CECO Environmental Corp. (NASDAQ:CECE) Q2 2016 Earnings Conference Call August 9, 2016 10:30 AM ET
Tracy Krumme - Vice President, Investor Relations
Jeff Lang - Chief Executive Officer and President
Ed Prajzner - Chief Financial Officer and Secretary
Martin Pranger - President, Energy Technology
Steve Fritz - President, Recurring Revenue
Brian Drab - William Blair
Gerry Sweeney - ROTH Capital Partners
Sean Hannan - Needham & Company
Greetings and welcome to the CECO Environmental Second Quarter 2016 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Tracy Krumme, Vice President, Investor Relations. Thank you. You may begin.
Good morning, everyone. Thank you for joining us on the CECO Environmental second quarter 2016 earnings conference call. On the call with me today are Jeff Lang, Chief Executive Officer and President; Ed Prajzner, Chief Financial Officer and Secretary; Martin Pranger, President of our Energy Technology segment; and Steve Fritz, President of CECO’s Recurring Revenue business. Martin and Steve will be briefly discussing their business and/or answering questions after the prepared remarks.
Before we begin, I would like to note that we have provided a slide presentation to help guide our discussion. The call will be webcast, along with our earnings presentation on our website at cecoenviro.com. The presentation material can be accessed through the Investor Relations section of the website under the Upcoming Events tab. I would like to also caution investors regarding forward-looking statements. Any statements made in today’s presentation that are not based on historical facts are forward-looking statements. Such statements are based on certain estimates and expectations and are subject to a number of risks and uncertainties. Actual future results may vary materially from those expressed or implied by the forward-looking statements.
We encourage you to read the risks described in our SEC filings, including our Annual Reports on Form 10-K for the year ended December 31, 2015. Except to the extent required by applicable securities laws, we undertake no obligation to update or publicly revise any of the forward-looking statements that we make here today, whether as a result of new information, future events or otherwise. Today’s presentation will also include references to certain non-GAAP financial measures. We have reconciled the comparable GAAP and non-GAAP numbers in today’s press release as well as the supplemental tables in the back of the slide deck.
And now, I would like to turn the call over to Jeff.
Thank you, Tracy. Good morning and thank you for joining our call. Please turn to Slide 3. Ed will walk you through the financial details in a moment, but I wanted to provide my perspective on Q2 and the first half of 2016. CECO made progress in our main strategic imperatives in Q2. Revenues grew, operating profit improved, working capital and free cash flow improved and we paid down substantial debt, which reduced our leverage ratio. We showed improvement in Q2 2016 despite some soft macroeconomic conditions in our Asia, North American industrials, and EMEA regions that we messaged in Q1 and as well in Q4 of 2015. We delivered record revenues of $112 million, 8.7% above Q1. Bookings were $109 million in Q2 in line with the average of Q4 and Q1 bookings run rate.
Our backlog remains consistently strong at $224 million, similar to Q1 and up 60% year-over-year and our operating income improved sequentially. We are growing market share as our second quarter organic bookings were up 16% and 4.5% year-to-date. That is the positive signal as many global markets have contracted year-over-year. Also, Peerless had softer bookings in the quarter versus Q1. Net cash provided by operating activities reached new highs and our adjusted EBITDA hit an all-time high of $15.5 million for Q2, which is another positive signal illustrating that we are delivering on our operational commitments.
I am pleased to report that our team is delivering on our commitments to shareholders. Our de-leveraging process has been successfully executed to-date lowering our net debt to EBITDA ratio to 1.8x, which is down from 3.6x at the closing of the Peerless acquisition three quarters ago. Debt repayment and deleveraging of our balance sheet is ahead of schedule and remains a priority. Consistent with previous quarters, we have been paying down debt at a level of 2x or greater the required quarterly principal commitment. We paid down over $18 million of debt in the second quarter of 2016, lowering our net debt to EBITDA ratio and that is mainly attributable to the team’s working capital position as well as executing on the sale leaseback deliverables. Margin expansion also remains a key strategic imperative.
Consistent with our operational excellence focus, we delivered second quarter improvement in operating income, free cash flow, network capital and EBITDA as well as bookings. Growing our recurring revenue is another important strategic focus. We delivered second quarter growth as expected and we are tracking toward our double-digit growth goals. Steve Fritz, our President of Recurring Revenues, will expand more on that shortly. The team is delivering on our promise of working capital and free cash flow improvement, while shifting us to a lower leverage ratio profile for our shareholders. Ed will talk more to those metrics, but this is an essential component of driving shareholder value and we expect to continue focus in this area.
