EnPro Industries, Inc. (NPO) CEO Stephen Macadam on Q3 2018 Results - Earnings Call Transcript

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About: EnPro Industries, Inc. (NPO)
by: SA Transcripts

EnPro Industries, Inc. (NYSE:NPO) Q3 2018 Earnings Conference Call November 1, 2018 10:00 AM ET

Executives

William O'Neal - SVP, Strategy, Corporate Development & IR

Stephen Macadam - President, CEO & Director

Marvin Riley - EVP & COO

Milton Childress - EVP & CFO

Analysts

Jeffrey Hammond - KeyBanc Capital Markets

Joseph Mondillo - Sidoti & Company

Charles Brady - SunTrust Robinson Humphrey

Justin Bergner - G. Research

Operator

Good morning. My name is Deidra and I'll be your conference operator today. At this time, I would like to welcome everyone to the EnPro Industries 2018 Third Quarter Results Conference Call. [Operator Instructions].

I will now turn the call over to our host, Mr. Chris O'Neal, Senior Vice President of Strategy, Corporate Development, and Investor Relations. Sir, you may begin your conference.

William O'Neal

Thank you, Deidra. Good morning and welcome to EnPro Industries' quarterly earnings conference call. I'll remind you that our call is also being webcast at enproindustries.com where you can find the slides that accompany the call. Steve Macadam, our CEO; Marvin Riley, our COO; and Milt Childress, our CFO will begin their review of our third quarter performance and our outlook in a moment.

But before we begin our discussion, I will point out that you may hear statements during the course of this call that express the belief, expectation or intention, as well as those that are not historical facts. These statements are forward-looking and involve a number of risks and uncertainties that may cause actual events and results to differ materially from such forward-looking statements. These risks and uncertainties are referenced in the Safe Harbor statement, included in our press release and are described in more detail, along with other risks and uncertainties, in our filings with the SEC including our Form 10-K for the year ended December 31, 2017. We do not undertake to update any forward-looking statements made on this conference call to reflect any change in management's expectations or any change in assumptions or circumstances in which such statements are based.

Our earnings release and conference call presentation materials contain additional disclosures regarding the following. First, non-GAAP financial information; second, collective references to EnPro and our subsidiaries; third, the deconsolidation of Garlock Sealing Technologies, or GST, and OldCo, LLC or OldCo, during relevant periods until their reconsolidation effective as of July 31, 2017, and finally, pro forma illustrative financial information for the 3 months and nine months period ended September 30, 2017, presented as if GST and OldCo were reconsolidated for financial reporting purposes throughout that period. These disclosures are important to understanding comments we will make on today's call and we urge you to read them carefully.

Consolidated results for the period after July 31, 2017 reflect the reconsolidation of GST, its subsidiaries and OldCo, as a result of the completion of the Asbestos Claim Resolution Process. Pro forma results for the period prior to July 31, 2017 have been prepared has if GST and OldCo have been reconsolidated and the basis in our earnings release. Most of the difference between consolidated and pro forma information is in Sealing Products, with only small differences in Engineered Products and Power Systems, stemming from foreign operations of those segments included in GST foreign subsidiaries. We believe that investors will find comparisons of consolidated results for 2018 period to pro forma results for the prior year period to be most illustrative of the year-over-year performance of all of EnPro's businesses. For clarity, throughout this script, we will compare consolidated results for the third quarter and nine months period of 2018 to pro forma results for the third quarter and nine months period of 2017.

And now I'll turn the call over to Steve.

Stephen Macadam

Thank you, Chris. Good morning and thanks for joining us this morning. In the third quarter, we generated robust year-over-year sales and earnings growth, driven by continued favorable demand in many of the markets that we serve. Sales of the semiconductor, aerospace, food and pharma, heavy duty tractor and trailer OEM, general industrial, metals and mining, and oil and gas markets grew year-over-year.

Also as expected, we generated strong sequential and year-over-year growth in our Power Systems segment, due to increased engine revenue for programs with the U.S. Navy and robust aftermarket parts and service demand.

Organic sales, which we define as excluding the impact of acquisitions, divestitures and currency translation, were up approximately 10% over the prior period, up 12% in Sealing Products, 5% in Engineered Products and up 10% in Power Systems. A big part of our increased profitability in the third quarter came as a result of addressing 4 key issues that weighed on our first half results.

First, as we have mentioned throughout the year, Power Systems' military, marine, engine and aftermarket parts and service revenues is heavily weighted towards the second half of the year. This resulted in both sequential and year-over-year increases in segment profit in the third quarter and we expect this momentum to continue through the end of the year, supported by a record level of aftermarket backlog.

Second, we had a better than expected wind down of the industrial gas turbine business, which eliminated the need for any additional restructuring charges in the second half of the year. As you'll recall, beginning last year and accelerating in the first half of this year, we experienced structural changes in this market that had strong negative impact on the business and led us to the restructuring actions that we spoke about previously.

