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Parker-Hannifin Corp
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Good day, ladies and gentlemen, and welcome to the Third Quarter 2018 Parker-Hannifin Corp. Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. As a reminder, today's conference is being recorded.
I would now like to turn the call over to Ms. Cathy Suever, Executive Vice President and Chief Financial Officer. Ma'am, you may begin.
Thank you, Chelsea. Good morning, and welcome to Parker-Hannifin's Third Quarter Fiscal Year 2018 Earnings Release Teleconference. Joining me today are Chairman and Chief Executive Officer, Tom Williams; and President and Chief Operating Officer, Lee Banks.
Today's presentation slides, together with the audio webcast replay, will be accessible on the company's investor information website at phstock.com for one year following today's call.
On slide number 2, you'll find the company's Safe Harbor disclosure statement addressing forward-looking statements as well as non-GAAP financial measures. Reconciliations for any reference to non-GAAP financial measures are included in this morning's press release and are also posted on Parker's website at phstock.com.
Today's agenda appears on slide number 3. To begin, our Chairman and Chief Executive Officer, Tom Williams, will provide highlights for the third quarter. Following Tom's comments, I'll provide a review of the company's third quarter performance, together with the guidance for the full year fiscal 2018. Tom will then provide a few summary comments, and we'll open the call for a question-and-answer session.
Please refer now to slide number 4, as Tom will get us started with the highlights.
So thanks, Cathy, and good morning, everybody. Thanks for your participation today. We really appreciate your interest in Parker. So the combination of the Win Strategy, the CLARCOR integration and the strong growth that we saw in the quarter put some very, very nice results for the quarter. Thank you to the Parker team members around the world for all your hard work and dedication and the great progress that we're making.
So let's jump into the quarter, starting first with safety. So our injuries were down 25%, and this is driven primarily because of our engagement initiatives, specifically the high-performance teams.
Regarding high-performance teams, this initiative has got about 80% of our people across the company are high-performance teams, about 5,000 teams worldwide. Remember the goal here is to create an ownership culture, and that idea of ownership starts with safety. And the kind of progress we've seen on safety, we expect to translate to the progress we want as we create ownership around quality, cost and delivery.
We hit a number of all-time records in the quarter as reported. And just a reminder, when I say all-time records, this means in the history of Parker. So we had sales of $3.75 billion for the quarter, net income of $366 million, net income ROS of 9.8% and EPS of $2.70.
We had a third quarter record for segment operating margins of 15.8% as reported. This is especially noteworthy, given the amount of depreciation and amortization we have in CLARCOR, the restructuring, the CLARCOR costs to achieve and all the activities that happened in the quarter, to still put up an all-time record for Q3 is very impressive.
Other highlights for the quarter, sales increased 20%. It was 8% organic, which is approximately 2 times the growth rate for global industrial production. We had order entry rates increase 11%. This marks the third quarter in a row of double-digit order entry. Adjusted segment operating margins were 16.3%, and EBITDA margins were up 280 basis points to 17.1% as reported or 17.6% adjusted. Adjusted EPS was $2.80, increasing 33% versus the prior year.
So let me switch to cash and capital deployment. As you've heard me say before, our goal is to be great generators and deployers of cash. And our priorities are, in this order; first, dividends. And last week, we were very excited to announce our 15% dividend increase, very positive for our shareholders. This marks the 62nd consecutive year of increase in annual dividends paid. It's a track record we're very proud of and a track record we have every means to continue with.
Organic growth investment, which is the most efficient investment we can make on behalf of shareholders, and we've done a great job paying down debt. Our gross debt-to-EBITDA multiples, if you start when we did the CLARCOR close, it was at 3.6 times. And at the Q3 close, we're at 2.6 times. So, very significant progress on debt reduction, really tied to the fact that we've driven significant improvements in generating EBITDA.
We're going to continue our 10b5-1 share repurchase program. And as our debt reduces, we're going to reevaluate acquisitions and discretionary share repurchase and, as always, try to make the best decisions we can on behalf of our shareholders.
So I'd like to make some comments on operating margin performance and just make a couple of reminders on a couple of key points and to provide some context into the operating margin performance for the quarter. I'll start again reminding everybody that this operating margin for Q3, despite all the extensive restructuring, was the best in Parker's history.
What it does is really points to the upside that we have on margins once the restructuring and costs achieved are behind us. The strategy here on all this activity is that it's a long-term approach. We're going to protect our customers during these extensive plant closures, and this drives some short-term impact, but absolutely the right thing to do long-term, long-term for our customers, long-term for our shareholders. To provide some additional context, we're closing about 36 facilities, which represents 2 million square feet of floor space, so a pretty significant endeavor.
The headwinds that impacted North America Industrial margins are a couple things: first, mix; plant closure inefficiencies; and the fact that we had higher volumes, which is a good thing, but those higher volumes required the closing plants to stay open longer. So as a result, we had redundant fixed costs, redundant variable costs, with both the closing and the receiving plants running simultaneously.
The good news in all this is that the North America headwinds are short-term in nature. This is a transitional issue, not a structural issue. The productivity metrics at the closing and receiving plants improved throughout the quarter, and this is the first sign of healing, and in my words, the ship is turning when you look at all the plant closure activity.