Please turn to Slide 4. Our outlook and business conditions remain consistent with our Q1 2016 and Q4 2015 messages. Global natural gas power remains strong and midstream natural gas pipeline activity is slightly down from last year. The global environmental segment tied to industrials have been challenging, but the global refinery and petrochemical activity continues to perform well and delivered above average bookings in the quarter, coupled with the segment’s excellent aftermarket deliverables.
The fluid handling and filtration segment end markets have also been challenging and have been impacted the most of our segments this year as we messaged in Q1. Their bookings and revenues have trended downward in Q2. The fluid handling and filtration segment is now gearing up for EMEA regional global growth opportunities as well as expanding recurring revenues at a faster pace to drive growth and margins. This segment needs to move faster to harvest our sentry of growing the installed base.
Our 2016 performance improvement has been centered on improved market share and delivering our value equation and unique technological offerings to end users. The numbers demonstrate that we are making progress in our market share growth journey. In Q1, we communicated the CECO story, the growth strategies, the value equation of our portfolio, total market sizes and the global growth market share opportunities that we are rigorously pursuing. Please refer to that Q1 document as needed in your review of our business and we are always available to our shareholders. And there will be Exhibit 25 in the deck to talk further about those items.
In summary, CECO is a global provider of leading engineered technology solutions in three core areas; One, natural gas power generation emissions management and pipeline distribution; Two, environmental air pollution control technology; And three, fluid handling and filtration Technology. We have a broad portfolio of integrated solutions, well known reliable brands for critical, complex processes and a strong reputation for flawless execution, enabling us to hold key market positions one, two, or three in most of the identified niche markets that we serve. Customers place orders with CECO due to our excellent technology, high reliability within critical applications, competitive supply chain and a superior project execution.
Here are a few examples of some compelling wins in the second quarter that highlight our strategies, excellent technologies and global capabilities. Number one, the environmental technology segment received a very large order from major global refinery in Africa for fluidized catalytic cracking cyclone processes due to our best-in-class technology, project management execution, brand name and competitive supply chain. Number two, our energy technology sector captured several large global orders for the natural gas turbine OEMs, GE and Siemens, for new natural gas power plants being constructed. We are a premier technology provider for the natural gas turbine downstream systems. Our technology, flawless project execution and the competitive global supply chain capabilities were fundamental in winning these excellent contracts.
Number three, supporting our recurring revenue strategy of improved customer asset efficiency, we secured another energy sector win with Technip and PCC in Abu Dhabi for an offshore project wherein we provide an engineered solution to improve the systems performance of our pressure products group. Number four, the fluid handling filtration sector had a large win at a North American pharmaceutical facility for a critical application whereby our engineered solution provided the right value equation. Similarly, we won orders for major wastewater treatment facilities in complex liquids applications in Saudi Arabia. We continued to make headway in the Asia energy region with our engineered portfolio and well known brands, technology and project management excellence. We won a large order from a growing global China EPC engineer procurement firm called Sepco for a large exhaust silencer technology system application for a Saudi petrochemical facility. We are also starting to see the China EPC firms expand successfully into other regions of the world.
Please turn to Slide 5. As mentioned in the past, you will see that we have strategically evolved into a more diverse company, with a more favorable product mix, with diverse end markets as illustrated in the pie chart, providing a solid foundation to drive growth through various economic cycles. To highlight the overall strategy, CECO is making progress in 2016 even though we faced some global and regional end market challenges. It is exciting to see this take place for our shareholders despite less than optimal market conditions this year as it is one of our strategic transformational objectives.
Within our three business segments, our energy group is the largest, contributing nearly one half of our total revenues. Our environmental air pollution control business makes up approximately 38% of our revenue base, with fluid handling and filtration segment representing the remaining 15% of revenue.
We have a strategically balanced global footprint with approximately 40% of sales outside of North America. 5 years ago, CECO’s international business was only 18% of the total and we were too dependent on the domestic U.S. economy. The 40% of international revenue today approximately 25% come from EMEA and approximately 15% from Asia. Asia represents a significant long-term growth opportunity as we have low market share and a large total available market and our technology solutions are needed to solve their growing challenges.
Looking now to our end markets, approximately 35% of our total revenue and likely our new largest near-term growth opportunity is in the combined natural gas power and midstream gas pipeline market, which is in our energy segment. Industrial manufacturing, spreading among the environmental fluid handling and filtration segment, represents about 32% of the total revenues. The chemical, petrochemical refinery sector, part of the environmental segment, represents about 25% of revenue. And lastly, solid fuel or coal represents approximately 8% of our revenue with the U.S. and Asia in particular, where coal is the dominant energy source. And of course, our attractive recurring revenue base that we can classify as our aftermarket parts and service business, which grew to 27%, up from 25% in Q1 of our total revenue across all three segments. Growing the recurring revenue business is on track and is an important strategic focus for us, which applies to all three of our operating segments.
