Regal Beloit's (RBC) CEO Mark Gliebe on Q4 2016 Results - Earnings Call Transcript

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Regal Beloit Corp. (NYSE:RBC) Q4 2016 Earnings Call February 7, 2017 10:00 AM ET

Executives

Rob Cherry - VP, IR

Mark Gliebe - Chairman & CEO

Charles Hinrichs - VP & CFO

Jonathan Schlemmer - COO

Analysts

Julian Mitchell - Credit Suisse

Christopher Glynn - Oppenheimer

Mike Halloran - Baird

Nigel Coe - Morgan Stanley

Scott Graham - BMO Capital Markets

Jeffrey Hammond - KeyBanc

Joshua Pokrzywinski - Buckingham Research Group

Bhupender Bohra - Jefferies

Sam Eisner - Goldman Sachs

Chris Dankert - Longbow Research

Robert McCarthy - Stifel

Operator

Good morning and welcome to the Regal Beloit Fourth Quarter 2016 Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instruction] After today's presentation, there will be an opportunity to ask questions. [Operator Instruction] Please note this event is being recorded.

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

Rob Cherry

Thank you, operator. Good morning, and welcome to Regal Beloit's fourth quarter 2016 earnings conference call. Joining me today are Mark Gliebe, Chairman and Chief Executive Officer; Jon Schlemmer, Chief Operating Officer; and Chuck Hinrichs, Vice President and Chief Financial Officer.

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

On Slide 3, we state that we are presenting certain non-GAAP financial measures in this presentation. We believe that these are useful financial measures to provide you with additional insight into our operating performance and for helping investors understand and compare our operating results across accounting periods and in the same manner as management.

Please read this slide for information regarding these non-GAAP financial measures, and please see the appendix for reconciliations of these measures to the most comparable measures in accordance with GAAP.

Now, I will turn the call over to Mark.

Mark Gliebe

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

Our fourth quarter results were generally in line with our expectations. We expected that organic growth would be flat to slightly down, and we would improve sequentially. Organic growth overall was negative 0.7% for the quarter, and we did improve sequentially for the fourth quarter in a row. At a segment level, organic growth in the Climate segment was up 3% with strong sales in residential HVAC partially offset by weakness in the Middle East.

In the C&I segment, overall organic growth was slightly positive with weaker sales into oil and gas offset by organic growth in most other end markets. Finally, in the PTS segment, organic sales were down 7.1% for the quarter driven mostly by renewable energy demand patterns and weakness in oil gas end markets.

From an operating profit perspective, it was a better quarter than it appeared, as you may recall at the time of our fourth quarter guidance, we specifically excluded any LIFO impact. Soon after following the election, copper and steel prices spiked. The actual LIFO expense in the fourth quarter was $14.5 million. We were able to offset the impact of the LIFO expense with operation improvements and cost controls, focusing just on adjusted operating margin, adjusted margins would have been 11.4% in the fourth quarter excluding the LIFO expense.

Overall with sales essentially flat, we felt pretty good about our margin performance in the quarter. We had another good quarter and free cash flow with free cash flow coming in at 202% of net income. Part of the way we accomplished these results was by reducing working capital. For the quarter, we again improved cash cycle days with inventory reductions of an additional $25 million. With the strong free cash flow, we paid down a healthy $100 million of debt in the quarter.

As we look forward to 2017, we expect that a number of the top line headwinds that held us back in 2016 will ease as we move through the year. First, given the recent commodity inflation, we expect the two-way material price formulas to be a tailwind to sales. Next, we expect to anniversary last year's declines in the Middle East as we entered the second quarter in an oil and gas as we enter the third quarter. Further, our residential and commercial HVAC customers are predicting mid-single digit growth rates for 2017.

The biggest top line headwind we expect for 2017 will be the strong dollar which will continue to be a drag on our customer's ability to export. Overall for the year, we are expecting slight positive organic growth. Given the success of our simplification efforts, we expect that the increase in revenues will deliver strong incremental margins. We are expecting price costs pressures driven by materials inflation especially in the first half as the two-way material price formulas take full effect as we enter the third quarter.

Overall, our 2017 guidance reflects total year adjusted EPS of $4.50 to $4.90, up 6% at the mid-point over 2016.

I will now turn it over to Chuck.

Charles Hinrichs

Thank you, Mark, and good morning everyone. Sales in the fourth quarter 2016 were $758.1 million, down 2% from the prior year. Foreign currency translation in the quarter was a negative 0.7%. The divestiture of the Mastergear business reduced sales by $4.7 million or 0.6%. Therefore, organic sales declined 0.7% from the prior year in line with our earlier guidance for the fourth quarter.

Our adjusted operating profit margin in the fourth quarter was 9.5%, but both this quarter and the prior year quarter has significant LIFO impacts. The fourth quarter of 2016 had a LIFO expense of $14.5 million, and the prior year quarter had a $15.3 LIFO benefit, excluding the LIFO impact from both periods. The adjusted operating margin for the fourth quarter of 2016 was 11.4%, which compares favorably to the 8.3% in the prior year. The higher than expected LIFO expense was offset by operational improvements and cost control actions, which reduced both cost of goods sold and SG&A expenses in the quarter.

Let me explain the LIFO expense in the fourth quarter of 2016. Our earlier guidance did not include any LIFO impact, which was not forecasted to be a material amount. Following the U.S. election, commodity prices spiked up with steel prices increasing 13% and copper prices increasing 20%. This spike in commodity prices droves the LIFO expense.

