also invested $14 million in Capex, half of which related to the new facility in Poland. On an adjusted basis, Q2 free cash flow was $49 million, a significant improvement over Q1. We ended the quarter with $229 million of cash on hand and just over $1 billion of total debt. Net leverage was at 3.1 times.

As it relates to the debt refinancing, as we've said previously, we have been monitoring the debt markets and evaluating various opportunities to refinance our $600 million 6.875% senior notes, which mature in August of next year. Following the Brexit vote, the U.S. high-yield market has seen a significant amount of cash inflows with many international investors looking to invest in the U.S. market.

We've seen three solid weeks of activity in the high-yield market and after considering several different options, we believe this is a very good opportunity for us and have made the decision to move forward. Earlier today, we announced our intention to offer $600 million of new senior unsecured notes targeting to split equally between an 8 year and 10 year tranche.

Subject to market conditions, we expect to be able to secure these notes at beneficial pricing to our current rate by the end of this week. It is likely for all of the bond transactions to close in the first half of August. That concludes my prepared remarks.

At this time, I’ll turn the call back over to Marc.

Marc Michael

Thanks Jeremy. In summary, I’m pleased with the progress our teams across the enterprise have made addressing our cost structure through the first half of the year. That said, given the challenging order environment we are accelerating our realignment program and identified plans to further reduce our cost structure. I’m confident that we will execute on these plans and achieve our increased savings target of $135 million.

We're holding firm to the value creation and our 2018 illustrative model. Based on the actions we have planned and on flat revenues to 2016, we are targeting just under $300 million of EBITDA and nearly $5 of free cash flow per share in 2018. Furthermore, I believe all the steps we are taking will establish a healthy foundation for long-term success and enable us to better drive and leverage organic growth going forward.

That concludes our prepared remarks, I appreciate you joining us on the call this morning and at this time, we’ll be happy to take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from the line of Shannon O'Callaghan with UBS. Your line is now open.

Shannon O'Callaghan

Good morning guys.

Marc Michael

Good morning Shannon.

Jeremy Smeltser

Good morning Shannon.

Shannon O'Callaghan

Hey Marc just on the illustrative model for 2018, I mean obviously things have been more challenging and excited and sort of continued to be that way, when you think about trying to achieve that, what kind of flex or other leverage you have, if you think about things continuing to be a little more challenged that you plan?

Marc Michael

So when we came in to the year Shannon we, the team came together and we identified the $110 million that we believe we could achieve and as we said at the start of the year our focus and emphasis, which is going to be to continue to look for other opportunities and what you're seeing reflected today is the outcome again continuing to look at where we can gain efficiencies across the organization globally and looking at how we can be more effective in our functional activities, as well as through the business and translating into lower cost countries with certain parts of our resources reducing structural costs in general.

So that’s something we are going to continue to look at as we move through the second half of the year. And I do believe that there can be additional opportunities that we will identify as we move through the year. And my commitment is to, based on the run rate of our business and what we see happening, is to adjust accordingly and to hold for that commitment to achieve this 2018 objective that we have. And the team is fully committed to that. And I feel confident, if we do see additional reductions in order to run rates that will take the necessary steps to continue to keep the cost structure in line with the run rate of business.

Shannon O'Callaghan

Okay thanks. And then just, on the dairy market, I mean it has been tough for several quarters, but yet you got the large projects in the first quarter and now all the large projects are grown gone, I mean can you just maybe make sense of a little bit of that and I mean could these things continue to come and go, or does it really feel like that no one is really in a position to be doing any large projects anytime soon?

Marc Michael

And there’s still some large projects out there. You know the front log in general actually increased quarter-to-quarter modestly. So, we still see activity and a lot in the fresh dairy space and the nutritional space still remains good and that’s where we've seen a lot of orders and again in Q2 there were some of the smaller type orders, which again isn't necessarily a bad thing, if we can execute on those things orders more quickly and typically there is more attractive in general.

So there are a large orders still out there. It's been more a question of timing and I think there will be some of those that will develop, you know still the pressure point remains around the commodity space and in the powder market. So the skimmed milk powders and the whole milk powders, and that’s where there is really the major void of activity. The overall supply demand balance is expected to improve as we move through 2016 and into 2017.