Turning to Slide 6, please, I would like to turn the call over to Steve Fritz, our President, leading our recurring revenues for CECO.
Thank you, Jeff and good morning. Our recurring revenue continued on a double-digit growth trajectory in Q2 with sequential growth from Q1 of plus 10%. As we have stated previously, we have strategically targeted improvement on our recurring revenue percentage from 25% of our total coming from recurring revenue in 2015 to 30% in 2018. Our 2016 year-to-date recurring revenue performance is approximately 27% of our total revenue at CECO. We continue to instill daily actions to target our $5 billion of products and systems installed and in use large manufacturing plants of our customers.
Our recurring revenue results come from customer transactions that include a wide portfolio of options that include replacement parts, maintenance, technical enhancements, retrofits and other services. I work daily with each of our three segments and teams to improve how we take care of our customers during the lifecycle of the assets they have purchased for CECO Environmental. We continue to see growth opportunities in each of our three segments. On a year-to-date basis, our environmental technology segment is the largest contributor of recurring revenue with a broad base of customer needs that we address with both at parts and a service portfolio. Both our energy segment and fluid handling and filtration segment are similar in size in recurring revenue. We continue to monitor our performance in each of the divisions inside of these segments and publish our results on a weekly basis.
In last quarter’s presentation, we discussed how important it is for us to stay connected to our end customers. We measure our connectivity as determining, which customers on our installed base have transacted with us and our recurring revenue portfolio in the last 12 months. Today, our connectivity across our organization is still less than 15%, which offers great opportunities for us in growth. Our daily actions and investments to extract this growth opportunity are targeted to reconnect with this 85% or so of our customers who might have drifted away from us in the past. I wanted to provide a bit more insight today into how we show value to our customers who have purchased our CECO assets in the past. We show value to our customers by helping them optimize their total cost of operation by maximizing the availability, reliability and efficiency of their operating asset.
One example of that is by leveraging our deep expertise in the systems that these assets operate. One item in our recurring revenue portfolio that we offer to our customers is something that we call a system assessment. This assessment leverages the deep expertise we have to help our customers solve complex and ever-changing problems in their manufacturing environment. These assessments provide an implementation plan for success to meet our customers’ complex needs, improve asset reliability enhance asset efficiency, etcetera.
We are focusing on the growth and expansion of our ability to offer these types of assessments within multiple areas of our organization. We also are meticulously monitoring our incoming versus outbound calls to our install base. We have hired additional resources whose sole job is to contact these customers and help solve any problems they might have. We see success in our efforts based upon a plus 20% growth in our aftermarket core pipeline from the first quarter of this year. The growth in the core pipeline and the recurring revenue results are driven due to large and talented dedicated aftermarket specialists across our company.
This group continues to be approximately 10% of our total employees in the CECO organization. This group of employees attend aftermarket university training sessions to share best practices, new standards for growth, sales, supply chain, pricing and many critical subjects. We continue on subjects such as standardization and supply chain excellence and also are sharing best practices on customer contacts and effective management of our territories with our continued investment in CRM related tools.
I look forward to answering any of your questions in the Q&A following the call. Now I will turn it back to Jeff.
Thank you, Steve. Now, please turn to Slide 7. Peerless is delivering on our shareholder value creation commitments with its performance. In the first half of 2016, Peerless delivered $53 million in bookings, $50 million in revenues and $8.8 million of adjusted EBITDA. While pro forma revenues are down from last year, you will see the significant improvement of $8.2 million of operating income non-GAAP up from an operating loss of nearly $6 million in their comparable first half of 2015 for a $14 million absolute improvement highlighting our core strategy of running Peerless as a large integrated portfolio within our energy technology segment. We delivered significant margin expansion running past the $80 million of cost out synergies and exceeding expectations. This is due to operational streamlining, applying CECO operating business systems, which is our clear competitive advantage, improved project management discipline with strict pricing standards and much more external strategic application centered on the asset light business. In addition to that, we have a leaner, but very talented and capable Peerless operating, sales, engineering and financial team integrated within the CECO energy team.
Bookings in the second quarter were soft for Peerless. Both the integration and cost out synergize – synergies realized were now increasing our sales and growing share. We are investing in sales engineering efforts, sales resources and in general the front end of the business to achieve growth. The Asia region and EMEA region and midstream markets have slowed, impacting our numbers. But we are ramping up our sales management focus and resources around business intake activities. We are not satisfied with our business bookings intake of Q2 for the engineered equipment side of the equation, but the aftermarket recurring revenue side is improving at a faster rate.