Third, during the quarter we gained confidence that we'd addressed that 2 product quality issues in our heavy-duty truck brakes business and that our warranty reserve is sized appropriately. And finally, our heavy-duty truck business was able to partially recover tariff related commodity cost increases through ongoing price increases.

Our third quarter adjusted segment EBITDA was up 14% versus last, up 19% in Sealing Products, 5% in Engineered Products and up 7% in Power Systems. Looking ahead, we expect favorable conditions in most of our core markets to continue through the end of the year. In the fourth quarter, we anticipate positive market conditions in aerospace, food and pharma, heavy-duty tractor trailer OEM, general industrial, metals and mining, and oil and gas. Momentum in these markets could be partially offset by softer demand in semiconductor, automotive and nuclear.

Now I'd like to turn the call over to Marvin, who I've asked to provide an update on our operating model.

Marvin Riley

Thanks, Steve, and good morning, everyone. As Steve noted, we corrected several operational issues that impacted our profitability in the first half of the year, and we're performing quite well operationally. Our ability to identify, isolate and resolve operational issues is a direct result of the robust and flexible operating system we've developed over time. Our operating system is fundamental not only to our operational capabilities, but also to how we go to market, how we develop talent, how we innovate new products and how we formulate and deploy our strategy throughout our businesses.

Let me give you a couple of examples of where our operating system is helping our business. We know there is a lot of concern about tariffs. We've been impacted directly by tariff related commodity cost increases and have incurred indirect impacts as a result of the tariffs. But our operating system has enabled us to respond effectively and minimize the impact. Where possible, we're shifting the sourcing and production of products between the regions in order to minimize tariffs. Given the premium position of our products in the market and their use in critical applications where performance matters, we've also adjusted pricing to offset much of the impact. These initiatives are ongoing as the tariff situation continues to unfold.

Another example is where we have deployed the system as a use of switch cost analysis to reduce costs from our steel supply chain. Utilizing our switch cost approach, we've been able to secure a savings of 2% to 6% on hot and cold rolled steel for Q1 of 2019. Switch costing is just one of many tools we are deploying across every business within our segment to reduce costs. These are just a few examples of how we leverage our unique operating system to drive value in our businesses.

And now I'll turn the call over to Milt.

Milton Childress

Thanks, Marvin. Our reported third quarter sales of $388.2 million were up 9.4% over the third quarter of 2017. Organic sales were up 9.9% over the prior year, up 11.6% in Sealing, up 4.7% in Engineered and up 10.2% in Power Systems. Gross profit margin for the third quarter was 32%, down about 3 percentage points compared to the pro forma gross margin in the third quarter of last year. There were 3 primary drivers of the year-over-year decline. First, an IT reclassification from SG&A to cost of goods of approximately $3 million. Second, raw material cost increases, net of price increases of approximately $2 million, primarily in our heavy-duty truck business, and third that impact of customer mix shifts in Sealing Products and Engineered Products totaling approximately $2 million.

In the Sealing Products segment, we experienced strong sales growth in the quarter with sales up 11.1% over the pro forma results in the prior year period. This year-over-year sales increase was due to strength in semiconductor, aerospace, food and pharma, heavy duty tractor and trailer builds, and metals and mining, partially offset by the exit from our industrial gas turbine business and tariff driven softness in the U.S. oil and gas high banking structured market.

Segment adjusted EBITDA, which excludes the impact of restructuring and acquisition expenses, was $50 million, up 18.8% relative to last year. The increase year-over-year was driven by higher sales volumes and a $4 million net credit related to a legal matter in the heavy-duty truck business, partially offset by tariff related cost increases in the heavy-duty truck business.

The legal settlement was for recovery of a portion of damages in connection with the 2015 acquisition of ATD, which had adversely affected earnings in prior periods. Also of note, and as Steve mentioned, our restructuring activities in connection with reducing our exposure to the industrial gas turbine market are now complete.

Sales in Engineered Products segment were up 3.3% over the prior year period, driven by demand strength in general industrial and downstream oil and gas markets, partially offset by year-over-year decline in automotive. Segment adjusted EBITDA was $12.4 million, up 5.1% over the third quarter of 2017. Excluding the impact of foreign exchange translations, segments adjusted EBITDA increased 5.8% in the third quarter over the prior year period, primarily due to increased sales volumes. Segment adjusted EBITDA margins in the third quarter were 15.9% compared to 15.6% in the prior year period.

In the third quarter, sales in Power Systems were $61.4 million, up 10% over the prior year period. As Steve noted, the increase was primarily due to higher aftermarket price of service revenue driven by a record aftermarket backlog and strong engine sales in the military and marine segment. Results for the quarter included $2.7 million of sales related to the EDF program.

Through the end of the quarter, we had shift 9 production engines and expect to shift 3 to 4 additional EDF engines by year-end. Production of the 21 engines was approximately 76% complete at the end of the quarter, and we have built approximately 46% of the total contract value. Due to the timing of billings, primarily after individual engine deliveries, at the end of the quarter, we had a net investment in the EDF program of approximately $39 million. This investment consists primarily of accounts receivable and unprocessed engines, which we expect to convert to cash in 2019 as we complete delivery of the remaining engines.