Our fourth quarter 2016 earnings per share reported on a GAAP basis were $1.01. There were two adjustments to the GAAP EPS in the fourth quarter. The first adjustment was $2.6 million or $0.04 per share of restructuring and related costs for projects in all three reporting segments. The second adjustment was the $500,000 after tax gain or $0.01 per share from the gain on the sale of assets. Net of these adjustments, the adjusted EPS for the fourth quarter was a $1.04 in line with our earlier guidance for the quarter.

Now, I'll summarize a few key financial metrics. Our capital expenditures were $19 million in the fourth quarter and $65 million to the full year 2016. From a restructuring standpoint, restructuring expenses were $2.6 million in the fourth quarter and $6.8 million for the full year 2016. In the upper right quadrant, we show our effective tax rate information. The ETR in the fourth quarter was 17%. The lower ETR was driven by the LIFO expense in the U.S., which impacted our mix of earnings and lowers the ETR in the quarter.

In the lower left quadrant, we provide data on our fourth quarter 2016 balance sheet. Our total debt was $1.4 billion, and our net debt was $1.1 billion. In the fourth quarter, we achieved strong debt reduction, repaying a $100 million of debt. For the full year 2016, we reduced our total debt by $315 million. Our strong debt reduction in 2016 reduced our total debt to EBITDA ratio to 3.0 at year end.

In the lower right quadrant, we present information on our free cash flow. We generated $92 million of free cash flow in the fourth quarter representing 202% of net income for the quarter. For the full year 2016, we generated $374 million of free cash flow representing a 184% of net income. We had a very strong quarter and a record year for cash flow generation. The full year 2017 free cash flow benefited from the $114 million of inventory reduction.

Now, I will review our full year 2017 earnings guidance. Our guidance for 2017 reflects our expectation that organic sales will grow slightly with momentum improving in the second half of 2017. We expect FX translation to continue to be a headwind to our total sales of 1% to 1.5% in 2017. Our adjusted operating margin is expected to improve in 2017, as we benefit from the success of our simplification initiative and the increase in sales. Our full year 2017 GAAP EPS guidance is $4.35 to $4.75.

On an adjusted EPS basis, our 2017 guidance is $4.50 to $4.90, the adjustments to convert the GAAP EPS to the adjusted EPS, our restructuring cost of $9 million or $0.15 per share. I'll comment on the key assumptions in our 2017 guidance. We expect our capital expenditures to be approximately $75 million. Regarding our free cash flow in 2017, as always we target our free cash flow to be greater than 100% of net income and we expect to again be successful in 2017.

We will continue to use a portion of our free cash flow to reduce our debt and expect our debt reduction in 2017, to be greater than $200 million. As we reduced our debt in 2017 our interest expense will also decrease. We estimate our net interest expense in 2017 to be approximately $47 million. And our last assumption is that we expect our tax ETR to be 23% in 2017, excluding any discrete tax items that may occur. Obviously, this does not include any changes in the U.S. tax code in 2017.

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

Jonathan Schlemmer

Thanks, Chuck, and good morning everyone. Let's first walk through each of the segments. In Commercial & Industrial Systems, sales were $369 million, organic sales turned positive and we are up slightly from prior year. This was in line with our expectations and represents the third consecutive quarter of improving organic rates. In the quarter, we experienced strength in Asia and Europe as well as strengthen data centers in the North America pumping market. These strengths were partially offset by weakness in the oil and gas and power generation end markets. Price was slightly negative in the quarter; however, prices did increase sequentially due to the two-way material price formulas.

Adjusted operating margin was 5.8% of sales, down from prior year due to the impact of the $8.4 million LIFO expense. Excluding the impact of LIFO from both periods, adjusted operating margins increased by approximate 50 basis points in the quarter. Last week, Regal participated in the AHR Expo in Las Vegas. On the slide you can see one of the highlights of the show for us was the launch of our UlteMAX product, an axial industrial motor and a Regal designed fully integrated electronic control.

As you can see from the picture, the exciting part of this new technology is the form factor. The UlteMAX motor is only about 5 inches wide while a standard motor with the same horse power is approximately 15 inches wide that's a tremendous difference. The key benefits are smaller more compact footprint, much lower weight and higher efficiency. We had tremendous interest at the show and created many new leads. We are just now launching the product and we are excited about the organic growth we receive from this new platform.

In Climate Solutions, sales were $215 million. Organic sales turned and were up 3% from prior year. This represents the fourth consecutive quarter of improving organic growth rates. We had low double-digit sales strings in our North America Residential HVAC business partially offset by continued headwinds in the Middle East and the non-HVAC North American end markets. Similar to C&I price from the two-way material price formulas remained, the headwind in the quarter, but improved sequentially from the third quarter.

Adjusted operating margin was 12.8% of sales, down 40 basis points from prior year, but up substantially excluding the impact of LIFO. The underlying business performed well benefitting from the increased sales volume, slightly improved mix and the simplification efforts in cost controls. At the AHR Expense for those of you who attended, you saw our new expanded line up of DEC Star blower products designed to help our HVAC customers meet the increasing efficiency targets. DEC Star is a high efficiency system, integrating an axial motor, a Regal designed electronic control and our latest high efficiency air moving technology.