So we expect the plant closure work to continue the rest of calendar 2018, so it will go into the first half of FY 2019. And you should expect to see gradual improvement in North America Industrial incremental margins over the next three quarters.
We had an absolute fantastic quarter in Aerospace. Aerospace segment margins were up 390 basis points year-over-year to 18.1% adjusted. And we had a very good quarter on Industrial International margins as they improved 80 basis points year-over-year to 15.3% adjusted. Just make a comment for both of those segments, Aerospace and International margins are really showing the fruits of extensive amount of work we've done over the years on margin expansion, and it's really starting to come through in the results.
Switching to the CLARCOR integration, it's going well, and it's really hard for us as a leadership team to imagine that we just hit the one-year anniversary. It feels like it's been part of the team for much longer. When you think about what's happened in one year, we have accomplished a tremendous amount in one year. So in one year, we've raised the synergy targets, which were already pretty aggressive targets. When announced, and all of you remember this, but as announced, we had cost synergies of $140 million. Those are now $160 million. We had revenues synergies which we didn't disclose at that time; the revenue synergies now are $100 million incremental revenue over the first three years.
What that does from a growth rate standpoint is it changes the CLARCOR – legacy CLARCOR growth rate from a 3.5% CAGR over those three years, 2018 to 2020, to 4.5% CAGR. So it's a nice improvement in the growth rate. So overall, we continue to be very pleased with the progress on CLARCOR.
Now let me switch to EBITDA margin because given what's been happening with – and to compare year-over-year, the best way to do that apples-to-apples is to look at EBITDA margin. When you look at the combination again of the Win Strategy, the CLARCOR synergies and the higher organic growth, we've seen dramatic improvement in the total Parker EBITDA margins. So at the time of announcement, our EBITDA margins, adjusted EBITDA margins were 14.7%. End of this quarter, 17.6%. At the announcement, we established a goal that we wanted to increase the total EBITDA margins for the company 300 basis points over five years. Well, we've almost done that short – within two years, so we're well over three years ahead of that type of expansion, so terrific progress there by everyone across the company.
So, the outlook, so we've increased organic sales growth rate for the year; it was previously 6.5%, now it's 7.6%. We increased the adjusted EPS by $0.20 at the midpoint. The new range for adjusted EPS is $9.95 to $10.15. Business realignment and CLARCOR costs to achieve are being reduced from $110 million to $95 million. The reason for that change is twofold.
One, we are more efficient on the implementation costs, and the second is increased volume, moved some plant closures into FY 2019. There's no impact on forecasted savings from all the restructuring in FY 2018. So going forward, lots of positive momentum. The new Win Strategy, the CLARCOR synergies, the organic growth, our ability to generate strong cash flow has enabled us to increase the corporate targets.
And if everybody will remember, we revealed those corporate targets, the new five-year targets at the recent Investor Day. So as a refresher, our goal was by 2023, sales growth at 150 basis points greater than global industrial production growth. We want segment operating margins at 19%, EBITDA margin at 20%, free cash flow conversion at 100%-plus, and earnings per share CAGR of 10%-plus.
So with that, I'm going to hand it back to Cathy for a more detailed review of the quarter.
Thanks, Tom. I'll now refer you to slide number 5 and begin by addressing earnings per share for the quarter. You see here as-reported earnings per share for the current year third quarter of $2.70 and adjusted earnings per share of $2.80. The $2.80 compares to $2.11 for the same quarter a year ago, a 33% increase year-over-year.
The respective adjustments for both years are as follows: fiscal year 2018 Q3 operating income adjustments include business realignment expenses of $0.04 and CLARCOR costs to achieve of $0.06. And Q3 of FY 2017 adjustments include $0.09 for business realignment expenses and $0.27 of acquisition-related expenses.
On slide number 6, you'll find the significant components of the walk from the prior year adjusted earnings per share of $2.11 to the $2.80 for the third quarter of this year. The most significant increase came from higher adjusted segment operating income of $0.60 attributable to earnings on meaningful organic growth, income from acquisitions and increased margins as a result of our new Win Strategy initiatives.
This $0.60 improvement is net of incremental depreciation and amortization expense of $0.11 taken on with the CLARCOR acquisition. Lower other expense equated to an increase in earnings per share of $0.13, while a lower effective income tax rate resulted in an increase of $0.09. Adjusted earnings per share was reduced by higher corporate G&A equating to a $0.07 reduction, while earnings – I'm sorry, while interest expense was also a $0.07 reduction in the current quarter.
Moving to slide number 7, you'll find total Parker sales and segment operating margin for the third quarter. Total company organic sales increased year-over-year by 8.4%. There was a 7.5% contribution to sales from acquisitions, while currency positively impacted the quarter by 4.3%. Total segment operating margin on an adjusted basis improved to 16.3% versus 16.1% last year.
Compared to last year, current quarter margins include 50 basis points of CLARCOR-related incremental depreciation and amortization expense. This overall margin improvement reflects the benefits of higher volume, combined with the positive impacts of our new Win Strategy initiatives.