Going forward, as we reach the 1 year anniversary of the successful Peerless acquisition, we will message CECO as a total company and discontinue specific messages on Peerless. We are very pleased with the Peerless acquisition, high operating margin transformation, great cash management practices, exiting unnecessary fixed assets and we would like to grow the revenues much more. We are now confident as we grow revenues, the operating income metrics and EBITDA metrics will continue on a favorable accretive trajectory.
Please turn to Slide 8. CECO is focused on and delivering on three core strategic imperatives. Number one is growing market share organically and recurring revenues – revenue growth both engineered systems, OE and aftermarket. We have made progress with organic growth in the first half of 2016. We are facing challenging regional markets and growing market share is our strategy. Number two, as we have communicated, paying down debt, de-leveraging the balance sheet and expanding EBITDA remains a key priority. Bringing the debt to EBITDA leverage ratio to below 2x is taking place quarterly. Our de-leveraging process is well ahead of schedule and each dollar of debt reduction has the potential to translate into an increased dollar of shareholder value. So this remains a core deliverable for CECO. CECO levered up to acquire Met-Pro in 2013 and again in 2015 to acquire Peerless. We successfully integrated both businesses and improved the EBITDA generation. And now once again, we are de-leveraging the balance sheet to a more normalized leverage level.
Number three, margin expansion activities, improved cash flow generation and working capital reductions were achieved in the quarter and are interwoven into our operational fabric and commercial order intake activities. Ed will speak in more detail on our progress and goals for this. From a high level, net cash from operating activities was a new all-time record high for CECO. And net working capital at June 30 was at a new all-time record low for CECO validating our focus and meticulous cash management deliverables in running our business. Thank you to the team. It is truly a great group effort.
CECO has an attractive operating system, low working capital, strong free cash flow and minimalized or asset-light manufacturing characteristics, which is an important aspect of our competitive advantage. Greater than 70% of our manufacturing fabrication is achieved through external third-party strategic manufacturing partners while improving our global supply chain. This provides us with a more nimble, higher variable cost and lower fixed cost model, which is a differentiator to many industrial and energy technology companies.
Our team strives diligently to obtain project, progress payments and/or milestone payments from beginning to end of a project to enhance our free cash flow. As messaged in Q1, we completed the sale leaseback of two manufacturing facilities in Q2 for gross proceeds of $11 million. As promised, the net proceeds of the sale leaseback were 100% applied to the debt repayment and de-leveraging of the balance sheet. In summary, we paid $7 million of debt as per our normal quarterly aggressive repayment plan plus an additional $11 million from the sale leaseback, totaling a little over $18 million of debt repayment in the quarter. And lastly, we have recently signed a new Letter of Intent for one remaining sales leaseback facility opportunity that will eventually provide an additional $3 million of net cash proceeds to accelerate our de-leveraging process in Q3 to meet our shareholder commitments.
Before I turn the call over to Ed to provide more detail on our financial performance, I would like to restate that our company remains rigorously committed to best-in-class operating standards, performance and metrics, market share growth and exceptional cash management generation practices to expand our earnings to create more shareholder value. We are emerging as a business that can grow and succeed through challenging regional economic cycles, which shapes many of our strategic changes and choices at CECO. As evidence of our commitment to deliverables since the Peerless acquisition in Q3 of 2015, we have to improve CECO’s trailing 12-month EBITDA by almost $9 million to $55 million and we have reduced the total debt load by almost $42 million in total, which is how we are striving to create shareholder value.
With that, I will now turn the call over to Ed.
Thank you, Jeff and good morning everyone. As mentioned, I will highlight in more detail both the GAAP and non-GAAP performance for the second quarter and first half of 2016 for both our consolidated results and three business segments. As a reminder, our non-GAAP adjustments include several items such as acquisition and integration expenses and the impact of acquisition asset valuation adjustments on the income statement, including higher depreciation, amortization and earn-out expenses as well as other non-recurring items. Our non-GAAP presentation is intended to provide better trend analysis and assessment of our core business performance.
