Regal Rexnord Corp

NYSE:RRX

Earnings Call Transcript 2019-Q2

[Operator]

Good morning, and welcome to the Regal Beloit Second Quarter 2019 Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded.

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

[Robert Cherry, executive]

Thank you, operator. Good morning, and welcome to Regal Beloit's Second Quarter 2019 Earnings Conference Call. Joining me today are Louis Pinkham, our Chief Executive Officer; Jon Schlemmer, our Chief Operating Officer; and Rob Rehard, our Vice President and Chief Financial Officer.

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

On Slide 3, we state that we are presenting certain non-GAAP financial measures in this presentation. We believe that these are useful financial measures to provide you with additional insight into our operating performance and for helping investors understand and compare our operating results across accounting periods and in the same manner as management. Please read this slide for information regarding these non-GAAP financial measures, and please see the appendix for a reconciliation of these measures to the most comparable measures in accordance with GAAP.

Now let me briefly review the agenda for today's call. Louis will lead off with his opening comments and an overview of the quarter. Rob will then review our second quarter financial results in detail and provide an update on our 2019 outlook. We will then move to Q&A, after which, Louis will have some closing remarks.

Now I will turn the call over to Louis.

[Louis Pinkham, executive]

Thanks, Rob, and good morning, everyone. Thank you for joining Regal's second quarter earnings conference call and thank you for your interest in Regal. As Rob mentioned, our COO, Jon Schlemmer, is joining us today. And although he will not be making prepared remarks, he will be available on this call to help answer questions. I would like to take this opportunity to thank all of the investors and analysts that I have had the pleasure of meeting with over the 4 months since I started at Regal. I look forward to meeting even more of you in the future.

In these past 4 months, I have visited many of our facilities, met with many of our associates and visited with a number of our customers. The talent in our organization is strong, and we have deep application knowledge in our served markets. Our products are differentiated, push the boundaries of energy efficiency and are increasingly IoT-oriented. Our customer relationships are strong and deep. In all, we have a great organization.

Turning to the current period, we had tough macro conditions in the quarter. Our second quarter financial results reflected lower-than-expected demand due to abnormally wet and mild weather, the ongoing global trade uncertainties, including the June Mexico tariff concerns; efforts by distribution partners to reduce channel inventories, along with an overall continued economic malaise in Asia Pacific and Europe. Regal posted negative 2.2% organic growth in the quarter with overall orders down mid-single-digit year-over-year against tough comps. Despite the challenging sales environment, we delivered an adjusted earnings per share of $1.52, which was flat to the prior year. We had strong margin expansion in our Climate segment of 110 basis points and solid expansion in the PTS segment up 40 basis points. In the C&I segment, we continued to experience significant weakness in some key end markets with operating margins down 160 basis points. This led to overall organic growth being down 2.2% and adjusted operating margin being down 20 basis points, deleveraging at far below our normal rates. Year-to-date, our adjusted operating margin is up 20 basis points.

In particular, I want to highlight 2 significant impacts on our second quarter adjusted earnings per share. The first was an unfavorable inventory adjustment in the C&I segment that was the result of a full physical inventory performed during a facility move. This adjustment had a $0.06 negative impact. The second was a year-over-year translational headwind in FX for the total company with the majority of the impact in the C&I segment. This FX headwind had a $0.07 negative impact. Rob will give more clarity on both later in the call.

Before going into more detail on the performance of the segments, I want to share with you a reorganization that we have undertaken, which my leadership team and I believe will improve alignment and accountability, increase speed of decision-making, improve financial performance and better position Regal for talent development. Simply, this reorganization takes us from a centralized model, which was appropriate at the time of its implementation, to a decentralized model. This will result in greater visibility and focus on P&Ls at the business level and manufacturing site level rather than just at the segment level. These business units have clear leaders with dedicated teams that are fully responsible and accountable for the business units' profitable growth. We've implemented a monthly cadence of operating reviews with these business units, which allows us to quickly identify and address issues and spot opportunities on which to capitalize in a more timely fashion. Another key benefit of this reorganization into decentralized business units is that it enables our teams to leverage their deeply rooted vertical knowledge and experience in order to drive our product innovation roadmaps, organic growth and customer relationships. Ideas will be fostered and nurtured by these teams that have the expertise in the business and the incentive to drive them. Through this reorganization, we will incur some short-term restructuring costs, but the changes will improve performance, turn into cost savings and pay long-term dividends in the execution of the business. We estimate that the annual savings of this reorganization will be at least $15 million and we should see the full benefit in 2020.