Moving to slide number 8, I'll discuss the business segments, starting with Diversified Industrial North America. For the third quarter, North America organic sales increased by 10.4% compared to last year. Acquisitions contributed 13.8% to sales, while currency also positively impacted the quarter by 0.5%. Operating margin for the third quarter on an adjusted basis was 16.4% of sales versus 18.2% in the prior year. Compared to last year, the current quarter includes 90 basis points of CLARCOR-related incremental depreciation and amortization expense and also reflects what we believe to be the height of the impact of inefficiencies we're experiencing relating to footprint consolidation.
The higher sales volume experienced in the quarter caused us to delay the closure of some of our consolidating plants so we could continue to service customer deliveries. Delaying these closures resulted in absorbing duplicate plant costs for longer than expected. Our productivity improved as the quarter progressed, and we expect steady improvement in Industrial North America incremental margins as plant closures continue during the rest of calendar year 2018.
I'll continue with the Diversified Industrial International segment on slide number 9. Organic sales for the third quarter in the Industrial International segment increased by 8.6%. Acquisitions positively impacted sales by 3.3%, while currency positively impacted the quarter by 11.2%. Operating margin for the third quarter on an adjusted basis was 15.3% of sales versus 14.5% in the prior year. Compared to last year, the current quarter includes 25 basis points of CLARCOR-related incremental depreciation and amortization expense. We continue to see progress in margins in Industrial International from the realignment and simplification efforts.
I'll now move to slide number 10 to review the Aerospace Systems segment. Organic revenues increased 3.4% for the third quarter, demonstrating strength in all segments of the business during the quarter, both commercial and military and both OEM and aftermarket. Operating margin for the third quarter adjusted for realignment costs was 18.1% of sales versus 14.2% in the prior year, reflecting the impact of a favorable aftermarket sales mix, successful execution of the Win Strategy and lower development costs during the quarter.
Moving to slide number 11, we show the details of order rates by segment. As a reminder, Parker orders represent a trailing average and are reported as a percentage increase of absolute dollars year-over-year, excluding acquisitions, divestitures and currency. The Diversified Industrial segments report on a three-month rolling average, while Aerospace Systems are based on a 12-month rolling average. Total orders continue to be strong, growing at 11% as of the quarter end. This year-over-year growth is made up of 11% from Diversified Industrial North America orders, 8% from Diversified Industrial International orders and 17% from Aerospace Systems orders.
In slide number 12, we report cash flow from operating activities. Year-to-date, cash flow from operating activities was $905 million or 8.6% of sales compared to 9.2% of sales for the same period last year or 11. 8% last year adjusted for a $220 million discretionary pension contribution. The current year of free cash flow of $710 million has us on track to continue our 15-year consecutive years of 100% or more free cash flow conversion of net income. The significant allocations of capital year-to-date have been $264 million for the payment of shareholder dividends, $194 million or 1.9% of sales for capital expenditures and $150 million for the company's 10b5-1 repurchases of common shares.
The full year earnings guidance for fiscal year 2018 is outlined on slide number 13. Guidance is being provided on both an as-reported and adjusted basis. Total sales increases are expected to be in the range of plus 17.7% to plus 19.7% as compared to the prior year. Anticipated full year organic growth at the midpoint is plus 7.6%, which is 110 basis points higher than our previous guidance. Acquisitions in the guidance are expected to positively impact sales by 8.1%. Currency is expected to have a positive 3% impact on sales.
We've calculated the impact of currency to spot rates as of the quarter ended March 31 and we have held those rates steady as we estimate the resulting year-over-year impact for the fourth quarter of fiscal year 2018.
For total Parker as-reported segment operating margins are forecasted to be between 15.4% and 15.6% while adjusted segment operating margins are forecasted to be between 16.0% and 16.2%.
The full year adjusted tax rate is now projected to be 24% down from our previous guidance of 25%. For the full year, the guidance range on an as-reported earnings per share basis is now $7.77, $7.76 to $7.96 or $7.86 at the midpoint. On an adjusted earnings per share basis the guidance range is now $9.95 to $10.15 or $10.05 at the midpoint.
In addition to a full year net loss on the sale and write-down of assets of $5 million and the net provisional tax charge of $225 million, this guidance on an adjusted basis excludes business realignment expenses of approximately $50 million for the full year fiscal 2018.
Savings from business realignment initiatives are still projected to be $25 million. In addition, guidance on an adjusted basis excludes $45 million of CLARCOR costs to achieve expenses. CLARCOR synergy savings are still estimated to be $58 million in fiscal year 2018.
We continue to remain on pace to realize the forecasted $160 million run rate synergy savings by fiscal year 2020 on CLARCOR, which was updated at our March Investor Day.
Savings from all business realignment and CLARCOR costs to achieve as well as anticipated full year favorable effects from U.S. tax reform are fully reflected in both the as-reported and the adjusted guidance ranges.
Fourth quarter fiscal 2018 adjusted earnings per share is projected to be $2. 85 per share at the midpoint, and this excludes $0.12 of projected business realignment expenses and $0.09 of projected CLARCOR costs to achieve.
We ask that you continue to publish your estimates using adjusted guidance for purposes of representing a more consistent year-over-year comparison.