Beginning on Slide 9, I would like to provide a little more detail on the summary that Jeff provided earlier. Our revenue was $112.3 million for the second quarter of 2016, an increase of 29% year-over-year and up 9% sequentially. Bookings were $108.8 million, up 46% year-over-year, resulting in backlog of $224.7 million, which is up 60% year-over-year. Operating income was $8.6 million, an increase of 91% year-over-year and 48% sequentially. Our non-GAAP operating income was $13 million, up sequentially from $10.9 million. Our adjusted EBITDA of $15.5 million which was up 22% sequentially from $12.7 million. GAAP EPS per diluted share was $0.12 and non-GAAP EPS for the quarter was $0.21 per diluted share. And as Jeff highlighted, our strong cash flow allowed us to pay down $18.3 million of debt in the quarter and $25.4 million for the first half of 2016.
On Slide 10, you will see our revenue trend for the past five quarters. Our revenue was $112.3 million for the second quarter of 2016, an increase of 29% year-over-year and up 9% sequentially. On an organic basis, revenue was flat as double-digit growth in recurring revenue was offset by weaker original equipment demand in some North American markets and Asia.
On Slide 11, please see our booking and backlog trends for the past five quarters. We are encouraged with our level of backlog at $224.7 million as of June 30, 2016, up 6.4% from year end and up 60% year-over-year. We are also encouraged with our $108.8 million of bookings in Q2 2016, up 46% year-over-year. Organic bookings were up 16% year-over-year and 4.5% year-to-date, primarily driven by the environmental segment. Our outlook remains consistent with what it was at the end of Q1.
Continuing on to Slide 12, our non-GAAP gross margins were 30.3% in Q2 2016, down slightly year-over-year and sequentially due primarily to weaker demand in Asia. Non-GAAP operating margins have improved sequentially to 11.6% in Q2 2016 from 10.6% in Q1 2016 due to a favorable mix of the aftermarket sales and Peerless exceeding margin expectations.
On Slide 13, our non-GAAP operating income was $13 million, up sequentially from $10.9 million. Our adjusted EBITDA of $15.5 million was up 22% sequentially from $12.7 million. These overall improvements are attributable to overall operational excellence as well as Peerless’ excellent performance. Our continued performance improvement is evidenced by consecutive quarter since Q4 2015 of improving adjusted EBITDA and non-GAAP OI in terms of both dollars and margins.
And now moving on to our segment discussions beginning on Slide 14, revenue in our energy segment was nearly $53 million, up 94% from $27.3 million in the prior year period. The higher revenue was driven by our Peerless acquisition, contributing $25 million of revenue in Q2. Aftermarket and retrofit opportunities continued to grow in this segment as well as global expansion. Organic revenue was up 1% year-over-year, but down 2% on a year-to-date basis. Energy bookings of $41.1 million for Q2 were up 64% over the prior year period, although down 36% sequentially. Organic bookings were down 24% year-over-year due to Asia and domestic utility softening in Q2. However, organic bookings were up 1% on a year-to-date basis.
Moving on to Slide 15, revenue in our environmental segment was $44.2 million, up 6% from $41.8 million in the prior year period and up 13% sequentially from $39.1 million in Q1 2016. Bookings at approximately $53 million were up 71% over the prior year period and up 31% sequentially over Q1. On a year-to-date basis, organic revenue was flat but organic bookings were up approximately 14%.
Moving on to Slide 16, revenue in our fluid handling and filtration segment was $15.4 million for Q2, down 13% from the prior year period and down 7% sequentially. Bookings were down 21% on a year-over-year basis to $14.8 million from $18.6 million in the prior year period and down sequentially 6% from $15.7 million in Q1 2016. Weaker industrial demand in North America has been adversely impacting equipment sales in this segment although recurring revenue remains consistent. The fuel handling and filtration segment has begun to expand into the EMEA region during 2016 leveraging the Peerless EMEA footprint in order to drive growth in 2017.
On Slide 17, we illustrate our focus on debt repayment and de-leveraging. We paid down $18.3 million of debt in Q2 2016 and $25.4 million on a year-to-date basis. Since the time of the Peerless acquisition, we have reduced debt by $42 million. Our net debt leverage ratio reduced to 1.8x as of June 30, 2016 from 2.6x at March 31, 2016. Our goal is to continue paying down at least $7 million per quarter for the remainder of 2016. We are on track with lowering our leverage ratios as previously committed that being to be at less than a 2x gross debt to trailing 12-month EBITDA leverage ratio by the end of 2017.
On Slide 18, we show a trend of our cash flow generation for the past 2 years compared to the current year. We begin with gross free cash flow for the each period as reconciled to cash provided by operating activities. Our ability to generate cash flow is very strong, with $37.3 million of gross free cash in Q2 2016, which resulted in $34.7 million of net cash from operations after accounting for cash paid for interest expense and income taxes. This in turn allowed us to pay down $18.3 million of debt in Q2 2016, which included the $11 million of gross proceeds from the previously mentioned sale leaseback transactions.