So some minor recovery we would think we would start to happen as we get in through the first half of 2017. That being said those large powder projects will probably still be pretty limited just based on the fact of continuing recovery, but you know that hasn't been a huge part of our business historically. We’ve focused on more the high value products versus the commodity products. And again, we do still see a few large projects out there that we're working on in the high value nutritional space, but again we're still very encouraged with the front log overall that has been maintaining over the last four quarters or so. And again then even slightly improve from Q1 to Q2 in terms of just overall activity in the front log.

Shannon O'Callaghan

Okay great, thanks.

Marc Michael

Sure.

Operator

And our next question comes from the line of Mike Halloran with Robert W. Baird. Your line is now open.

Mike Halloran

Hi, morning guys.

Marc Michael

Good morning Mike.

Jeremy Smeltser

Good morning Mike.

Mike Halloran

I just want to want to attack on his question there, so components are doing fine on the Food and Beverage side, you know the aftermarket is doing okay as well, obviously the dry dairy markets where the headwind is. So as you just said Marc that is a smaller piece of the business historically. So, as we track towards 2017, are you guys in the mode where you are planning for growth in that segment or do you think that some of those dry dairy trends just override what the overall market looks like for the segment specifically?

Marc Michael

For the segment specifically, I mean the overall environment we’re not planning for growth. We’re planning, I would say for stability across the Food and Beverage space as we look at 2016 versus 2017 and that’s really how we would cash it. We did have the good orders in Q1 that were larger, but we didn't necessarily plan on that in our 2016 outlook either and again that’s why we are seeing some favorability as we move into Q4 as those projects start to execute. So, our approach and are thinking around our food and beverage businesses that will see consistency as we move into 2017.

Jeremy Smeltser

And I will add a couple of points Mike, I think. One if you go back to Q1, the order run rate was around $250 million or so in the quarter and if you back out those three large orders you are at $160 million and we were at about the $180 million in Q2, and so what that means is on the smaller system side, sequentially we actually did see an improvement, and so that's one positive and relatively consistent with our expectations. The larger order timing is pretty lumpy and is certainly a challenge to predict timing, but I also look at the backlog at year-end compared to the end of Q2 and it’s up $20 million, $25 million. Now, we will work of some of that as we start recognizing revenue on those large projects, particularly in Q4, but it really supports the stability that Marc just mentioned. Has a current look at where we can kind of predict in the 2017 as of today.

Mike Halloran

That makes sense and then just on the ramp from 3Q to 4Q, it sounds like this is a function of cost savings, project timing and then maybe a little bit of seasonality, is there anything that you are expecting that’s aberrational that's maybe above normal seasonality or embedding improvement, it doesn't sound that way, but just want to make sure I understand what the thought processes is from an underlining market perspective.

Marc Michael

Yes, and it is pretty consistent with everything you just said and pretty consistent with our historical ramp. I would say the one unique thing in this year's seasonal profile from Q3 to Q4 would be that, particularly in queue Q2 and Q3 both we do have over burdened transition cost as it relates to the manufacturing transition from Denmark and Germany and to Poland and we expect that to start dissipating in Q4 and that certainly helps the sequential profile.

Mike Halloran

That makes sense and then last quick one, the potential debt refinancing or the swapping that you are doing that is not - any benefits would not be embedded in your guidance range, correct?

Marc Michael

That's correct.

Mike Halloran

Great, thanks guys. Sorry.

Marc Michael

Probably one quarter of slightly lower interest expense in the model than we previously had, but it’s pretty immaterial to this year.

Mike Halloran

Great, thank you.

Marc Michael

Thanks Mike.

Jeremy Smeltser

Thanks Mike.

Operator

And our next question comes from the line of Nigel Coe with Morgan Stanley. Your line is now open.

Unidentified Analyst

Hi guys, good morning it’s Drew [ph] on for Nigel.

Marc Michael

Hi Drew.

Jeremy Smeltser

Hi Drew.

Unidentified Analyst

Just a quick one on Power and Energy, I wanted to get your thoughts on 2017 and really in the context of the backlog, if you just look at the backlog at year-end 2015 versus the outlook this year and then in kind of in the backlog of 364 and kind of assume that that holds and implies another sort of mid-single digits decline into next year, is that generally how you are thinking about the likelihood of a headwind in Power and Energy next year, is there anything you are seeing in MRO or maybe the small project funnel that crossed at that?