As we start to leverage this reorganization, it will enable us to deploy our version of an 80/20 approach across Regal focused on improving margins, executing on our remaining footprint synergies and driving further product rationalization and consolidation. In my first few months at Regal, it is clear that there are value creation opportunities around accelerated simplification, but also around customer margin management.

I am a believer that if a customer values the product, technology or service that you offer, it is clear in the margins you earn from that customer. At Regal, we have an opportunity to more effectively manage the lower-margin mix with some of our customers. However, if we don't earn a reasonable margin, there are 3 choices: Regal becomes more market-competitive; we work with our customer to raise prices in a partnering fashion; or we exit the business and address our cost position. All of our segments have opportunities to better manage our product and customer margin mix. This will be a focus and priority over the next few quarters.

In the quarter, we also continued to execute on our portfolio management as we divested a noncore vapor recovery business that was focused on the oil and gas market. The business had annualized sales of approximately $50 million, which brings the total annual sales that we have either exited or divested to approximately $270 million over the last 12 months. Again, as part of my review of the business, I am taking a nonbiased approach at evaluating our portfolio, comparing and plotting our businesses against 2 shareholder value creation metrics: ROIC and EBITDA. For those businesses that lie in the bottom quartile, it is very simple: we will need to fix or exit. I am in the process of working with my leadership team and discussing options with our Board. These learnings will influence our strategy that we will begin to share with you in the fourth quarter and then later with a full rollout at our investment day -- Investor Day in March.

Returning to the quarter and the segments performance. In Climate, we continued to see a benefit from the pre-buy of standard motors ahead of the July implementation of the fan energy rating regulation for furnaces. North America residential HVAC was up low to mid-single digits, but without FER, it would have been up only slightly due to the cool weather in the quarter. Weakness in the commercial refrigeration, along with our ongoing 80/20 account pruning efforts, were partial offsets and dampened our organic growth to 2.3% in the segment. The 80/20 account pruning efforts in Climate, which was -- which we are deploying across Regal, have a near-term negative impact on our sales, but will improve our profitability over time. These pruning efforts along with a mix-up due to the divestitures as well as positive price cost resulted in a 110 basis point year-over-year improvement in adjusted operating margin.

In PTS, we faced a tough comparison having grown over 10% organically in the prior year. Approximately 70% of our sales in PTS go through the industrial distribution channel. This channel has been experiencing a slowdown in North America as industrial markets cool and trade uncertainty weighs on the end market. While we do not see much of a direct impact from the tariffs in this segment, we do feel the indirect impacts on the markets we serve. Altogether, we believe that this has led to higher inventory levels in the channel and is resulting in destocking. Also hampering PTS deals are challenging end markets in upstream oil and gas, agriculture and beverage equipment. Together, these markets represent approximately 25% of the segment sales. The overall net impact drove organic growth down 1% in the segment. Despite these sales headwinds, our productivity, positive price cost and deployment of cost controls delivered a 40 basis point year-over-year improvement in adjusted operating margin.

In C&I, we saw significant slowing in several of our end markets. The cool and wet weather had a double-digit negative impact on our pool pump business. In Asia Pacific, we saw single and, in some markets, double-digit declines. We are also continuing to be negatively impacted by project delays in the power generation market as we highlighted in the first quarter. There is also broader weakness in the generator rental market driven in part by the decline in the upstream oil and gas activity and milder weather. And finally, we experienced minimal share loss in North America related to tariffs that we are in the process of mitigating as we discussed on our last call by establishing production capability and capacity within the region. This program is well on track. Our service levels have improved along with our cost position as we mitigate the China tariffs. We expect order improvement in Q3 and Q4 from these actions. However, altogether, these sales headwinds contributed to organic sales growth being down 5.5% in the segment. The adjusted operating margin in C&I was down 160 basis points from the prior year. The inventory adjustment and FX headwinds that I've previously mentioned, along with the volume headwinds, drove the entire decrease. Our deleverage rate was 28%, which would've improved to 9% without the inventory and FX headwinds.