On slide number 14 you'll find a reconciliation of the major components of fiscal year 2018 adjusted earnings per share guidance of $10.05 per share at the midpoint compared to the prior guidance of $9.85 per share.
Increases include $0.04 from higher segment operating income, $0.05 from lower other expense, $0.14 from a lower effective tax rate and $0.02 from a lower projected share count.
Offsetting these increases is a $0.03 per share decrease from higher forecasted corporate expense and $0.02 per share from higher projected interest expense.
Please remember that the forecast excludes any acquisitions or divestitures that might close during the remainder of fiscal 2018. This concludes my prepared comments. Tom, I'll turn the call back to you for your summary.
Thank you, Cathy. We're making good progress. We're seeing broad-based improvement demand across geographies. The Win Strategy initiatives are generating improvements in both growth and in earnings.
We're increasing our earnings guidance. We're on track for a record year performance. And we really have a bright future ahead. Those new 5-year targets we've announced put Parker in the top-quartile performance versus our peers. So I want to say again thank you to the Parker team members around the world for all their progress, their hard work. And I want to thank the shareholders for their continued confidence in us.
At this point, I'll hand it over to Chelsea to start the Q&A portion of the call.
Thank you. And our first question comes from the line of Ann Duignan with JPMorgan. Your line is open.
Hi. Good morning.
Good morning, Ann.
Good morning. Can we talk about the realignment costs and the CLARCOR costs? Maybe you could give us some color in terms of have the absolute costs gone up? Or are we just pushing out costs because volume is too strong, and we have duplication? And any color you can give us around quantifying how much more we're going to spend now in fiscal 2019 than we might have thought a quarter ago or a couple of months ago.
Yeah, Ann. It's Tom. So we're moving some costs from 2018 to 2019. I'll talk about that in a minute. But what we experienced during the quarter is what I described at the beginning. It's a significant amount of restructuring that we're doing, a tremendous amount of floor space, and we took the long approach on it as far as protecting our customers and making sure that we protected lead times and service our customers to the best of our ability. So we ran redundant plants, and we also have redundancy in bridge builds that we did to help cover for that.
Now we track productivity at all the closing and the receiving plants, and what we saw during the quarter is that productivity started to get better. So I fully expect that what we experienced this last quarter was kind of the worst of what we're going to experience in inefficiencies. We moved only three plant closures from this year to next year. So it was 39. We're now at 36, and so those three that we moved were tied to the CLARCOR integration, mainly because of the volume that we've seen. So we really think that we've got some nice gradual improvement in front of us.
Even with all this, I keep coming back to the fact that these are all-time best margins that the company's had, and the EBITDA margin improving 120 basis points adjusted year-over-year. So to me, the glass is very much half-full on this, that we accomplished a tremendous amount. We're only at the beginning of year two of CLARCOR. When you look at all the synergies, the buckets that we look at, they're all ahead of schedule. The footprint, we fully expected year two to become a big year for all the footprint activity, and that's what it's turned out to be.
And even with the slight push-outs and running the plants longer because of the volume, which obviously is a good problem to have, we're still on track for the original footprint plan that we had when reviewed this with the board and when we communicated to everybody here. So this is short-term noise that's going to work its way through, and we look forward to seeing nice, nice progress as we progress in the next several quarters.
Yes, Tom, can you give us any color on the cadence of the improvement of incremental profits, particularly in North America? I mean, I think what investors are focused on is the incremental profits. When will we get back to your more normal 25%, 30% incrementals?
Yeah, what we've got in the guide for Q4 is a 19% incremental for North America. I'm not going to go beyond that at this point because I'd like to just have another quarter under our belt to see all the plant metrics and how that progresses. So I'm not going to get into FY 2019. We do expect that we're going to see some of those inefficiencies go into the first half of FY 2019, but that is going to continuously get better as we go into 2019. The low-water mark was this last quarter, going to get a little better in Q4. Obviously, we'll give you a full look in August of what we think for the next year. But you're going to see some of it in the first half of 2019. It's just going to lessen each quarter as we go.
Now on the restructuring, which I want to come back to the costs achieved, so we lowered it from $52 million this year to $45 million. So that's $7 million we moved into FY 2019. So originally, it was $10 million FY 2019. It will be $17 million in FY 2019 as far as the costs achieved for CLARCOR.
Okay. I appreciate the color. I'll get back in queue.
Okay. Thanks, Ann.
Thank you. And our next question comes from the line of Nathan Jones with Stifel. Your line is open.
Good morning, everyone.
Good morning, Nathan.
Again, following up on some of the margin questions here. I think we've seen several companies report so far this quarter having some trouble passing through raw material inflation. And I think probably some of the stock reaction here is people wondering how much of the margin drag here is CLARCOR stuff versus price cost. And I know you guys track those indices very closely. So can you talk about where you are on price costs, both in the quarter and what your expectations are going forward?
Nathan, it's Lee. Yeah. I thought that was going to be the first question. So, as you know, you've followed us for a long time. Pricing for us is more than just passing through input costs. I mean, we've got a very strong discipline in this company on how we do things when it comes to price. But we're definitely in a period of inflationary costs throughout the supply chain. And it's not the first time we've been here before. I mean, we've been through several cycles before in the past where this has happened. But I will tell you first and foremost, this is not contributing to the North American margin incrementals. I mean, I think, one way you can look at that is the nice margin accretion we had in International and in Aerospace as just some indication that price costs, you know, our processes are recovering price costs.