Segment adjusted EBITDA on Power Systems was $10.4 million, up 6.9% over the third quarter of 2017. Results for the quarter include a program loss of $700,000 for the EDF program of which $200,000 was FX related. Excluding the impact of foreign exchange on the EDF contract, which had a positive impact of $2.3 million in the third quarter of 2017 and a negative impact of $200,000 that I just mentioned in the third quarter of this year, segment adjusted EBITDA increased 42.6% in the third quarter versus the prior year period.

Adjusted earnings per share for the quarter of $1.36 was up 63.9% compared to the third quarter of 2017. Adjusted earnings per share adjust for items such as environmental reserve charges, restructuring costs, impairment charges, acquisition expenses and normalized tax rates, all are shown in the tables attached to our earnings release.

Third quarter increase was driven by increased segment profit of $8.7 million, a $3.4 million decrease in corporate and other costs and a $2 million decrease in net interest expense, partially offset by a $2.8 million increase in adjusted income tax expense. Average diluted shares outstanding were $20.9 million in the third quarter of 2018 compared to $21.8 million for the same period a year ago. The reduction was primarily driven by share repurchases.

Slide 11 summarizes our major uses of capital in the quarter. In the third quarter, we invested $18 million in facilities, equipment and software, driven primarily by spending in Power Systems to support programs with U.S. Navy. We also paid a $0.24 per share dividend totaling $5 million and we completed our most recent $50 million share repurchase authorization. Since beginning of 2015, we have repurchased a total of 2.8 million shares for approximately $177 million.

We announced yesterday that the Board of Directors authorized the company to repurchase up to $50 million of its common shares over a 2-year period of time. Under this new authorization, we may repurchase shares in both open markets and privately negotiated transactions. As you know, we are taking actions to realize the benefits of the loss created last year in conjunction with the ACRP-related trust funding.

On our first quarter earnings call, we indicated that we anticipated receiving federal tax refunds, totaling approximately $128 million by the end of 2018. In the first half, we received $96 million of the federal tax refund and we estimate that we will receive the remaining $32 million in the fourth quarter of this year. In addition, we refined our provisional federal and state toll charge estimate with a reduction in the toll charge of a $11.7 million to $5.1 million.

At September 30 this year, our cash balance was $120 million and our borrowings totaled $480 million, down from $189 million and $618 million respectively at December 31 of last year. The reduction in cash resulted from the repatriation of overseas cash facilitated by tax reform. The reduction of borrowings is primarily a function of repatriation and a federal tax refund we received in the second quarter.

On October 17, 2018 -- October 17 of this year, we completed an offering of $350 million 5.75% senior notes due 2026. And on October 31 of this year, just yesterday, the pre-existing $450 million 5.875% senior notes to 2022 were redeemed in full. The refinancing of our senior notes extends the tenure of our fixed rate debt by 4 years providing a solid base to our capital structure for the foreseeable future. The refinancing also lowers our cost of debt and have reduced size provides flexibility to pay down debt in the future. In addition, the new issuance includes more favorable indenture provisions including an expanded capacity to repurchase shares.

We outline on Slide 14 our consolidated net debt and leverage ratio at the end of the third quarter. As you can see, our leverage ratio at the end of the third quarter was approximately 1.7x trailing 12 month pro forma adjusted EBITDA. Based on our guidance for the year, an outlook for cash generation in the fourth quarter, exclusive of any share repurchases and acquisitions, we would expect to end the year with a trailing 12-month leverage ratio of approximately 1.4x.

I want to take a moment to discuss one way that we're managing our currency risk. As you know, a significant portion of our revenue is generated by European subsidiaries, while our debt is denominated in dollars. Earlier this year, we entered into a 4-year cross currency swap to protect the U.S. dollar value of our euro asset exposure. And at this, we are synthetically swapping a portion of our debt from dollars to euros. But the benefits of this are twofold; first, we obtain better alignment of assets and liabilities through revenue distribution globally; and second, we lower our effective borrowing rates due to the lower euro interest rates. As a result, we expect to see interest expense savings of approximately $7 million per year over the life of the swap.

Another accomplishment in the quarter was the annuitization of a portion of our pension obligations. On June 26, we entered into an agreement to purchase a group annuity contract to transfer approximately $68 million of outstanding projected pension benefit obligations related to certain U.S. retirees or beneficiaries. The transaction closed on July 3 and was funded with pension plan assets with a value of approximately $71 million.

As a result of this transaction, our non-cash pre-tax pension settlement charge of approximately $12.8 million was recognized in the third quarter related to the acceleration of amortization of net actuarial loses. This charge was recorded in other non-operating expense on the consolidated statements in operations. The annuitization reduced our pension obligations by about 20%, and our pension retiree population by about out 70%, thus eliminating current cost of servicing this portion of the pension population as well as reducing future cost that might result from changes in market rates and changes to PBGC fees.

Now I'll turn the call back to Steve.