We are bringing a full suite of energy efficient products to our customers as they work to meet the upcoming fan energy rating or FER requirements for 2019. It was nice to see that five of our customers were displaying new products, using our new DEC Star platform. The picture on the far right shows one of our customers air handling units where they were highlighting the DEC Star system. These customers are using our new technology to help solve problems related to noise, space and energy efficiency.

Sales in Power Transmission Solution were approximately $174 million with organic sales down 7% versus prior year. The decline was driven primarily by lower demand and the renewable energy in the oil and gas end markets. The organic growth rate while still down mid-single digits improved as compared to organic growth rates of the second and third quarters. Further, the order rates in this segment continue to improve and we expect another quarter sequential organic growth rate improvement as we move into 2017.

Adjusted operating margins were 13.3% of sale, benefitting from the cost controls, synergies and favorable timing of some SG&A expenses. On the right side of the slide you will see the Browning tool box technician app that we rolled out at the AHR Expo last week with a number of new features. One of the new features is a motor cross reference tool that allows the contractor to search and find one of our Marathon Motors. This app is utilized by thousands of AHR contractors to select the appropriate Browning products. By adding the motor cross reference capability, we're leveraging our Browning brand to cross sell Marathon Motors.

We continued our focus on simplification in the fourth quarter with three new announcements. First, we announced the consolidation and closure of our smaller Monetary Mexico HVAC facility into our existing HVAC manufacturing footprint. Second, we announced the consolidation of two of our China-based small motor factories. And finally, we announced the consolidation of two India large motor facilities. The combined restructuring cost, for these three programs are expected to be approximately $7 million, $800,000 was expensed in the fourth quarter and the remainder will be spent in 2017.

All three of these programs are underway, and we expect all of the programs to be completed by the end of the fourth quarter of 2017. We will begin to realize the savings from these projects in the second half of 2017 with the majority of the benefits impacting 2018. Payback on these programs will be less than two years. We're convinced that our Performance Excellence program is having a significant impact on our ability to exceed the customers' expectations. Performance Excellence is part of Regal's business system and is the underlying framework that drives our operations to continuously improve.

In 2016, across the Company we increased on-time delivery by two full percentage points and improved delivered quality by 38%. We received more good news from our customers during the quarter. We received two more awards from customers recognizing our performance around quality, delivery and innovation. That makes five awards that we've received in the last six months from some of our largest customers. The picture on the right shows our team receiving a continuous improvement award just a few weeks ago from one of our largest and most demanding customers that their annual supplier event.

At the event, our customer recognized our team for improvements in service, engaging in joint problem solving efforts, bringing them innovation and our commitment to their team at all levels in the organization. Performance Excellence is building a growth foundation by helping us to grow with existing customers and to win new customers.

I'll now turn the call back over to Mark.

Mark Gliebe

Thanks, Jon. Now, before we go to Q&A, I would like to do three things. First, I'll address the proposed Border Adjustability Tax. Second, I will briefly summarize our fourth quarter performance. And third, I'll summarize our total year performance.

With regards to the Border Adjustability Tax under consideration, as you all know, this is a dynamic situation and there is still a lot unknown. However, we thoughts we would explain our view at this time. We believe there are three key considerations. The first consideration is the fact that Regal's production based in Mexico is 35% to 40% of our total production, and we ship those products to customers in the U.S., Mexico, Canada, Europe, The Middle-East and other countries.

Second, a significant portion greater than 50% of the material used them at production is U.S. based. It's not clear how domestic content will be handled in the regulations. And finally, we believe the critical question in all of this is competitiveness. We have looked into manufacturing footprint of our electric motor competitors and most of our competitors produced their products outside of the United States. There are still many unknowns related to this potential legislation and we will share more with you as we learn.

Now, onto the fourth quarter review, our performance was in line with our expectations. Sales were down slightly with organic growth in Climate and C&I offset by slower markets in PTS. Margins were relatively strong in the quarter; however, they were masked by our $14 million LIFO expense. We were able to offset the LIFO impact with stronger operational performance. Our cash flow to net income was 202% and we used the free cash flow to pay down a 100 million in debt.

Now, I'll summarize our 2016 full year performance. There is no question we faced difficult market headwinds all year along. Oil and gas markets, the Middle East and two-way material price formulas were a drag in our top line from most of the year. The good news is that our organic growth rates improved for four sequential quarters, and the organic growth rates in Climate and C&I turned positive in the fourth quarter. As you can see from the slide, the highlights for the year were a 17-day reduction in cash cycle days, free cash flow of 148% to net income, a $315 million reduction of our debt, and total shareholder return of 20%.

Behind this performance was an incredible amount of operational change that gives us momentum as we entered 2017. We continue to simplify the Company with 13 additional plan product line transitions, three more warehouse consolidations and three more ERP conversions. A well-timed simplification investment helped us through the year when we had top line headwinds and promises to further payback as our organic growth improves.

And as we continue to simplify the Company, we have also continued our investments in exciting new energy efficiency technology such as DEC Star and UlteMAX that we believe we will pay dividends in the near future. We also continue to invest in our performance for our customers. We again improved both our deliveries and our quality. Our customers recognized our improvement performance with the highest ever customer survey scores and by rewarding us with five more quality and performance awards. The customer recognition is encouraging to us and bodes well for our future.

Before I close, please note that Regal will host an Investor Day on March 10th in New York City. We look forward to seeing you all there. We will now take your questions.