Jeremy Smeltser

Not as of now. I mean if you just do the math and look at the backlog as you did and look at the current order run rate, I think you get mid-to-high single digit, really depends on what happens to the order run rate in the second half of the year and obviously the first half of next year.

Unidentified Analyst

Okay, makes sense. And then just one follow-up on the free cash flow and I recognize there is quite a few hurdles to get through this year on the cash calls, but could you just update us on how you're thinking about capital allocation next year and maybe in the context of the $200 million of illustrative free cash flow that you highlighted? Thanks.

Jeremy Smeltser

Sure, I mean the illustrative is really a 2018 figure and excludes any restructuring spend and then has all the savings in it. For 2017, I would expect it to be below that level. I don't have a specific 2017 number today, but as it relates to capital allocation for 2017, the way I'm thinking about it as of right now is that it remains very consistent with our approach in 2016, which is predominantly focused on the remaining restructuring actions and the realignment program, and if there is additional capital, I would expect it to be towards delivering at this point based on where we are at from a leverage perspective. You know we don't see anything that tells us based on our current order run rates that we would be active from the stock buyback acquisition or dividend perspective in 2017. That would not be reflective of the current environment that we see ourselves in.

Unidentified Analyst

All right, thanks guys.

Jeremy Smeltser

Thanks Drew.

Marc Michael

Thank you drew.

Operator

And the next question comes from the line of Nathan Jones with Stifel. Your line is now open.

Nathan Jones

Good morning Marc, Jeremey, Ryan.

Marc Michael

Hi Nathan.

Jeremy Smeltser

Hi Nathan.

Nathan Jones

I figured, I’ll start on Power and Energy, I mean that’s really where the reduction in the fundamental outlook came from, can you talk about if it was concentrated in Power or in upstream, midstream, downstream or pass out a little bit more how those different parts of the market and looking and how it changed from the first quarter?

Marc Michael

Yes sure Nathan. Sequentially, Q1 to Q2 we actually as mentioned saw a slight increase modest albeit again of a very low base. Short cycle orders were up about 2% sequentially and really kind of hanging in there and short cycle being where the aftermarket and service part are for business. The margin profiles are holding up okay too. OE business does continue to be a challenge again off of a cyclically low point and I think in orders if you look over the past six quarters or so, but again sequentially we still overall for a Power and Energy grew we are basically flat if we look Q1 to Q2 for OE orders.

If you break it down into oil and gas, upstream we saw a slight uptick there, not really significant, but a slight uptake. Midstream is the area that we're watching more closely with our value orders. Again the front log as we mention remains active and projects are identified that we're working on, but the timing of those orders has continued to move to the right so that was where we saw some softness in the order intake in the midstream area. And then downstream for us is significant. When we look at Power, we did have an order in nuclear in Q2, which helped that part of the business out and those nuclear orders are nice for us again we're working on several orders or order opportunities in the nuclear space when we look at the activity across India, the UK, China.

So those nuclear orders as we mentioned in prior calls can be nice and support us. And so that again help offset some of the softness that we saw in the midstream area in terms of the overall OE orders development quarter-to-quarter. But again, we didn't see deterioration overall, we came basically flat quarter-to-quarter sequentially on our aftermarket and short cycle business, up modestly again a couple of percent, but we didn't see deterioration, I guess that’s the good part of what came out of Q2 for us.

Nathan Jones

Okay. And if we are thinking strategically and a little bit longer term here, you've got system consolidation into Poland, which is all Food and Beverage, we haven't yet heard of any plans to do a similar seeing maybe in the Power and Energy segment or in the industrial segment, are there opportunities to do something similar to Poland in either of those segments down the road?

Marc Michael

Yes, so for Poland, our heat exchanger business has moved into Poland and we’re up and running 100% there and things are progressing very well with our heat exchanger business in Poland in terms of the production output. So that’s on track, we ramped up quickly, we’re already matching what we were doing in our Denmark facility for heat exchangers and we are seeing really better efficiencies developing in terms of the overall labor required to produce our heat exchangers in Poland.