Lastly, on Slide 19, you will see our condensed balance sheet. As I mentioned earlier, total bank debt was reduced from $170.6 million to $152.5 million as a result of our debt payment of $18.3 million. We also increased cash and cash equivalents by $23.2 million during Q2 from $33.4 million to $56.6 million. Net working capital, excluding cash and cash equivalents, was an all-time low of just $16.7 million. The team is diligently working on generating free cash flow by lowering net working capital. This is a priority for us and we will utilize our strong free cash flow, which is fueled by working capital improvement initiatives to accomplish this objective. We are focused on further improving our working capital practices and wisely managing capital expenditures to maximize free cash flow for debt repayment. Our working capital as a percentage of revenues is favorably trending downward both sequentially and year-over-year.
At this time, we would now like to open up the call for your questions. Operator, please open the phone lines.
Thank you. [Operator Instructions] Our first question comes from the line of Brian Drab with William Blair. Please proceed with your question.
Hey, good morning, Brian.
In the past, you have commented on how comfortable you are with the consensus forecast. And at the moment, the consensus forecast is for revenue to be down slightly on a sequential basis in the third quarter and again in the fourth quarter. Given the sequential decline in bookings, I guess, is that a fair forecast?
Any additional color…
I would say, yes.
In terms of magnitude of sequential decline?
Well, we said earlier, we were going to show some decline in the OE side of the business in Q1. And I think you are seeing a little bit of that probably not to the extent – we are probably seeing low single-digits. But our outlook on the business is very – our outlook on the second half is very consistent from the first half is kind of how I would color that, Brian.
Okay. Alright. Thanks, Jeff. And I guess I wanted to ask about the selling and admin costs have been $21 million pretty consistently since you closed the acquisition. I am looking at PMFG pre-acquisition, it was running about $13 million in terms of operating expense and CECO is running at about $14 million. So, the total for combining those about $27 million and that suggests that if you compare that with the $21 million that you are running at now that you have got about $6 million in SG&A per quarter, which annually is well over $20 million. And I am just trying to reconcile that with – it seems like a figure that’s greater than the $18 million that you have reported in terms of cost synergies, so can you help me reconcile that and then also remind me how your cost synergies broke down between SG&A and I assume there was quite a bit in COGS too?
Yes. There was a lot in COGS, there was a lot of fixed assets, the plants and SG&A and corporate. But every quarter, we seem to be doing a little bit better. In Q4, the combined SG&A was around 22%, which was around $23 million. In Q1, we were in the $20 million neighborhood or 20% neighborhood, which was around $21 million. And in Q2, we ended up around $20 million – about the same, $21 million of absolute dollars for SG&A, which for the first half put us at about 19.5%. And I think that’s a pretty good run rate for the rest of the year. We have added some resources at corporation to fill out some positions. We have added some corporate governance investments to build a longer, bigger, broader organization and to address some challenges. So we have made some investments in the corporate governance side. But I would think that 19.5% is probably a pretty good run rate for the second half, 19.5% is kind of how we are modeling it. That would be the first part of your question, Brian. The second part of the question relates to the synergies of Peerless and it’s across the board. It’s shop overhead streamlining. It’s shop overhead exiting a plan, shifting to half a dozen strategic fabrication partners. We have trimmed the corporate headquarters to a reasonable level. And so there is quite a few things we did to help Peerless move into the CECO model. And we have made some investments in the corporate side as well. So I hope that helps.
Yes, that helps. Can I ask just one more and how much revenue did you generate in China in 2Q. And then can you talk a little bit about what the latest is around the regulatory environment and any of the secular drivers for emissions control in China, how that’s developing?
Yes. We are seeing a little pickup in some of the environmental regulatory statutes and rules being enacted. That’s always an important aspect of our business there. That’s why we are there. We are probably seeing a little bit of that take place in 2016. China is – has declined a little bit over the past couple of years, so some of that is probably not being implemented as strongly as it was at the peak. But we do see that as a driver of our activity. And that’s principally our technology is used for emissions, filtration and those type of core areas. China is running – CECO Asia is on track to be flat to last year. Even though the market is down, certainly some of the things that we focused on to grow this year have been a little muted. But our outlook for CECO Asia for 2016 is to track similar to last year in the low $63 million, $64 million, $62 million is kind of what we are targeting. And I think that would be pretty solid given that the economy has not grown like we have needed it to this year. So I hope that gives you a couple of answers.
Yes, that’s all really helpful. Thanks. Can you just tell me how much of that $62 million or $64 million China accounts for, is that like 80% of Asia or just roughly, how much is China as a percentage of your Asian...