Question-and-Answer Session

Operator

We will now begin the question-and-answer session. [Operator Instructions] Our first question comes from Julian Mitchell with Credit Suisse. Please go ahead.

Julian Mitchell

My first question would just be around the -- you talked about price cost pressure on margins in the first half of this year. Just give us a sense of how severe those are and what kind of LIFO headwind do you dialing in for the first quarter for example?

Mark Gliebe

So, I’ll walk you through Julian and then perhaps Chuck or Jon, want to add in. So, you got to back to the third quarter when we were starting to see a turn in our material price formulas as a result of the fact that steel had been starting to inflate in the third quarter. And so, we had been predicting and forecasting that our material price formulas would start to turn, and as Jon mentioned, they had.

And then, coming into prior to the election, we announced one day before the election, we have kind of all that baked into our view and we have commented that we were excluding any impact of LIFO in our views from that point on. But copper and steel jumped, as Chuck said 13% and 20% that copper and steel right after the election. So that was the $14.5 million LIFO expense that we saw in the quarter.

Now, we will start to see that impact our cost in the first half, but there is a lag to the timing of the material price formulas kicking in. So, we will start to see the full benefit of the material price formulas on that inflation occur in the third -- beginning in the third quarter and then carrying on for some time after that. So that addresses a third of the Company. In terms of the rest of the Company that’s not impacted by material price formulas, we had a history of being able to offset inflation with appropriate pricing and we believe we will be able to do that.

So Chuck, do you have anything else you want to add to that?

Charles Hinrichs

Yes, Julian, just specifically about the LIFO impact in 2017. We have that in our guidance. We don’t have any specific LIFO impact, but the higher inflation that we are entering the year is built into our guidance.

Julian Mitchell

Understood. And thank you and then just my follow up would be around operating expenses. You had a very, very big reduction in OpEx year-on-year in the fourth quarter, a decent reduction in OpEx for 2016 as a whole. Should we expect that OpEx or SG&A line again to come down quite a bit in 2017? And were there any sort of one-time factors in that SG&A drop in Q4?

Charles Hinrichs

Good question, Julian. In the fourth quarter of the prior year, you would adjust out the Venezuelan write-off and the gain in assets sales that we had, so comparing that total of a $9.1 million reduction. Year-over-year, we got about $22 million reduction in SG&A, 10 of that was lower compensation and benefits, but five of that was foreign currency translation on some of our balance sheet and P&L items that runs through SG&A. So, you wouldn’t that serially count on that. When you look at the full year number, again, you’ve got to adjust out some of the larger entries in the prior year. And the base would then be reduced by again good control over compensation and benefits. And I think you would expect to see going forward that we would see some increase in SG&A year-over-year, but you know our history, we got a good control of controlling our SG&A and that’s factored into our guidance for the year.

Operator

The next question comes from Christopher Glynn with Oppenheimer. Please go ahead.

Christopher Glynn

Hey, Mark, I appreciate the complexions particularly on finished goods versus value add with respect to Mexico. Have you gained any perspective on what's gaining favor in terms of phase-in periods?

Mark Gliebe

We're really not hearing anything about that at this point, but as you know it literally changes every single day. So, we're going to stay quite close to it. We're analyzing all the different potential ways this could be implemented and will be ready. But like I said, I do think regardless of when if it's implemented or when it's get implemented, it really does come all down to a discussion of competitiveness for us. And so, most-most, not all, but most of our competitors make the product outside the United States.

Christopher Glynn

That makes sense. Just want to dive into the C&I segment, the trend you're seeing there in terms of first the oil and gas, how you describe your mix of early cycle sensitivity versus later lagging cycle? And then for power gen, if there are any indications there of that coming back and where that's landed sort of from peak to trough?

Mark Gliebe

Okay, I'll take a pass I don’t know if Jon must have any color he can. So, first, on the oil and gas, I'll start off by saying two years ago with oil and gas was 8% of our revenues. Today, it's as we excited '16 that was roughly 4% of our revenues, so -- and two-thirds of that being upstream for us. So, we have seen an increase in both increased enquiries and orders. So we have -- science started to see some green shoots so that gives us little bit of confidence about that market, but too soon to call it a dead trend. But we have seen a little bit of improvement there. On the power gen side, we saw if the market is down in the fourth quarter for us, and I don’t know Jon, do you want to comment on?

Jonathan Schlemmer

Yes, on power gen, we haven’t seen the same thing we've seen in oil and gas. I would call it slightly up as we went through January, if we compare the January order in power gen to the fourth quarter order rates, but not a material change at this point. And we really haven’t baked in any real markets strength into our guidance for power gen for the year.

Christopher Glynn

Okay. And any way to characterize oil and gas went 8% to 4%. Can we take a similar look at power gen?

Mark Gliebe

Over that period of time, I don’t know. Roughly, I think we've characterized power gen to be a $130 million business for the Company in total.

Jonathan Schlemmer

And we would have been down, Chris, double digits in throughout the year in 2016 in that business.

Operator

The next question comes from Mike Halloran with Baird. Please go ahead.

Mike Halloran

So let's start on the PTS margins, could you just help talk about a run rate there that you think looks appropriate? Margins have jumped around 2Q through 4Q a little bit. How do you think about the margins as we go through the year here?