So those heat exchangers sit in an industrial segment because they touch so many vertical end markets and that’s to give one example of moving into an industrial product in there and we do, when we look at Poland we do have plans as we previously mentioned for additional consolidations there. We haven't announced those formally as of yet and again out of respect for our organization and the requirements that we have there, we will do that once we've had the right conversations with our organization, but we do have plans to more, identify at least a couple of other possible opportunities in Poland.

So Poland is going to be multipurpose for both our Food and Beverage, as well as our industrial business. And then in power and energy if you reflect back we have already taken some steps to do some consolidations in Power and Energy. We've moved some activity, or consolidated some activity in North America prior to this year for Power and Energy. And what I’d also mentioned, if you think about what we just announced to or look back at what we just announced in terms of North American consolidation, we moved, we consolidated some of for industrial operations with one of the plant closures in North America.

And then we did a similar thing with one of the industry groups in China. We moved that plant, one of the plants that was in the industrial segment we consolidated into [indiscernible]. So, we're looking at this very holistically, I guess is the message and we're taking advantage of the opportunities that exist to consolidate our factories where we see the opportunities and we will continue to do that and that’s part of our plan as we continue into 2017.

Nathan Jones

Okay, then I know you've already been asked about the potential outlook in Power and Energy in 2017 and Food and Beverage in 2017, I know industrial is pretty short cycle, do you have any preliminary outlooks for growth, no growth or negative growth in 2017 in that segment at this point?

Jeremy Smeltser

I mean, all we can really say is the current order run rate in the first of the year is down about, blended about 5% compared to the quarterly order run rate last year. As it relates to Q3 and Q4, what we’ve embedded in our 2016 numbers are consistent with Q1 and Q2 and we will just have to see what happens from a global industrial BMI perspective.

Nathan Jones

Fair enough, thanks for the time.

Marc Michael

Thanks Nathan.

Jeremy Smeltser

Thanks Nathan.

Operator

And our next question comes from the line of Julian Mitchell with Credit Suisse. Your line is now open.

Julian Mitchell

Hi, good morning.

Jeremy Smeltser

Hi Julian.

Marc Michael

Hi Julian.

Julian Mitchell

Hi. Just wanted to circle back to the EBIT jump in Q4 sequentially, so if you look at slide 20 you’ve sort of got your base segment income a lot higher in Q4 than in Q2 with the same revenue base, is all of that gap the lower transition costs that you talked about?

Jeremy Smeltser

Well, no that is additional sequential cost savings from…

Julian Mitchell

Oh, but I meant from the base segment income. So, I think that’s separate from savings.

Jeremy Smeltser

Oh on the grey bars, got you. So, we talked about Poland, we talked about some nuclear awards that we already have in backlog in Power and Energy. We also talked about our typical seasonal aftermarket increase from Q3 to Q4, I mean those are the big drivers in the base grey bars that you see on slide 20.

Julian Mitchell

Okay. All right. I guess I'm just confused, I’m a probably comparing with Q2 where you've got the same revenue number, so I guess there is some revenues going up, I guess versus Q2, but there must be something coming down?

Jeremy Smeltser

That’s really a mix improvement with that aftermarket revenue that we talked about.

Julian Mitchell

Okay, perfect and then I guess any color you could give on pricing trends across the different segments. You had very heavy sort of gross detrimentals in Power and Energy for example in Q2, you pulled out a competitive environment a couple of times, has pricing changed anywhere versus three months ago, I guess particularly in Food and Beverage or power or you think it is pretty consistent?

Marc Michael

What I mentioned overall, if we look at the run rate business it’s holding up fairly well and that’s pretty much across the three segments. The primary area that continues to be challenging is in OE pumps in the oil and gas base especially and P&E. And then when you look at industrial, what would be larger projects in industrial again these kind of $1 million to $5 million, may be up to $10 million range, those have been very few, but when there are ones out they are quite competitive and we would be very disciplined in our approach and we have actually chosen not to take some orders that have gotten to competitive as we've looked at the market environment.

And then Food and Beverages I would say that the opportunities that are the larger ones that are out there, again there hasn't been too many of them so far. The once we went in Q1 we've been working on for quite some time and so we will have to see how those larger Food and Beverage orders kind of play out as we move through the rest of this year to see what happens with the pricing in that particular area.