That’s principally China. That is principally – probably 85%, 90% of that is all China.
Okay, that’s really helpful. Thanks.
Our next question comes from the line of Gerry Sweeney with ROTH Capital Partners. Please proceed with your question.
Hey, good morning Jeff, Ed and Martin how are guys doing?
Hey good morning. Hey Gerry.
I had a couple of questions on the environmental side, the U.S. industrial production index seems to be bottomed out, improving, I want to see what you guys were seeing in that market. Are you seeing any improvement? Obviously, bookings were up, but there was a portion of that probably from that African quarter that you highlighted, but want to see what you are seeing in that market as we move forward in ‘16 and into ‘17 as well?
As you look at the numbers to the Environmental segment, you can see they are in that $40 million run-rate if you look at the last few quarters. So, we feel that’s a pretty solid or pretty consistent number as we look down the road. Number two, they have done a really nice job. Steve and Payman have done a really nice job with the team accelerating the recurring revenues of that business, so we have seen a nice uptick, harvesting the installed base and building – and growing the recurring revenue. And the global refinery cyclone activity has been as strong as it was last year. So, we are seeing some nice uptick there. Regarding the U.S. industrials, nothing has really changed from our last two quarters of outlook. The industrials are down and we are trying to grow globally to make up for that. We are trying to grow the aftermarket piece to make – to offset that. I think CECO is doing a nice job in that initiative.
On the industrial side, when you said similar to your previous messaging, is that down, but stabilizing or down and still feeling pressure?
I am sorry, Gerry, I didn’t hear that. Can you repeat that, please?
On the industrial side, you were talking about your previous messages of it being down. I wanted to know, is that down but stabilizing or down but still facing some headwinds?
Oh, sure. I would say it’s down and stabilizing.
Okay, perfect. And then on the Energy side, you did mentioned the Midstream was a little a – was down slightly year-over-year. I am just curious, what percent of the Midstream is that of Energy as a whole?
For North America, it’s about $10 million a quarter. Globally, it’s probably $15 million to $17 million a quarter. But first and foremost, that midstream pipeline distribution business is an excellent business. We have got a terrific brand. The margins continue to do well. We are going to grow share. We want to be in that business. We just saw a little bit of RFQ decline over the past 30, 60 days, but we are very excited about that business. We like it. We want to invest in it and we want to become a leader in that midstream, the midstream distribution business globally and right here at home.
Okay, got it. That’s fair. And then finally, Ed, this might be more for you, but just curious on the working capital, it looks like it probably had a big impact on the free cash flow in the quarter, but what percentage of sales are you targeting, because it also sounds as though there is even more improvement can be made?
We had a very good quarter on working capital, Gerry. As you know, last couple of years we have been hovering around 20% of revenue. We always seek to improve that year-over-year, quarter-over-quarter, where we heavily incentivize the team to do that. And this quarter, we saw very good improvement in lowered AR, lowered inventory, working on milestone billing, so very good success there. Some of our business units can run negative working capital. But as a company, we seek to just improve it every year. We had a very exceptional quarter here where we drove down working capital to its lowest level and we want to continue to maintain that by staying very positive with cash flow and every job that builds up to the total. So, we are – we seek ever improvement in working capital. It’s a huge team effort impacting lots of folks roles, responsibilities and we have made a lot of progress and we want to hang on to those gains and keep that net working capital as low as we can possibly maintain it.
Got it. I think right, I mean, at the end of the day, there is going to be some variability quarter-to-quarter, but on an annualized basis, you are going to keep moving it down – try to keep moving it down as a percentage of revenue?
Yes. Our goal is every year to knock it down a couple of 100 basis points. And I think we have been doing that over a number of years now. Again, this mid-year, it’s exceptionally lower than last year. But yes, we fundamentally are putting lots of focus on keeping working capital low to free up cash for debt service and other purposes and that remains a very, as Jeff mentioned earlier, one of our top three strategic focuses.
Got it. I appreciate it. Thanks, guys. Thanks, Jeff.
Thank you, Gerry.
Our next question comes from the line of Sean Hannan with Needham & Company. Please proceed with your question.
Yes. Thanks. Good morning, can you hear me?
Yes. Hey Sean.
Good morning folks. So there are some viewpoints that within the fluid handling and filtration you had some expectations really to move more so within the EMEA region this upcoming year, just wanted to see if we can get a little bit more perspective around the strategy to do that, to what degree is there already some aspect of an install base that you are able to leverage there and to what degree you are going to look at local partnerships or what have you, just any sense there as we better understand the opportunities and the ability to execute? Thanks.