Mark Gliebe

Yes, I understand your question. I think the way to think about it is that take the third quarter and fourth quarter and combined them. So, look at the second half and I think it will be a normalized rate of about 10%. So, I think that's a way to think about it going forward.

Charles Hinrichs

At that sales level, sales level in our second half and look at the combined margins that's probably is the way to think about our starting point as we enter 2017.

Mark Gliebe

Yes, this particular business leverages hard on the way down and leverages nicely on the way up.

Mike Halloran

Okay. And then second question on the inventory side. What's your view on channel inventory as we enter the year?

Mark Gliebe

So, if you recall our comments back on the third quarter, we thought the destocking was going to end in our PT distribution channel, as it turned out there were some late activity by a few of our customers who were destocking as they exit of the year. So that actually has helped the frontend the start of 2017. Customers are putting inventory back in place.

Charles Hinrichs

And I would say in Climate, our view is that inventory levels are not high at this point and especially through the distribution channel and we would feel that, if anything probably inventory is little light in the channel.

Operator

The next question comes from Nigel Coe with Morgan Stanley. Please go ahead.

Nigel Coe

I just want to dig in a few points already covered. The Mexican color is really helpful. Just wondering how much of production in Mexico is destined for the U.S. directly and maybe any color on, in terms of how much goes into the Mexican supply chains of the OEMs and then how much of that is exported, ex-U.S.?

Mark Gliebe

Good questions, I would say the majority of production out of Mexico is headed towards the U.S. We do supply, as I had mentioned a number of other companies, but it's not, if the majority would go to the U.S. And I think your second question was. How much of the product is actually going to OEMs who are right in Mexico? I would say a sizable chunk of it. I don't have the answer of the top of my head. That’s one we'll have to get for you. It is a good question, but it is a sizable piece of the business that goes right to our customers with operations in Mexico.

Nigel Coe

Okay. Great. You mentioned, I think Chuck mentioned, that comp was a $10 million piece of good news, '16 versus '15 on G&A and I think you also had a benefit in '15 as well. I'm just wondering what's dialed into for '17 in terms of comp maybe coming back in '17 over '16? And then perhaps given that you seem to be chasing more materials on the way up through the first half of the year, should we expect margins to be flat or even down in the first half of the year?

Charles Hinrichs

Nigel, this is Chuck. I'll start with the comp question. I think in terms of total SG&A which is included in our guidance. I think the year-over-year decreases and comp in benefits have really being achieved in 2015 and '16. And as we move into '17 where we expect to see some organic growth, I think the stability or stability with some slight inflation would be the trend. But again, we are still very good at controlling our SG&A.

Nigel Coe

Right, but my question was. Should we get a step up as you're still looking bonuses in '17?

Charles Hinrichs

It would not be in material amount.

Nigel Coe

Okay. And then just finally on the question on the raw material inflation and the impact on margins in the first half of the year.

Mark Gliebe

No question, Nigel, it's going to be a headwind in the first half of the year. And then our material price formulas as we expect there is a three to six months delay, it will start to get feathered in late second, early third quarter.

Operator

The next question comes from Scott Graham with BMO Capital Markets. Please go ahead.

Scott Graham

Good morning. Nice quarter, nice guidance, good job. The one thing I did want to ask, and again, sort of the same question that several have asked on the raw materials inflation. Pricing is obviously going to be two-thirds of sort off -- the hope is that we offset two-thirds of the business through pricing the inflation. And with the spike that you saw, assuming that your people are hard at work sort of formulating price strategies and increases and what have you, and I was just hoping you could give us, this is probably more a question for you Jon, some type of an indication as to how that's going, have any price increases been implemented, are they sticking, you know, what's the game plan there and any type of traction data points would be helpful?

Jonathan Schlemmer

Scott, good morning, this is Jon. So, I'll give you my view on that, and certainly Mark or Chuck can add in. So I'm going to go back to 2016, if you look at 2016, we had a price cost headwind for the full year, and when we were in the other environment with deflation, and a lot of that is due to the timing of some of the MPF and also the impact that we had in price cost as we entered the year last year. We talked about that throughout last year. What's built into our guidance for this year is we do expect a head wind as we have been talking about in price cost for 2017 having more of an impact in the first half than in the second half because of the timing of the MPF.

For the non-MPF business, as Mark said, we have a history of being able to manage pricing to offset commodity inflation. I feel good about that entering 2017. As Chuck mentioned earlier, we did take the latest inflation and copper and steel in the commodities as we exited 2016, factor that into pour guidance for 2017, and we also factored in what we believe we can achieve on the pricing side, and I would say so far there's been no surprises there. We have been able to manage that well across a number of our businesses.

Mark Gliebe

And you're right, Scott, that if the people are working real hard at it, it was probably too soon to say directly how it's going. It's a little early yet but you're right, everybody is working real hard at it.

Scott Graham

I'm sure. Does this change the seasonality of earnings for '17 a little bit more back half oriented?

Jonathan Schlemmer

I would say, it's not a big impact overall. We have other, a lot of other things that we have some carry over and simplification that helps us in the first half as well to offset some of those challenges on price cost. So, I think if you think about the earnings profile not a significant change.

Scott Graham

Okay. Last question, on the end markets, I know you touched on a number of different ones relative to the, each of the segments, could you kind of re-sketch that for us. I mean, you guys are in a ton of different end markets, sort of which of the best ones right now, which are still the laggers and any kind of charge at the margin, just on your larger end markets, if you can just sort of sketch that out?