Stephen Macadam

Thanks, Mill. We'll close with a discussion of current market conditions and our outlook for 2018, and then take questions. As we've always explained, we have limited visibility of future demand. With the exception of Power Systems, most of our businesses have relatively short order-to-shipment cycles. A typical order backlogs range between a handful of days to a couple of months. Additionally, the component nature of many of our products often obscures correlations with macro and market indicators. As usual, our guidance excludes impacts from future acquisitions and acquisition-related costs, restructuring cost, the impact of foreign exchange, changes subsequent to the quarter end, and any litigation or environmental charges.

Given current macroeconomic forecasts, a robust backlog in Power Systems and positive demand patterns in many of our markets, we believe that our sales momentum will continue through the end of the year. We expect full-year sales to be up about 9% over last year's pro forma sale. And we've tightened our full-year adjusted EBITDA outlook to between $217 million and $220 million. This reflects confidence in our ability to execute on the Power Systems backlog and our current visibility of order trends in our other businesses.

Now we'll open the line for your questions.

Question-and-Answer Session

Operator

[Operator Instructions]. And our first question comes from Ian Zaffino with Oppenheimer.

Unidentified Analyst

This is Mark on for Ian. So I guess -- thanks for going over the breakdown of the tariffs and material cost and trucking during the quarter. Can you just speak a little bit on the sentiment and confidence in the pointing I guess price increase is going forward as we exit the year-end and to 2019 offset potential elevations and tariffs and of cost and especially on the overall segment profitability?

Stephen Macadam

Yes. Well, Mark, we remain confident -- this is Steve. We remain confident that we can pass through price increases that are direct to tariff impacts as well as indirect. We typically suffer a bit of a lag when that happens. And -- but we don't know exactly where those are going to happen and this work to get them through. But our experience has been over time, we can pretty much support the gross margins that we've had historically.

Unidentified Analyst

And then just a follow-up. Can you, I guess, like share any updated thoughts on Power Systems, on your revenues margins for the balance of 2018 that's now is going to 2019? And any updates on OP 2.0 discussions will be much appreciated.

Milton Childress

Mark, this is Mill. I'll take the first question and then Marvin will provide an update on trend. We're expecting as we've been communicating throughout the year, as Steve talked about in the call, a strong second half of the year. We saw that in the third quarter. And we will also expect to have a very strong quarter in Power Systems in the fourth quarter supported by the backlog, backlog being the engine, new engine backlog as well as the record aftermarket parts of service backlog. So our team is working very diligently and everybody is on board to working on plant to try to get up production through the support of the business that we have in hand. So we're expecting it to be a good -- another good quarter in Power Systems.

Marvin Riley

I'll provide a little color -- this is Marvin. I'll provide a little color on the drive in OP. So this part, we've narrowed in on a launch customer and we hope, and we have signed a letter of intent with this particular customer. We intend to perform field testing of the drive in OP in Latin America at this point with this customer. In terms of timing, we anticipate that we will ship that engine late Q2 of 2019 or let's call it the first 2 weeks of Q3 of 2019. And around this time next year, the customer will have taken delivery, and we'll have likely commissioned the engine at that point. We are currently also working on a finalized and more definitive agreement at this point as well and we can provide you an update at later call, we send this whenever we get that finalized.

Operator

And our next question comes from Jeff Hammond with KeyBanc Capital.

Jeffrey Hammond

So STEMCO is good to see that snap back there. Can you just give us your confidence level that some of those product quality issues are fully behind you?

Stephen Macadam

Well, in both cases, the product quality issues were behind us even before our last quarter call. We booked a big warranty reserve in 2 product categories. We had solved the problem, Jeff. So the problem was contained months ago. But the question really was -- the uncertainty really was, were our estimates for the warranty reserve adequate to cover what was already in the field. And so, at this point, we're pretty confident that we've got it covered. And don't see it at this point. And we don't have it completely covered. Certainly I can't imagine it's going to be any kind of a big number, but -- so that's kind of where we stand.

Jeffrey Hammond

And then just on the end markets, it looks like some of the arrows turn red, semi, oil and gas which I think you called out around some tariff issues, and auto. Just so a little more color on what you're seeing there. I know there is some market volatility out there.

Stephen Macadam

Yes. That's a good question. Let me take all 3 of them separately. The first which is the easiest one which is oil and gas is actually very isolated down to U.S. oil and gas pipeline construction, new pipeline construction. It turns out that a very high percentage of steel pipe for pipeline construction comes from China. So that was impacted pretty dramatically 25% tariff earlier in the year and many of those projects kind of stalled. And our view is because the cost per mile went up quite a bit and there was a bit of a flurry if you'll recall over the summer, there was a bit of a view that, hey, maybe this whole thing will get negotiated away and be eliminated relatively quickly. And so -- excuse me, our view with discussions with customers as they were kind of just pulling back hoping that that would happen.