But just as a reminder on how this works maybe for everybody on the phone is we've got standard processes inside the company that really start at the division level or business unit level. And we've got core teams that work around price and then work around purchasing. And in both of those, we track our selling price index, what we're charging for something this year versus prior year, and our purchase price index, what we paid for something this year versus prior year.
And the benefit of that is we've got teams that have good communication about what's happening on input costs, and we can take actions very quickly. And for myself and Tom and our senior management team, all this rolls up to us, so we have a very good visibility at the corporate level on what's happening.
So year-to-date, to be specific, we do have a positive spread between our price and input costs. We use surcharges on heavy commodity-based contracts. Those contracts that have heavy commodities like copper would be a perfect example. So those contracts are material-indexed, and we get out in front of that. And then just in terms of the channels distribution, a lot of channel checks have gone on. You can see we've done price increases there, and we can do those frequently. And then on OEM customers, it's really customer-by-customer negotiation.
So just to put a ball on that. You said year-to-date, you're positive on price costs. Were you still positive in the third quarter?
Yes, we were.
And then my follow-up question, you've still got very strong orders going on here, 11% North American Industrial versus a 9% comp and 8% in International versus a 13% comp. Raising revenue guidance here for the year. Can you talk about which markets have been better than you thought they were going to be coming into the back half? Because I think you guys have been pretty clear that you didn't think the double-digit North America order rates were going last this far into fiscal 2018. So any color you can give us there?
Well, I would say that inorganic growth really moved in the direction we highlighted and expected during our call. I mean, maybe I'll just -I'll do my typical quick walk here, and it will be brief. But on Aerospace, we continue to see very good demand for single-aisle commercial aircraft. So build rates are up, and we're seeing that, and which goes hand in glove with that is the commercial MRO increase throughout the quarter with continued traffic growth and then the benefit that there is fewer retirements with planes because fuel prices are so low. So that increases the spares and repairs opportunity.
There are some headwinds in commercial. It's really has to do around product mix. There's some changeover in some wide-body aircraft and a pullback on some build rates with some of the wide-body, but that's really a product mix. On the military side, we continue to see very strong military MRO growth with fleet upgrades. And then we've seen on the military side on an OE level F-35 production continues to ramp up, so that's been positive.
On the industrial side, I have to tell you, if I look at all our heat maps, it's really hard to find an end market that's not accelerating. We continue to find significant markets that have had year-over-year growth and continue to grow during the quarter. All the natural resource end markets continued to grow during the quarter. This includes agriculture, construction equipment, mining, oil and gas, to name some. And on the oil and gas, the land base is really back very strong. And we've also seen, for the first time, some increased activity in offshore activity, so a lot of quoting and exploration at this point in time, which is positive.
And then semicon and distribution, I'll comment on distribution here in a minute. When it comes to distribution, we continue to see just a strong rebound in activity from our partners around the world, very optimistic. And really a reality or a gut check for me is what's happening with the capital project business with our distributors. So these are bundling of Parker technologies for our customers on capital projects, and that business has become very robust, which tells me there's a lot of activity in the channel.
I would say the only notable end markets that we saw contraction on, which you would guess was the power-generation market. So that – there's been a pullback there. Just quickly touching on the regions, North America, very strong, and the sentiment across our base continues to be strong, especially with our distribution. In EMEA, we continue to see year-over-year order entry growth in most of our end markets and countries, and we're forecasting a second year of organic growth, which is really nice to see for EMEA.
And in Asia, China continues to lead with strong industrial and natural resource end markets. The strength in China really has been led by infrastructure investment and a strong housing market. And Southeast Asia continues to be strong. So I would say we continue to be very encouraged by what's happening with our end markets, both domestically and internationally. And there continues to be a lot of positive global sentiment to growth right now.
Excellent, thanks very much.
Yes. Thank you, Nathan.
And our next question comes from the line of Joe Ritchie with Goldman Sachs. Your line is open.
Hi. Good morning, everyone.
Good morning, Joe.
So I guess, just maybe touching on the CLARCOR disruptions one more time. Can you guys try to quantify what the disruptive impact has been? I know you took down your North America guidance by roughly 50 basis points. Was all of that – can all of that be contributed to CLARCOR? And then I know you talked a low bit about the first half of next year you're seeing a bleed-in. Yeah, talk us through your confidence and what you're looking forward to really start to see the improvement in incremental margins as we progress through the early part of next year?
Joe, its Tom. So just to clarify, the disruptions that we see, everyone wants to talk about CLARCOR, obviously, there's a lot of activity that's happened there. We're closing 36 plants. 19 of them are tied to the CLARCOR integration. 17 is the rest of the company. And the high volume that we're seeing obviously hits all of those activities. So this isn't just a CLARCOR. So this – the inefficiencies related to plants closures really hits across the company because of the higher volume and the fact that we are doing absolutely the right thing long-term is protecting our customers and running a little more redundant activities to protect those customers.