Mark Gliebe

So, I'll start off and Jon will help me out. So again, we commented on Resi and Commercial HVAC, Jon talked about low double-digit growth in residential HVAC, and you know, that was a help to us as we exited the fourth quarter. Commercial was positive. Commercial HVAC was positive, low, mid single digits. China was improving in the quarter, in the fourth quarter and we're seeing improved oil rates out of China. We -- on some smaller markets, our pool distribution market was positive in the quarter. Our top market was positive in the quarter; however, we were still feeling the effects of the Middle East on the top line, and still feeling the effects of oil and gas on the top line. Anything else I missed?

Jonathan Schlemmer

And those were the key ones.

Scott Graham

Well, one of your larger markets is that sort of, that factory market, sort of general industrial things that go through distribution. Could you give us an idea of what you're seeing there?

Mark Gliebe

Well, the good news is I would say we saw the third or fourth consecutive quarter of improved organic growth. And as we had commented overall, our C&I business was positive organic growth in the fourth quarter, but that general equipment market through the fourth quarter was relatively flat on a year-over-year basis. Order rates did show some improvement as we exited the year.

Operator

The next question comes from Jeffrey Hammond with KeyBanc. Please go ahead.

Jeffrey Hammond

So just on Climate, I just want to understand the margins a little bit better, 4Q to 4Q because if you pull out LIFO both years it seems like you have a 500, 600 basis point improvement in margins, versus the rest of the year where it seemed fairly stable. So what was really going on there ex-LIFO, how sustainable is that?

Jonathan Schlemmer

So, Jeff this is Jon. I would say that one of the things -- the two things of that really benefitted our margins in Climate in the fourth quarter. One was that, we mentioned that North America residential HVAC was up low-double digit sales growth. So, we had a lot of volume improvement in the business certainly in the quarter. We also had some pretty significant help from the simplification efforts that we've been working on over the last two years, and that starting to show up and help to improve our margins in that business. So to me those would be two the real big drivers in the quarter.

Jeffrey Hammond

Okay. So simplification, that stuff should sustain, and then it really depends on the volume and the North America resi volume, is that really the market or is this, a lot of the DEC Star stuff starting to kick in?

Jonathan Schlemmer

I would say it's mostly market. We are getting revenues from DEC Star and some of the new products, but the improvement we saw on the top line in the fourth quarter was more of the market.

Jeffrey Hammond

Okay. Great. And then Mark, again, good color on Mexico, can you just talk about should this border adjustability tax go in as discussed, what are you thinking about in terms of contingency plans or what changes or doesn't change?

Mark Gliebe

Well, the good thing is that we have this unique kind of footprint that we were making our products -- we have 14 -- I am sorry, we have 21 factories in United States though in this company. So to our home markets and so we're pretty good at making whatever we need to make right here in the U.S. if we need to. But we have a substantial footprint in Mexico with 15 factories and so, we also make product in India and China. So, we have a kind of relative to our competition. We have a unique footprint and what we have proven, we can make the product anywhere we need to make it and serve our customer base. So, we are going to need to be agile when it becomes clearer of which direction this is all going and we'll be ready.

Jeffrey Hammond

And if I could just speak one final one on oil and gas, clearly smaller piece of the business now given the market, but two-thirds upstream, we're seeing some good things on land base upstream, just and it sounds like your business is still weak, so kind of what's the underlying tone, quoting activity, how close do you see us to being kind of at an inflection? Thanks.

Mark Gliebe

So, as I commented earlier, certainly, our top line was weak in the fourth quarter, and we expect to have still top line pressure until we exit the second quarter; however, I did comment that we are starting to see better orders and better inquires, better backlog of entries than we have. So, that’s encouraging to us and this would have been a very tough market.

Operator

The next question comes from Joshua Pokrzywinski with Buckingham Research Group. Please go ahead.

Joshua Pokrzywinski

Just a follow-up on some of the oil and gas commentary, I guess Mark, what do you have in guidance for oil and gas, do you see that starting to rebound here maybe in the second half and could you just remind us what some of the lead times are for that? I guess upstream land-based product that led on the way down?

Jonathan Schlemmer

Josh, good morning. This is Jon. So, we do have in our guidance growth expected in the latter half of the year. We are looking at the year and I think that we could size up oil and gas for us, we have had in our forecast call at mid-single digit growth in the oil and gas end markets for the Company. So off a pretty low base, so grow, that’s good news, but off a pretty low base as we exited 2016. If you think about some of our business, we have some business that is, I call it kind of mid cycle, those are the businesses where we are seeing the increase in enquiries and increase in order activity right now.

Now, we have some other longer cycle businesses that we yet to see the increase in order rates. And we haven’t really factored in for those business as much strength even in the later half, but in our the part of the business that we considered to be more mid cycle in and major we have definitely seen the increase order activity and that’s where the mid-single digit growth expectation is coming from.

Joshua Pokrzywinski

And then just on the lead times for those? For what you have? Like could it come in the first half if order trends persist or is it really no chance of a turn before the second half?

Jonathan Schlemmer

I would say that we should think about a second half impact. There could be some latter second quarter activities. I think about lead time in some of these products, if the order rates continue to look positive. But I think in general, we should think about as a second half impact.

Joshua Pokrzywinski

Got you. And just turning to the balance sheet, is there any plan to kind of, you know, re-examine some of that bank debt for the PTS deal with interest rates moving up here?