Obviously at this point, it doesn't appear that that's going to happen. It appears like we're going to live with this for a while. And so we've actually seen a little bit of that order pattern kind of come back just really very, very recently. And our view is you just can't -- these are not projects -- excuse me, not projects that would be canceled because of this because there's obviously a lot of other things involved with building a pipeline other than just the cost of the pipe. And so we're hopeful that that was just a little bit of a blip. But that's very isolated. Other than that, the oil and gas market is strong -- certainly strong globally in all of our -- other than the construction of news that the mid-stream and down-stream markets are still feel pretty good. That's number one. Number two, auto, nothing is really changed in the automotive. In my sense, this has been going on now for a few months, and so frankly I don't think it's really decelerating greatly. I think it's kind of slowed a bit from the record auto production that we've had in the last few years and the first half of this year.

So I think it's kind of just kind of be stabilized, but certainly not be the robust builds globally that happened. And obviously, any and all tariff noise around that, and so certainly doesn't help things, right? So -- but I don't see that as we sit here today as a big change from what we've been dealing, certainly what we were dealing within Q3. So that's auto. The third is semiconductor. And there we have definitely seen -- we've definitely seen a slowing here really the late in the quarter that we do see -- and it was so late in the quarter, it really didn't impact the Q3. So we have very, very good backlogs in there. But we started to see some of the orders being pushed out a bit and so forth. So it's -- I think it's a question of whether we're entering a down cycle or we're just going to take a bit of a pause because as you know semiconductor has been also quite strong lately, but the semiconductor chip producers in China have gotten hit pretty hard in the market and so forth. So that's the bad news. It's a sizable business for us. But it's not the highest margin business that we have either. So it'll affect our top line I think probably more than our -- well, definitely more than our bottom line, just because the margin profile is not what we see across the rest of the sealing segment. So is that helpful, Jeff?

Jeffrey Hammond

Yes, perfect. And then just back on tariffs, is there a way to quantify what you think the '18 headwind? And as you look at all the lists, what the '19 headwind would be based on what you purchase? And just talk about any pricing actions you've taken more recently or are contemplating kind of in and around year-end?

Stephen Macadam

Yes. It's a damn difficult question. It's a good question, but it's a really hard one because obviously there is direct and indirect impacts, right? And we have both negatives and positives. Just a quick example of the positives. The U.S. steel industry is one of our big customers, right? And so they're actually running really hard, so we sell oil field into that market. It's a pretty good product line for us. And that demand has been great. So we have not done the exact where I don't know that we even could because there's so many second and third order effects. But we can say that on the direct side, not -- just on the cost side, so not net it out with price increases, our 2018 -- this is in essence the bogey we've got to go get, right? And we've gotten part of it, is about $5 million, right, Marvin? Wouldn't that be '18?

Marvin Riley

Incremental. It's about $1.5 million because we're already seeing...

Stephen Macadam

Incremental from today?

Marvin Riley

Yes.

Stephen Macadam

Yes, but if you looked at the whole year, it was around $5 million, $5.5 million. Now, gosh, I think probably during the first half of the year, we had recovered and that's an annualized -- an annual number. I don't -- I mean we hadn't recovered hardly any of it. So I think by the going into Q3, I think we've probably recovered 70% of it, would be my guess leaving a couple of million dollars more. And then we've got more comments. So I'm confident we can get that recovered. It just takes a little bit of time. And so I would say the same thing. But we never know what is going to really happen in '19. But I think, we have the same posture. These are not crippling things for our company. Unfortunately, the steel thing kind of came out of the blue so quickly and this time we see more stuff coming. So we're already in dialogue about additional pricing and so forth.

Marvin Riley

If I could shed any light on that, it would be that we've already gone out with our RFQs for Q1 of 2019, let's call it H1 of 2019. And the pricing is coming in a little better than we're seeing right now. So we'll see some improvement from a cost position in steel, which is where we're taking the majority of the impact. So it's only a little bit of room coming up in H1 of '19.

Unidentified Company Representative

And Jeff, we were feeling it the most in heavy duty trucking, specifically great products. We commented on that on our last call, if that's be a fairly heavy steel consumption in that part of our business.

Operator

And our next question comes from Joe Mondillo with Sidoti.

Joseph Mondillo

Just to follow-up on that last question regarding tariffs. So you're not significantly affected by any of the 301 tariffs that were implemented in July at all?

Stephen Macadam

We are. We got our tapered roller bearings that we bring from China into heavy duty trucking. That's where we've passed on most of the impact because mostly competitions in the same boat.

Joseph Mondillo

And any of the tariffs that are in place that are expected to escalate from 10% to 25% at the end of the year? Anything exposed to that?

Stephen Macadam

No.

Joseph Mondillo

I wanted to ask on the Sealings Segment. If you exclude, I think GST amortization annualizes at about $8.6 million roughly. If you exclude that non-cash amortization this quarter and then in the 2 months in the third quarter of last year, it looks like the incremental margins were above 40% which historically is really good. So I'm just wondering is that coming from STEMCO or where is that coming from? And how sustainable that is? I assume maybe not that sustainable, but just could you talk about what you saw there?