So the issue is just to help for people to understand, when we say inefficiencies, what does it mean? It's things like premium freight, it's overtime, its scrap, rework, lower productivity rates at the closing plant and receiving plant and just the redundant cost that you have if you happen to run plants simultaneously. You need to build a bridge inventory or because you're running both plants you've got too much volume and you need to do that.
And if you have a totally redundant plant structure and redundant variable costs, you can imagine what that does to your incrementals. So that issue is more than CLARCOR. It cuts across the grain. And we think about for 2019, again, I'm not going to get over my skis and start predicting 2019, we will benefit from having an extra 90 days of seeing how all the plant closure work is going. We check this we – again, I'll give you clarity. So we're closing 36 plants.
Within those plants are dozens and dozens of individual product line, pieces of equipment. So when you add it all up, you get hundreds, hundreds of product line moves that you're making. The team is tracking each one of those lines, a whole suite of metrics. That gets pulled up to Lee and I in a more summary version that we see once a week. And we saw good evidence during the quarter that those bottomed and started to improve, which was very encouraging.
But we wanted to give you better transparency. We now have better granularity on the data, and that's why we updated the North America margins the way we did going forward. And 19% is our best estimate based on the – all of the improvements we've seen so far, incrementals for Q4. I won't forecast 2019 other than just to say we expect gradual improvement beyond the 2019, and we still think we're going to have an additional six months the first half of FY 2019 we will feel it, but we're going to feel at a decreasing rate every quarter as we go forward.
Okay, that's helpful, Tom. And maybe just staying with this topic, and I fully appreciate that it was both CLARCOR and legacy Parker. I think the original expectation, though, is that all these plants will be closed by the end of this year, again, the end of this fiscal year. Clearly, the growth has been a lot better, which is a positive thing. Is there like a growth bogey perhaps for the fourth quarter where you would maybe even keep some of these plants open longer, or are we like or you feel pretty well committed that will get to the closures on the 36 plants by the end of this fiscal year?
I think we're in a pretty good trajectory for that. I mean, we've got the order entry right now for Q4 and all that. We've pushed the three plants into FY 2019. So we're really close to that 36 number for what we think is going to happen this year.
Okay, got it. Thanks,guys. I will get back in queue.
Okay. Thanks, Joe.
Thank you. And our next question comes from Joel Tiss with BMO Capital Markets. Your line is open.
Hey, how is it going?
Hey. Good morning, Joel.
You gave us a little bit of color on Aerospace, and I just wondered, are we kind of coming into a period of – is this a new higher run rate on the operating margins, or is it just a lot of things came together or coming together in the shorter term, and there has, you know what I mean, the balance between structural change and shorter-term or medium-term trends is like we're going to have lower margins going forward?
Yes, Joel, I would say that for the third quarter, things all aligned pretty nicely for us where it was a nice aftermarket mix. We tend to have our best aftermarket mix in the third quarter as the big airlines have lower traffic, so they're bringing aircraft in for maintenance. So it's typical for third quarter to have that nice mix. We'll see a little more of that extend into the fourth quarter, but as it wraps around the first quarter and second quarter next year, we don't enjoy as nice of a mix for aftermarket versus OE.
We also had lower development costs this quarter. This is the lowest cost we had all year so far. Some of that is delays and will move into the fourth quarter. So if you notice in our guidance, the fourth quarter margins aren't quite as high as third quarter came out to be because we are going to be experiencing high development costs in Q4. Beyond that, we are seeing nice, continuous growth in aftermarket, and that comes at higher margins. So as time moves on and we continue to have more and more hardware out there flying, the aftermarket continues to improve.
So in addition to that, the team has done a lot of hard work on simplification and the whole Win Strategy, and they're taking a lot of costs out. So I think the higher margins are the future, but it does mix a little differently in Q3 and Q4 versus the first half of the year.
Okay. And then just one cleanup question, can you talk a little bit about the why the free cash flow was down year-over-year? And then if you take out that pension contribution, it looks like it was down a little bit even more than the year ago.
Yeah. Compared to last year, we are behind in our percent of sales of free cash flow. A lot of it is the growth that we've had to invest in working capital, higher inventory and higher receivables moving through, and then – and just as we're moving through the higher volume.
The end of the year tends to be our best cash flow generation, and the trend is always very good towards the end of the year. So we still expect to make the targets that we have. We're at the 100% conversion of net income. We expect to finish the year that way, and we expect that free cash flow percent to improve during the rest of the year.
Great. Thank you very much.
Thank you, Joel.
Thank you. And our next question comes from the line of Andy Casey with Wells Fargo. Your line is open.
Thanks a lot. Good morning.
Good morning, Andy.
Question on the facility consolidation activities. I mean, you've had a lot of questions on this already, but I just want to go back and to a response, I think, it was to Joe Ritchie's question. Do you expect to have all but 3 of the 36 completed by the end of this fiscal year?
Andy, its Tom. The three I was referring to, last quarter, we said 39 plants that we're going to close. So we've updated it to 36. So those three are going to be pushed into FY 2019, but we're on track with the 36 to finish this fiscal year.