Sure. No, it’s part of our – globalization is part of our strategic initiative. In the fluid handling and filtration businesses, it’s principally a domestic North American business. And it’s a great business. We clearly want to grow it domestically. However, with the excellent acquisition of Peerless, we now have a stronger EMEA footprint, offices, sales people, project managers and an enabler to launch the fluid handling and filtration business, which is fluid handling, items, pumps, filtration in some emissions fan technology. We have already added some resources in EMEA. We have already established some sales in project management targets within the EMEA infrastructure and moving in that direction is very important. We think the EMEA market potential for fluid handing is similar to the North America market potential. So it’s an upside. It’s all growth for us and we want to be a stronger player in that. And we will probably see more revenues generate in 2017 as a result of that strategy. And that’s where we are headed. And we have been working on it for a while.
Okay. So as you see within that segment your revenues coming down a little bit as well as bookings, is the strategy partly an effort really to diversify and offset that in being stepped up as a priority, because of that dynamic, I guess kind of as a secondary question here and then part two to that, to what extent are there not similar market conditions impacting those local geographies over there similar to here, because we are – we have been seeing industrial softness, I think that you have been seeing that over there as well and it sounds that if there are a lot of dynamics in parallel that would be a pretty hard scenario to accomplish in a challenged market?
Right. I think the Peerless footprint has been an enabler for us to launch products into EMEA. And the fluid handling filtration is gearing up to do that. We have to keep in mind, it’s still a very large potential for us that we have very minimal share if not zero. So there is a lot of upside for us to come in. And our technology is very good. We are considered a leader in some of the sophisticated liquids niche markets. So to us it’s all upside. But it is a very large market as we messaged in our Q1 total available market share opportunities. So yes, it’s going to be challenging, but we are not there now and we see that as a revenue stream. Regarding the aftermarket, we have been very focused on building the recurring revenue strategy within the fluid handling and filtration market. They have 100 years of building the install base. And we have got to move a little faster with our aftermarket strategy within that business. But we have already secured a couple of orders from the fluid handling filtration sector, which leads us to believe there is more there and we are going to keep investing in that opportunity to help grow the fluid handling sector. And it is – it’s too heavily weighted to North America, so.
Understood. Okay. And then a cash flow question here, you guys did a fantastic job in the quarter and I think you have laid a lot of actions and talked about some of the increasing discipline around working capital management, etcetera. Obviously, free cash flow can be lumpy, but can you talk a little bit more here about what kind of expectations we should have for free cash flow today as we think about either ‘16 or ‘17, any numbers that you can put out there or ranges for us in thinking about either goals or potentials for achievement? Thanks.
I will give you my comments. First off, our expectation is the businesses will improve a couple of few points a year in working capital. So, if a business is at 14% working capital as a percent of sales or 17%, they would improve that by a couple a few points a year to drive free cash flow. Free cash flow in Q2 was quite good. We had $11 million of sale leaseback, but I also see the businesses have improved – accelerated their working capital, improving their free cash flow. So, we probably will be somewhere between Q1, Q4 and Q2 and looking out at the second half. But the improving working capital is part of the D&A as part of our commercial selling process. And I expect us to continue improving working capital on a quarterly basis. And with that, I will let Ed provide some color from his view.
Sure, Sean. The biggest variable here year-over-year has really been on the projects. I mean, we have controlled AR very well. But fundamentally, what we are really focusing on now is, as Jeff mentioned earlier, the milestone payments, progress payments on jobs. We are really focusing on getting into a better place. CECO has been historically slightly overbuilt on jobs, whereas last year we got underbuild. So, we have really caught backup. We are in a much better place now, where each job is cash flow neutral at worst, cash flow positive at best from beginning to end and that’s really where we focus. If you look back through the balance sheet and as we – on the milestones, that’s going to change there. We have got the – we have reduced the underbuild dramatically and plan to keep that there very consistent going forward. That’s what really causes the volatility for us and we talked a lot about that last year as you went along. So, overall fundamentally, we are managing working capital much better, but the change in the net over or underbuild is really where the differential has come from the positive improvement this year and where we will look to hold on to that gain and keep the cash flow much more consistent by keeping working capital a little more constant going forward.
Okay, great. Thanks for the feedback here, folks.
You are welcome.
Thank you. It appears we have no further questions at this time. Mr. Lang, I would now like to turn the floor back over to you for closing comments.
Thank you for joining the CECO call. Have a nice day.
Ladies and gentlemen, this does conclude today’s teleconference. You may disconnect your lines at this time. Thank you for your participation and have a wonderful day.
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