Unidentified Company Representative

Yes. That's -- part of that, Joe, is influenced by the $4 million ATD-related settlement that we had in the quarter. Now we have our earnings had been hurt prior periods, probably another just $700,000 in total year-to-date just for your legal costs, not to mention how we've been damaged in the marketplace. So that has -- that's -- the whole situation has hurt our earnings in the past. But we do recognize the one-time settlement of $4 million. So that's going to influence that when you do the numbers on the leverage for the quarter.

Joseph Mondillo

And then just so I'm clear with STEMCO and what you've been doing there, and the challenges that you had in the first half of the year, it sounds like most that you're confident most of it is behind you. And I think, correct me if I'm wrong, the biggest sort of concern here, if there is any concern still, is with the brake business and what you were doing there in terms of outsourcing some production, and then you had to sort of steel 180. Going forward just so I'm clear, how confident are you that there is no issues related to how you were managing production and the outsourcing and everything going forward?

Unidentified Company Representative

Marvin, go ahead.

Marvin Riley

Yes. I mean you're correct in saying that the majority of our issues is isolated to brake products. And at least from the perspective that I have and the team on the ground has is that we're probably experiencing the worst of it right now, and we should get better from here on out. I mean, we're definitely -- the issues are definitely not behind us in any way shape or form, but we are working to improve those issues.

Unidentified Company Representative

And when Marvin talks about these issues not being body, he's talking about the productivity and our online supply chain management so forth and so on for production. He's not talking about the quality issues that cost us the absence of $1 million, but those are -- those issues are behind us.

Joseph Mondillo

So looking at the third quarter, is there any risk of things getting worse say in the fourth quarter and then maybe we start to improve in 2019? Is it still sort of a volatile situation or should they at least get flat to better in 3Q? I'm just wondering how volatile?

Unidentified Company Representative

Yes. So that -- yes, that's the way to think about it, right. Other than the normal seasonal impact we would have in Q4, that's the only thing that would affect the STEMCO's performance in Q4, relative to Q3. But the big -- the improvements that we're going to be able to deliver are going to be in '19, not -- and fourth quarter is not going be some dramatic improvement, but it's also not going to go the other way.

Joseph Mondillo

And just referring to...

Unidentified Company Representative

It's not unusual. If you look at this business, it's not unusual for us to have a softer fourth quarter in our heavy-duty truck business. So some seasonal patterns that we would expect to continue this year.

Joseph Mondillo

And just regarding that seasonality, do you anticipate any -- a little more seasonality this year because I remember on the first quarter call or maybe it was the fourth quarter call, you mentioned that some production was brought forward in the 4Q because of some promotions that you were doing, and you don't necessarily do these kind of heavy promotions every single year. I'm just wondering in terms of the comp for 4Q with STEMCO?

Unidentified Company Representative

I mean we are as we're sitting here today and we're expecting to have some year-over-year growth at STEMCO. I mean I can't quantify the -- how the promotional and prior periods affected it, but we are expecting some year-over-year growth in the fourth quarter.

Joseph Mondillo

And just sticking with Steve's feeling. I think the expectation I thought was that nuclear Technetics was going to be a little weaker in the back half of the year, which would have been a little bit of a unfavorable product mix. But it seems like the third quarter nuclear was pretty good. Do you anticipate any unfavorable mix issues with nuclear in the fourth quarter or first quarter time period?

Stephen Macadam

Yes. I think it will be a little weak in nuclear. And there is 2 things going on, Joe; one is just in terms of next year, next year will be about like this year in nuclear which was in balance, a fairly week year for us, driven by 2 things. One, we're just tied to the normal kind of maintenance cycle that happens in nuclear power plants, and so just kind of naturally '18 and '19 were -- are not very robust years. Also we've had a couple of reactors be decommissioned after Fukushima. And then the third is, we actually like three years ago, sold forwards in inventory for large RPV seal that we sell which are really nice products for us. And so there's a bit more inventory. And so we are very -- yes, actually this is something we have reasonable visibility on. So I don't think it won't get a lot weaker next year, but it will be in the same ballpark as '18, which is -- was not a good year compared to prior years in nuclear.

Unidentified Company Representative

And as a result of that, Joe, we're likely to see some year-over-year decline in Technetics as a result of what Steve is talking about, if you look at the fourth quarter.

Joseph Mondillo

Last question for me on Power Systems. I don't know if you said it in your prepared remarks, but I saw it in the press release. You said that it benefited a little bit from lower R&D costs. Could you quantify that and what's going on there? Are you anticipating R&D will bounce back and this was just sort of a one-off quarter type of thing, just in terms of lumpiness? What's going on there?

Unidentified Company Representative

Yes, I'll have to get back to you, Joe, on the year-over-year change. I don't have that in front of me right now. It's not a big number, it was just a factor among other things. The big headline for us is Power Systems on the earning side was clearly the pro thing into the revenue and the aftermarket parts we serve. That's really what's driving the profitability. As I mentioned earlier in our prepared remarks that growth was quiet significant, especially when you take into account the negative impact of currency on the EDF contract last year.