Okay. So I know you don't want to talk about fiscal 2019 right now, but how linear is this? Is it really truncated into the two quarters that just have reported already the next quarter, and then it just kind of tapers off in the first half of 2019? I'm asking because it's pretty clear people are worried about carrying costs into kind of a decelerating environment.
Yeah. Well, I would say, when I look at – again, it's Tom again, Andy. The plant closure work really started in Q1 and then picked up steam in Q2 and Q3. Q4 will be another important quarter, and you'll see a tail off, which is why the MROS, when you look at what happened over so far this year, incremental margins for North America bottomed in Q3. We're expecting to get better in Q4.
Based on in-process productivity metrics that we see that you don't – obviously can't see, but we see that the progress is starting to turn and we should be able to experience that in the numbers that we give to you into Q4. And then it's going to gradually get better from the first half of the year.
So the worst is behind us. It's not going to flip like a switch to all of a sudden where, bang, it's not an issue. It's going to get a little better in Q4 and will continue to get better the first six months of FY 2019, and we should be through with it at that point.
Okay. Thanks, Tom. And then, if I go back to the Investor Day, there was a question, I forget who asked it, about the incremental margins assumed over the next – within the next five-year plan. And I think one of the answers was those will be truncated to the first. Those will be higher in fiscal 2019 and kind of trail off a little bit as you go through the five years. With this extension of the consolidation activities, is that still your expectation?
Andy, it's Tom again. Yes, they'll be higher in 2019. The first half will be a little bit impacted by it, but they'll be higher in 2019. When you look at that forecast, as that walk to 19% in FY 2023, and if I remember correctly, I think it was a 37% MROS through that whole period, it was running higher in 2019 and then starts to glide down to a more normal path as we go into the future years. So yes, even with this, you'll see an uplift in 2019.
Okay. Thank you very much.
Okay. Thank you.
And our next question comes from the line of Jamie Cook with Credit Suisse. Your line is open.
Hi. Good morning. I guess, my first question, just based on the shrink that you saw in your North American order book in the quarter, I mean, how much visibility do you have? And what's the risk that as we're shifting to 2019 does mix continues to play an unfavorable role in terms of margin shifts with the mobile equipment markets being so strong?
Jamie, it's Tom. So, if you just take the big – lead one through all the more specific markets, but if you just take the three big constituents, distribution grew high-single digits for us in the quarter, industrial grew mid-single digits, and mobile was low-teens. So yes, when we look at it year-over-year, mix was still a challenge for us. Compared to the previous quarter, mobile was up at 20%. So mobile has softened a little bit in comparison, and I think you'll see that continue to temper as we go forward.
So it will be a headwind a little bit year-over-year, but it will – these things will equalize. I would tell you that the lion's share of our challenges from incremental margins in North America is not tied to mix. It's tied to just all the work we're doing on plant closures, both CLARCOR and legacy Parker and all that work across the company.
Okay. And then sorry to ask the incremental margin question again, but I just want to make sure we're crystal clear. At the Analyst Day, you said post this inefficiency period, you would be able to generate above-average incremental margins, so above the 25% to 30%. That is not off the table. Whether it's the second half of 2019 or whatever, but we're still – that's still the right to think about it, just a delay?
Still the right way to think about it.
Okay. Thank you. I'll get back in queue.
Okay. Thanks, Jamie.
Thank you. And our next question comes from the line of Jeff Hammond with KeyBanc Capital Markets. Your line is open.
Hey. Good morning, guys.
Good morning, Jeff.
Just a couple cleanups on CLARCOR. One, can you just talk about the core growth rates that CLARCOR's seen? And maybe how much is – more broadly, how much is tied up in working capital around some of this plant transition?
Jeff, the growth rates that we see for CLARCOR are the standard in the filtration markets, I think low- to mid-single digits growth. Tom quoted that on the longer-term CAGR, we see about 3.5% growth for the CLARCOR business. But with the revenue synergies that we're adding in, that's going to go up to more like 4.5% over the long-term CAGR. So, but think of it in the terms of standard increases that you would see in the filtration market.
And the second part of your question was about inventory. Yeah, we certainly have higher levels of inventory as we are bridging from sending the inventory from the sending plant to the receiving plant. We do not want to fall behind on customer deliveries. So there is incremental inventory in the system today longer as we've delayed closing some of these plants that have extended longer than we had hoped. But we hope to see that come down a fair amount in the fourth quarter and then continue to come down as we finish these closures and these transitions in the first half of 2018.
Okay. And then finally, just I know the focus is debt pay down. But just with the stock being so dislocated, is that making you rethink buybacks and being more opportunistic? Thanks.
Jeff, it's Tom. So on the capital deployment, I went through some of those priorities in my opening comments, but just to refresh. Again, it's dividends, and we're very proud of the strong increase that we just made in our consecutive increase record, and we're going to invest in this organic growth. It's a fantastic time to do – it's always a good time to do that. The debt pay down, we've got $550 million of debt coming due in Q4 and Q1 that we want to make sure we're on top of. So that's top of mind to make sure that that happens. You've seen a nice improvement already, but we have those payments out that we want to make sure that we do.