Julian Mitchell

Very clear, thank you.

Marc Michael

Thanks Julian.

Jeremy Smeltser

Thanks Julian.

Operator

And our next question comes from the line of Robert Barry with Susquehanna. Your line is now open.

Robert Barry

Hi guys good morning

Marc Michael

Hi Robert.

Jeremy Smeltser

Hi Robert.

Robert Barry

So a couple of things to clarify, the earlier comments about Power and Energy kind of high-level read, down made to high single, was that a next 12 months comment or was that a 2017 comment.

Jeremy Smeltser

It was really a 2017 comment based on the current backlog at the end of the second quarter and then extrapolating the run rate of orders in the first two quarters of this year.

Robert Barry

Got you. And the restructuring that’s incremental versus last quarter, the extra 25% $25 million, how much of that is structural.

Jeremy Smeltser

It is actually $20 million is what we’ve raised this year in the full program in total dollars and I would say the vast majority view as structural.

Robert Barry

Got you. And so you are still kind of…

Ryan Taylor

This is Ryan, just to clarify, so $20 million of incremental restructuring expense in 2016, your question might have been more geared towards the $25 million of savings?

Robert Barry

Yes exactly. I guess where I’m going is, just it seems like you are continuing to find significant structural restructuring opportunities and…

Jeremy Smeltser

Yes that’s true and as I mentioned earlier, also we will continue to look for those opportunities, but we’re also gaining efficiencies across the organization. So, as we are managing the cost structure, we do pick up efficiencies along the way that reflect in the savings that you are seeing and again as mentioned also we are ahead of schedule $23 million in the first half and that’s why again we look if we just extrapolate out what we saw in Q2 the $16 million, we expect to continue to be successful to that level and then build upon it.

Robert Barry

Got you. And could you maybe provide a little color on the verticals within industrial where you are seeing the incremental pressure, is it oil and gasoline things or is it spreading elsewhere?

Marc Michael

Our industrial product lines serve us a lot of different verticals. That touches the general industrial space and if you look at dehydration for example that does go into a lot of different applications. We did see deceleration during the quarter and I think that would again be a reflection of the overall general weakness in the industrial space or continue to be muted in the industrial space. And we look at that product as being a proxy to what's going on in the markets in general.

So, we did see a sequential decline as we move through the quarter from month-to-month and again below Q1. If you look at our hydraulics business, we do - in the MRO space there and our bolting business, so it touches a level of oil and gas and again other parts of the industrial space. So, again it was, hydraulics was at a lower level also and then our mixture business is pretty broad-based also touching oil and gas and industrial and we saw that down Q1 to Q2. So, it’s pretty, it’s still pretty muted market out there in terms of the macro environment. Obviously, for oil and gas and also we believe we saw a weaker scenario from Q1 to Q2 in the general industrial space.

Ryan Taylor

I would add, you know we do have a lot of – the global compressor guys in our customer base for our dehydration equipment. And we saw they are spending decline sequentially as well Q1 to Q2.

Robert Barry

Right, is that geared to the heavy industrial?

Ryan Taylor

Pretty broad based actually. All scale.

Robert Barry

Got you. Any regions or is that also pretty broad based?

Ryan Taylor

Both U.S. and Europe.

Robert Barry

Got you. Thank you.

Ryan Taylor

Sure.

Operator

[Operator Instructions] And our next question comes from the line of Ryan Cassil with Seaport Global. Your line is now open.

Ryan Cassil

Good morning.

Jeremy Smeltser

Good morning Ryan.

Marc Michael

Hi, Ryan.

Ryan Cassil

Maybe just go to back to the nuclear for a second, in the opportunities there in China and India, we've seen some activity in China with the 81,000 just wondering if you think some of those order possibilities are more of a second half story or really 2017 at this point?

Marc Michael

Yes, you know again the nuclear, the large orders are difficult to find sometimes in other product lines and when you get into nuclear sometimes you need to get some more challenging based on all the requirements that are associated with gaining final approval and moving forward given the capital expenditures and the regulatory requirements. So, we would hope to see some in the second half of the year, but there is a chance that they can slip into 2017 just based on the requirements that kind of take place in order to get those orders out into the market.