Unidentified Company Representative

Positive impact.

Unidentified Company Representative

Positive impact last year compared to the negative impact this year. So that's the full story of Power Systems. R&D is just a -- it's a minor debt.

Stephen Macadam

Power Systems, just in general for everybody, not just this your question, Joe, but Power Systems -- once we get the EDF engines cleared from the shop, we'll be in really, really good shape. And as Milton mentioned, we're kind of 70-plus percent through on the production side of that, right? So you got to remember for this year and a lot of last year, what we did and what was very heavily dominated by engines and because of the massive currency move from what we did and we didn't make any money on it, right? So it was basically 0 margin. So just getting that contract complete will really help the overall profitability profile of Power Systems quite a bit.

Unidentified Company Representative

Joe, the IDE delta year-over-year is less than $1 million.

Joseph Mondillo

Just to follow-up on that. With OP 2.0 and sort of shipping the first engine in I guess 3Q of next year time period roughly your ballpark, and also getting closer to production there, and I know there was a lot of R&D and development and such over the last few years, is there any costs that are going to sort of go away as we get closer to production of OP 2.0?

Unidentified Company Representative

I would say probably not, Joe, only because -- we don't know to be honest with you. But I would not build that into your forecast because there is a good chance we'll be working on another variant of the unit or some other development to really take advantage of this kind of breakthrough technology that we've got. Remember, we've only got -- we're only going to market with 1 engine basically, so...

Marvin Riley

The current thinking is we'd like to keep this pending flat from where it is now, and we got the variance in. So I wouldn't expect a sharp increase or sharp decrease.

Operator

[Operator Instructions]. Our next question comes from Charley Brady with SunTrust Robinson.

Charles Brady

I don't know if I missed it. Did you guys talk about when you go into the end market, so I guess a just question about the aerospace end market specifically.

Unidentified Company Representative

No, he didn't raise that. He won't know about semi-automotive and nuclear. So do you want to hear about aerospace?

Charles Brady

I do.

Unidentified Company Representative

Yes. No, it's going well. We had a good quarter. Backlogs look good. Product development stuff we've been working on, it's always a long sales cycle, but very positive. So aerospace is a very good performing business unit for us.

Charles Brady

And I guess, just on the -- there were some navy contracts that were won by Fairbanks. I'm just wondering if on the maybe little more granular on timing and quantification of the revenue recognition on some of those contracts, since they're won maybe a month or so ago?

Marvin Riley

Yes, that's the LPD Flight II which is effectively a continuation of the prior LPD. So they're going to keep the whole of the ship the same and continue on. So for the most part, I would say that that's actually a fairly sizeable program. At some point, I'm sure the organization will announce the full size of that award, but the thinking is that the bridge program into the next generation of LPD vessels. And I think it's most appropriate to wait until they're prepared to announce what the size of that will look like and all the above. We've also picked up some incremental business in the aftermarket in Fairbanks as well that's really bolstering their aftermarket business as well.

Charles Brady

And this is where you -- so this is the -- that the 24 turbo chargers order that you're referring to?

Unidentified Company Representative

Yes.

Operator

And our next question comes from Justin Bergner with Gabelli.

Justin Bergner

Couple of clarification questions that have sort of accumulated during the call. The gross margin head wins that you outlined earlier I guess amounted to about $7 million or about 200 basis points. I think the year-on-year decline was at 300 basis points. Our tariffs in those three -- in the raw material number, if not really extra, what sort of the delta to that 300 basis points from the 200?

Unidentified Company Representative

Yes, well. Yes. Raw material costs, the impact of tariffs, net of price increases, yes, that's going to be in there. So if you want to isolate that part, there would be some impact there. And then just a whole host of other things. They're all miscellaneous, but the three big items are the ones that we noted.

Justin Bergner

And the tariffs amount of $5 million to $5.5 million, is that the annual amount in '18 or is that the annualized amount sort of looking at the most recent quarter and the tariff exactly.

Unidentified Company Representative

Yes, our estimate for full year '18.

Unidentified Company Representative

'19

Unidentified Company Representative

Excuse me, '19, I'm sorry. And then the number Marvin had just stated.

Unidentified Company Representative

That's not a mid-impact though. It's important to know, Justin. It's the -- that's the gross impact. That's what we have to cover with price increases and other moving production around and so forth and so on. That's the bogie we've got to go get. So I think we'll be able to get 75% to 80% of that without any trouble. We're working to try to get it all covered.

Justin Bergner

So that's $5 million to $5.5 million in '19, once the 10% steps up to 25% or if assuming 10% stays the same?

Unidentified Company Representative

It's the best visibility we have of what's going to happen.

Justin Bergner

And then one more clarifying question. On the OP 2.0, you were talking about the same customer in terms of the LOI and the final agreement, right?

Unidentified Company Representative

Yes, that's correct. Yes. So we signed an LOI with some conditions around. For example, there is conditions around discount pricing. One of the terms in the LOI is the customer wants to reserve the right to buy additional units at a discount price. So we have to work those details out in the final agreement.