Charles Hinrichs

Josh, this is Chuck. Not really, we have an increasing confidence in our ability to continue to generate strong cash flow. So, I think we are comfortable with the variable rate debt particularly given the progress we made in 2016 in debt reduction. So, no current refinancing plans on the table.

Joshua Pokrzywinski

Got you. And then just one final one on kind of the broader simplification or productivity initiatives, can you remind us if you had to sum up everything that you got in 2016, what would that look like kind of in the rear view mirror? And then how should we think about that same line item into '17 as being similar or accelerating, so not a price cost discussion not a, not like a mix discussion?

Charles Hinrichs

I think one way if you look at the year clearly we had margin rates down on a year-over-year basis for full year. For a moment, if you exclude the LIFO impact in prior year and in 2016 and look at what happen to the underlying margins in the business with organic sales down 8%, we would have been down something like 20 basis points on operating profits on adjusted our profit for the year.

And I think, we would say that the major reason for those decrementals being much lighter than normal is the simplification and productivity efforts that we have been working on for the past several years in the Company. And that’s -- so I don’t have any exact number, Josh, for the dollar impact in the year, but clearly we are seeing those benefits in the underlying performance of the business.

Operator

The next question comes from Bhupender Bohra with Jefferies. Please go ahead.

Bhupender Bohra

Could you talk about the vitality index? I don't know if you have that internally, but I think Jon talked about the new products you introduced over the last few years. Give us a sense of like how is that contributing and if there's a number on the vitality index, I would like to know that, thank you.

Jonathan Schlemmer

Yes, so we haven't calculated for a while. So, we do -- we are paying attention to it here and will be taken a closer look at it in 2017. And we will look at as new products that are five years older or less. But we don’t have the number for you right now, Bhupender, we can share in the future with you.

Mark Gliebe

And then -- sorry go ahead Jon.

Jonathan Schlemmer

I was just going to say, Bhupender. In terms of the products that we've talked about today and have talked about in the past calls, UlteMAX, we don’t have revenue in the fourth quarter from UlteMAX. We are just now launching that product. But the lead recreation that we had at AHR just last week for example, we are very excited about the level of customer interest on that. We have a number of launched customers that we will sell the product this year. Now, it won't have a material impact on our revenue in 2017 for the C&I segment. But we do believe that product will have a material impact over the three to five year period.

And DEC Star, we are selling the product today. We have a number of customers, number of customers have showed product in their products at AHR. We have the revenues today. Again, it's not a as I answered the question earlier, it's not the key driver and why our revenue was up in the fourth quarter. It is contributing though, and it will contribute at a higher rate as we move through '17 and into '18 especially with the FER requirements coming in 2019.

Bhupender Bohra

Okay. Got it. Now, just moving onto the next question here from the end market perspective, I think you did mention power gen was kind of weak and has been weak in 2016. Any color on why this market, you haven't seen much pickup like in January sequentially from fourth quarter?

Jonathan Schlemmer

I don’t know why we haven't seen a pickup in January. I just know that looking at our order rates, they were up -- I would call it up kind of mid-single digits from the orders rates that we had in the fourth quarter. So while that’s an improvement, it's only in one month, and this business is typically, when I look at the business, we have to look at more like three month order period to really see a trend.

Bhupender Bohra

Okay. Is that business mostly U.S. or international, any other color like whether the underlying factors within power gen kind of weak as we go into 2017 as some of the peer groups have been talking about?

Jonathan Schlemmer

Yes, most of the business we serve is, we consider to be standby power requirements. So most of our products go into some sort of standby power application, a hospital for example little bit of data centers. And it is an international business, so we have the sales in Asia for example that is a significant substantial portion of the business. So it's North America, Europe and Asia is the way to think about the revenue split.

Bhupender Bohra

And lastly just on the Climate Solution, if you remember in 2016 I think there was a revenue shift just because of the weather changes from second and third quarter. How should we think about the Climate Solution in terms of sales in the first half versus second half this year? Would it be -- the second quarter should be a bigger quarter like in terms of Climate Solution?

Jonathan Schlemmer

So, what happen in 2016 is interesting, both the cooling season and heating season had a similar dynamic. We started the cooling season rather weak, finished the cooling season rather strong and in fact to some of that demand carried over into the third quarter that we would have typically seen in Q2, and we even had some of that carry into in regard to Q4. So, I do think that is something that will see that in our comparisons in 2017.

Now, the heating season start off rather weak. If you recall on our last call, we talked about that, the start of the heating season was pretty poor from the weather standpoint, now it ended very strong in December. But when you go back now and look at January in terms of heating degree days, January hasn’t been anything to celebrate. So, our demand has been okay, has been solid I would say as we entered the year for Climate in 2017. But when you think about the cooling season last year, we will see that and we will see some of that in our comparisons in the second quarter and third quarter.

Operator

The next question comes from Sam Eisner with Goldman Sachs. Please go ahead.

Samuel Eisner

Just a couple follow ups on the power transmission business you guys called out the Mastergear divestiture of 2.5% and then also some synergies that were aiding the margin, any way to put some dollar numbers behind how much the divestiture as well as the synergies benefited that segment on an EBIT basis?