Ryan Cassil

Okay thanks. Then last one from me, just on the refinancing or that swap, it seems like earlier in the year, you know market rates were around that kind of 5.5% range, I don't know how much you can say, but are we still kind of in that ballpark, any color you can give us there?

Jeremy Smeltser

Well, I’m not going to get ahead of the market. We need to go through the process here, so I will be in New York and Boston today and tomorrow meeting with investors and likely price on Friday. What we've said is, we do expect it to be a lower blended coupon in our current 6.085%, but I want to respect the market process and I don’t want to speculate it at this point.

Ryan Cassil

Sure. All right, thanks guys.

Jeremy Smeltser

Thanks Ryan.

Marc Michael

Thanks Ryan.

Operator

And our next question comes from the line of Deane Dray with RBC Capital Markets. Your line is now open.

Deane Dray

Thank you. Good morning everyone. Hey, I would like to dig into your Brexit assumptions if we could, you all are disproportionately exposed that the UK region by our count about 13%, most of that food and beverage, have you calibrated any potential slowdown that would be more Brexit related or is it still too early?

A - Marc Michael

Yes, I would say on the market front Deane it’s still too early. We do pretty broad-based business in the UK, in addition to food and beverage we've got, we do have power and energy product lines based their across the UK, both ClydeUnion and our mixture business, we do some mixture business there, we do some valve business, filtration business that goes into Power and Energy. So, overall we do have an important base there for us, but we haven't seen any significant impacts thus far and a little bit too difficult to predict at this stage.

Deane Dray

Okay, I appreciate that. It’s interesting how the discussion about nuclear this quarter and it’s probably gives us some nice relief not to talk about oil and gas and powder prices, but what I thought is interesting, maybe you can expand on this is that $8 million order in safety pumps, I would have guessed that would have been a squib valve order, so maybe just talk about the offering, is that a cross selling opportunity, do you have squib valves at those installations and that helps you on the safety pumps or are those two separate engineering sales?

Jeremy Smeltser

I think we would separately and this case when we have customers that are doing upgrades or improving the current facilities in terms of safety performance and some of the Post-Fukushima activity that is going on that we see across the globe and France being an area and if you go into Japan itself that is where we see opportunities for these upgrades that are happening in our safety pumps. When we think about squib valves, we’ve again historically been tied to more new development in the market for nuclear plants in that area.

Deane Dray

Got it. And then just last question from me and as a follow-up to the last question, On the debt refinancing and Jeremy I know you don't want to get ahead of the market and there hasn't been in pricing, but what’s the breakeven from a timing standpoint that you are expecting on the refinancing, versus - the cash outlay versus lower interest costs, approximate breakeven.

Jeremy Smeltser

Well, frankly I never really think about it that way because the reality is with the technical requirement at our credit facility the absolute latest date of a re-fi is really May 1. Obviously, April is a quite period, which we couldn't go to market, which leaves you from next year window perspective, two weeks in February and the month of March and so it’s really depending on when you kind of pick when your required refinancing date and it’s really not I would say financially logical to assume the actual maturity date of those bonds.

So, again we will have more probably from a press release perspective later in the week and where the pricing lands right now I think albeit it, it’s earlier than absolutely necessary. I think that that interest leakage, the actual interest leakage that we will experience is very much worth it from a risk reward perspective over the, hopefully blended nine-year term of the refinancing that we are going to market with.

Deane Dray

And the covenant is more favorable?

Jeremy Smeltser

So, I would expect the indenture to be pretty consistent with the existing bond. The covenant on the credit facility we announced that about a month ago now and early part of July that we negotiated with our lending syndicate moved our net leverage covenant from 3.25 to 4 times and so very pleased with the flexibility in the marketplace therefore relatively nominal costs.

Deane Dray

Thank you.

Jeremy Smeltser

Thanks Dean.

Marc Michael

Thanks Dean.

Ryan Taylor

Thanks Dean. This is Ryan Taylor again. This concludes our call for today. We thank everybody for joining us. I would be available on the phones all day as normal to answer any follow-up calls. Thanks again for joining us, and we will talk to you next time.

Operator

Ladies and gentlemen thank you for participating in today's conference. This does conclude the program, you may now disconnect. Everyone have a great day.

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