Justin Bergner

And then a bigger picture question. Thanks for the nuance questions. On the guidance, you're clearly increasing the guidance modestly, but you're getting a $4 million benefit from this legal matter. So if you adjust for that, it's slightly lower than prior. What headwinds are sort of causing the EBITDA guide to be slightly lower than prior when you adjust for that $4 million?

Unidentified Company Representative

It's not really a headwind, Justin. As you might imagine, we've been expecting a settlement on this this year.

Unidentified Company Representative

I mean, we've been working on this for quite a while.

Unidentified Company Representative

And so we had a range of possible settlements baked into our guidance throughout the year. And part of our reason for tightening is now that we have visibility, we could bring that up because that was a pretty big variable, right, that could swing things. And of course, part of the timing is just getting closer to the end of the year.

Justin Bergner

And then lastly, as your cash flow improves, your leverage goes down. I mean you authorized $50 million of repurchases, but is your bias sort of with the stock at these levels in the M&A environment to lean more towards repurchases or to lean more towards bolt-on M&A?

Unidentified Company Representative

I would say we want support growth. And that's probably for us, that's consistent with what we've discussed. But we do have a balanced approach to looking at it, capital allocation. We try not to be stock price timers when it comes to repurchases and leaving a philosophy of overtime returning some capital to shareholders in the form of repurchases. So I mean that's our philosophy always in the context of, the god knows that we've talked about on our targeted 2x to 2.5x net debt to EBITDA debt levels.

Operator

[Operator Instructions]. Our next question comes from Joe Mondillo with Sidoti.

Joseph Mondillo

Just two quick follow-up questions. Regarding -- I might have missed this in your prepared remarks, but on the last call, you called out some foreign tax credits of about $31 million, $19 million of which were going to hit in the back half of 2018 or in 2018 overall I guess. Could you update me on that?

Unidentified Company Representative

Yes, nothing has really changed there, so there are no developments, so we didn't comment on. So the comments from last quarter are still how we see it.

Joseph Mondillo

So the $19 million should hit in the fourth quarter and the rest in 2019 or sometime in the future overall?

Unidentified Company Representative

Yes. Yes. I would say this way, the $19 million would be a factor in cash taxes that we would expect this year and in the balance, we would benefit from post 2018. And if you look at our effective tax rate, Joe, I mean we -- our adjusted number we use for taxes is roughly 29%. We're a little bit below that for the nine months of year. If you exclude the discrete items, I think we are running at around 27.5%. So from modeling going forward, that 29% is still I think a good number to use.

Joseph Mondillo

And then just secondly the capital distribution. Could you sort of overall update me on how sort of the M&A is going, how you're looking at stock repurchase? And also when was the new stock repurchase program passed? Just curious given the fact that no shares were repurchased in the third quarter and sort of just update me on all that?

Unidentified Company Representative

We completed the former authorization in the third quarter. We had used most of that through the second quarter, but there were a few shares that were purchased in the third quarter below the lot. And that program ended and then as I mentioned earlier, the Board yesterday authorized a new $50 million authorization.

Stephen Macadam

And, Joe, just so you know, you're probably aware of this, but the -- we had exhausted the repurchase basket from the previous indenture. It's one of the reasons we did the refinancing. We had to limit at that basket which is why it was important for us to do the -- one of the reasons it was important for us to do the refinancing.

Joseph Mondillo

And I mean it's still sort of a balanced approach I assume. Could you talk about M&A maybe as well?

Stephen Macadam

Yes. Yes. No. I mean it's not a secret that multiples are pretty hot, but we've got a number of things in the pipeline. I wouldn't anticipate anything have to get and over go on this this year, it might, it might. We still got a chance late in the year to get something closed. But yes, I mean we're in the same -- nothing's changed in terms of our strategy to do growth oriented, smart businesses that fit in our profile, that's had good financial characteristics to keep growing our addressable market. We are on the same -- running the same play we've been running.

Joseph Mondillo

And then just really quickly lastly, the interest expense. So yes, looking at this correctly, are you looking at roughly maybe $21 million annually if you account for that $7 million related to the swap?

Unidentified Company Representative

That's probably in the ballpark, Joe. I mean you can do the math. We got $350 million. If you're looking at it going forward, you have $350 million at 5 and 3 quarters. And we had additional borrowing of roughly $150 million at the end of the quarter. So excuse me, if you look at it post refinancing, so call it roughly $450 million, $460 million -- excuse me, roughly $500 million of borrowings in total and then offset by the interest expense. We can run through some of the details with you. But okay, I think you've got -- I think you're in the right ballpark.

Operator

And we have no further questions at this time.

William O'Neal

Okay, Deidra, we'll then close off the call. Thank you everybody for joining us this morning. If you have any additional questions, feel free to give me a call at 704-731-1573. Everybody have a great day.

Operator

This does conclude today's conference call. Thank you for your participation. You may now disconnect.