Once we clear that, clearly – and we're going to continue the 10b5-1 share repurchase, we'll be able to look at acquisitions and discretionary share repurchase and evaluate both of those simultaneously. And you've all heard me talk about how I want to make sure we have a more assertive balance sheet and that we're active and we'll look at both of those, and we'll look at the pipeline of acquisition. We haven't let off that, even with all the work we're doing. We're just not ready to do anything this minute. But we continue to build those relationships, and we think there's never a bad time to buy Parker stock, especially now. And so we will keep all those as potential opportunities as we go forward.
Thanks, guys.
Thank you, Jeff.
Thank you. And our next question comes from the line of Jeffrey Sprague with Vertical Research Partners. Your line is open.
Thank you. Good day, everyone.
Good morning, Jeffrey.
Good morning. Hey, I just wanted to come back to the disruptions one more time. Obviously, we've done a lot of analysis around this. It seems like we measure everything. To put it bluntly, the stock is kind of responding to concerns you guys have missed the cycle here by over restructuring at the wrong time. I wonder if you could just address that. I mean, is the plant footprint actually where you wanted to be when this is done? But also, kind of secondarily, can you give us some sense of, in aggregate, the headwinds that you have absorbed this year so we can try to make some sort of judgment on our own or where this might normalize or moderate as we move into 2019? Thank you.
Jeffrey, to help put it into context, I would take you to back what EBITDA margins have done over this period of time. 14.7% just from when we made an announcement was December of 2016 to 17.6% now. If you could have told me in little less than 1.5 years, I could – we could drive almost 300 basis points of EBITDA margins, I would have been ecstatic, and I'm still ecstatic with that kind of progress. It's absolutely fantastic. We put all-time records up on operating margin for the quarter even with all this.
We are going to put the businesses together, and we doing it in a very constructive, thoughtful fashion And this is -- again, I would just emphasize this is short-term so unless you're an investor for the quarter, and I'm hoping most of the people are listening are investing for the long term with us. You are absolutely ecstatic that we're doing what we're doing. We're taking care of our customers. We're taking share. We're driving margin expansion. And we put up a tremendous amount of records in the quarter even with all this. And we're setting the future up to put numbers up that nobody would have ever guessed this company could do. 19% up margin, 20% EBITDA, 10%-plus EPS growth, fantastic vision for where we're going to go. And I would just encourage everybody to jump on the bus because the bus is going places.
Thank you.
Thanks. Thank you, Jeffrey.
Thank you. And our next question comes from the line of Joe Giordano with Cowen. Your line is open.
Hi, good morning, guys.
Morning, Joe.
I just wanted to ask about we're starting to see some kind of directional changes in some of the more – in some of the broad macro indicators that impact your business. Still at really healthy levels, but just directionally, kind of plateauing or maybe starting to move lower and start to see them in Europe.
Now how do you kind of reconcile that with your order growth? We're still seeing some – looks really good, and Lee's commentary about acceleration. When do you kind of flip into, okay, now we have to start thinking about growing slower and different types of actions and you take about dealing with accelerating markets and decelerating? Where is that line? How does that change your thought process?
Well, I think, Joe, I think the key thing is that if we look at all our markets today, we can chart them all, and if I drew a line, 95% of them are growing. Now some are growing even on top of tougher comps on previous year, but the reality is they're still growing. So that's what we're looking at.
When I'm out with our customer base, very encouraged by the level of activity that's happening. And so I think this is – I think we're in for a fairly decent cycle here of continued economic activity and growth. Yes, I mean, it's the law of numbers here, right? I mean, the comps keep getting tougher as we go forward, but the bottom line is we're growing and we have a chance to put up some decent incrementals on top of that.
So at this point, like growing but decelerating is not something you're seeing too much yet that you have to start changing the way you kind of approach spending or anything like that?
No. It's not – I don't have that approach right now.
Okay. Thanks, guys.
Okay. Thank you, Joe. All right, Chelsea, we have time for one more question.
Certainly. And our last question will be a follow-up from Ann Duignan with JPMorgan. Your line is open.
Yeah, hi. I just have a follow-up question from an investor asking to clarify whether the incremental costs you're not going to see in the first half of 2019 is only from the three final plant closures, or is it – I know you said 36 will be closed at the end of the year. But are there still lingering costs associated with those 36 that will be incurred next year? If you could just clarify what the cost in 2019 are going to be?
Ann, again, it's Tom. It's hard for us to give you 2019 numbers, again, given where we're at right now But the cost for the three plants, obviously, you're going to see that. The inefficiencies, you'll see some of that, but it's going to continue to get better.
So again, I'm trying to paint the picture that this was the low watermark in inefficiency we continue to get better as productivity gets better first yields get better, scrap is down, let's see if it get better in Q4, you'll see it get better in each quarter going forward. But when we look – when we gave you that five-year look, we still expected FY 2019 to be a very good year as far as how we can – as we launch towards our new five-year targets, FY 2019 will be a very nice year.
Yeah, I appreciate that. But I think, if I'm interpreting what you said correctly, there will still be some lingering costs associated with the 36 plants that the flow into early part of next year?
Ann, it's Tom. If I'm not being clear, yes, inefficiencies for the 36 continue. They just get less and less in the first half.
Okay. Perfect. I just wanted to get that clear. So I appreciate that. Thank you.
Thank you, Ann.
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