Charles Hinrichs

Well, Sam. This is Chuck. In terms of the Mastergear, we had given earlier guidance that the sales were about $22 million, and the op profit was like $4 million for the full year. So, the amount that we're adjusting top line is pretty much along those same lines. And in terms of achieving the synergies, we are on track to hitting our third year of the PTS synergies. You recall originally our time line was four years, we brought that up and we have every confidence that we will achieve that in 2017.

Samuel Eisner

Got it. That's helpful. And then maybe on going through the simplification again, I recognize that you guys aren't giving any numbers here, but can you talk about the cadence of simplification throughout the course of the year? Was fourth quarter the strongest, just kind of help us understand the phasing and then ultimately how that's going to impact 2017 as well?

Charles Hinrichs

I would say that in terms of the cadence, we had a more impact in the second half than we did the first half in terms of some of the key programs and the timing of those programs. We have some night carryover benefit that will come into 2017, that will help, that is the key in helping us to offset the headwind on price cost.

Mark Gliebe

And then you mentioned, we have these are the three programs that will help late.

Jonathan Schlemmer

Yes, they'll kick in late. So, I think, if we think about it, we're set up pretty nicely I think to see solid impact from simplifications throughout the year in 2017.

Samuel Eisner

Got it. And then maybe just lastly on free cash flow, obviously a very good job on inventory reduction with about $115 million, $114 million or so. What is the expectation entering next year regarding working capital and how that ultimately affects your greater than 100% free cash of net income?

Mark Gliebe

So, as Chuck mentioned, we certainly expect greater than a 100% going to next year, so no question about that. We got a little bit of a help right at the end of the year to our $114 million number from the LIFO benefit. And then as we look at next year, we still expect to improve our total cash cycle days as we go into the year, certainly not at the same rate from an inventory perspective that we did in 2016.

Operator

The next question comes from Chris Dankert with Longbow Research. Please go ahead.

Chris Dankert

I guess first off, you commented on some of the renewable energy impact on 4Q, could you just kind of remind us how big is that business and have you seen any risk to that business just from maybe less federal regulation on energy efficiency and kind of where the energy comes from?

Mark Gliebe

So, renewable energy has -- the renewable energy business we have been talking about from last couple years. In '15 and '16, it was great new organic growth for us. We were selling into the solar panel space. And what we have been working through over the last couple of years and into 17 is the choppiness of the order pattern. This business is dependent on large projects, and so one quarter you will hear us talk about strength in that space in the next quarter you will hear us talk about weakness in that space. But it has to do more overall with the kind of big projects that our customers get in that space. So, we feel great about it, it's been good for us, and we think it will continue to grow. It's not clear to me from anything I heard of so far whether or not that business will be impacted by any proposed legislation, I just don’t know.

Chris Dankert

Got it. Yes, that's fair enough. And then I guess kind of looking at 2017 on the whole, were you calling out any additional program pruning just from lower margin stuff in 2017 at all?

Mark Gliebe

Well, we were always looking and analyzing our businesses and our SKUs and our portfolio for appropriate pruning. So, I would say that’s always potential.

Chris Dankert

But nothing explicit you call out at this point.

Mark Gliebe

No, not at this point.

Chris Dankert

Got you. And one last one if I could sneak it in here, as far as capital deployment you articulated what plan 2017 is, I guess exiting the year looks like you will be kind of below the 2.5 times leverage ratio you have been aiming for. Does that put M&A back on the table for 2018 then?

Mark Gliebe

So, Chuck made the comment that we expect to pay down 200 million more in debt, we're going to be using a portion of our free cash flow to pay down debt. And as we entered the 2.5 that the EBITDA ratios, we will be analyzing other forms of capital employment including share repurchases and M&A.

Operator

[Operator Instructions] The next question comes from Robert McCarthy with Stifel. Please go ahead.

Robert McCarthy

With that preamble, I'm going to go back to running the gauntlet of the border adjustability tax questions. In terms of your net importing exposure, I apologize I was switching between conference calls, but have you quantified the size of that? And just as a follow up is there certain end markets or product lines or SKUs where you just think pricing could be an issue in terms of getting price if we get in a situation where border adjustability becomes a real issue in terms of passing along through price the inherent cost of tax or the tariff? Could you comment on that?

Mark Gliebe

Yes, so from a U.S. perspective, we are net importer, we haven't quantified it. But it's probably in the range of two to one as probably the way to think about our…

Jonathan Schlemmer

Imports versus exports.

Mark Gliebe

Imports versus exports, so in terms of pricing, it's very too soon to be thinking about that. I think our perspective is just to say where we will be able to be competitive. And like I mentioned before, most, but not all, most of our competition makes the product outside the United States in our key markets. So, that’s to us is the key part.

Jonathan Schlemmer

And then the last question is just the extent of the line of questioning on M&A, obviously the focus is debt pay down and restructuring, not restructuring but improving the core business that is you do have. But do you think this amount of legislative uncertainty or tax uncertainty, how do you think about managing that down the road in terms of trying to do the right deals on the M&A side, do you think that makes selection, strategic selection of assets more difficult?

Mark Gliebe

Well, I think you are bringing up a good question. I mean, certainly, we are going to have to be analyzing what sort of potential impact to be of any of this proposed legislation and anything that we might be interested in. So, I think it's a fair question and one that through our diligence processes, we'll be particularly taking a hard look at when we get to that point.

Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Mark Gliebe for any closing remarks.

Mark Gliebe

Thanks for your interest in Regal and have a great day.

Operator

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

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