From a total company perspective, our free cash flow was 122% of adjusted net income. Our accelerated focus on working capital resulted in a $39 million inventory reduction in the quarter. We remain confident that we will generate free cash flow greater than adjusted net income for the full year. In addition, we continue to deliver on our balanced capital allocation approach. We raised our dividend by 7%, and we repurchased 731,000 shares for $56 million while maintaining our net debt to adjusted EBITDA ratio at 1.8.

Finally, we are reducing our adjusted earnings outlook for the year from a range of $6.15 to $6.55 to a range of $6.50 -- excuse me, $5.50 to $5.80. The reduction is driven in part by the divestiture that we announced this quarter, which has a $0.12 impact on full year performance, but also due to the ongoing weak end market conditions and the continuing global trade uncertainties. As evidence of these conditions, Regal's orders were down mid-single-digit in the second quarter. Consequently, we are laser focused on accelerating our mitigation efforts given these market conditions. The reorganization that I discussed earlier will help by reducing SG&A costs, but we are also further reducing discretionary expenses, accelerating productivity improvements and aggressively managing price cost. We will also be leveraging our reorganization by driving a P&L focus deeper into the business. With the business unit structure, we are further deploying our 80/20 approach into the organization, which we expect will improve margins. The P&L focus is also improving our order and backlog management, which then in turn is driving forecasting accuracy throughout the company.

In summary, poor weather, weaker macroeconomic trends and trade tariffs impacts have decreased our 2019 guidance expectations. But the fact remains that we have good products, good people and good technology that form a solid business, which is focused on profitable growth for the long term. I remain very excited about our prospects.

I will now turn the call over to Rob, who will provide more details on our financial performance.

[Robert Rehard, executive]

Thank you, Louis, and good morning, everyone. As Louis mentioned, we had a tough quarter that saw weakness in several end markets and regions, which was made more challenging by difficult prior year comparisons. Despite these headwinds, Regal delevered at 16%, far below our normal rate. Sales in the second quarter for the total company were down 9% from the prior year. After the impact from businesses divested or to be exited and foreign currency, the organic sales in the quarter decreased 2.2% from the prior year.

I will start by providing comments on the segments and end with more detail on the total company and our guidance.

Starting with Commercial and Industrial Systems. Sales in the second quarter were down 14.3% from the prior year. After adjusting for the impact from businesses divested or to be exited and foreign currency, organic sales in the quarter decreased 5.5% from the prior year. The segment saw double-digit declines in pool pump, China, and parts of our commercial HVAC business partially offset with gains in distribution. The adjusted operating margin in the quarter for C&I was 6%, down 160 basis points compared to the prior year. This margin was down mainly due to an unfavorable inventory adjustment, year-over-year FX headwinds and to a lesser extent, reduced volume.

In the quarter, Regal conducted a manufacturing facility move in the power generation business within the C&I segment. This facility is part of an engineered-to-order business. As part of the move, a full physical inventory was conducted, which resulted in an unfavorable adjustment of $3.4 million of inventory on a pretax basis, or approximately $0.06 on a diluted earnings per share basis. In addition, we had a $2.9 million year-over-year headwind in translational FX for the segment. These 2 items drove most of the decrease in operating margin, otherwise, margin would have been roughly flat to the prior year, and we would have delevered at only 9%. Orders in C&I for the quarter were down approximately 10%, reflecting weakness in a number of our end markets. The cool and wet weather in the quarter, along with high inventory in the channel, has softened our pool pump market. In China, we are seeing weakness in several of our commercial and industrial businesses. As Louis mentioned, due to the China tariff, the commercial and industrial business was impacted by some share loss in North America. But with our localization efforts, we have stabilized the situation and are working to regain our position over the next couple of quarters. We continue to see the impact from project delays in our power generation business that we previously shared in the first quarter. Lastly, we gained some share in distribution.

Turning to Climate Solutions. Sales in the second quarter were down 3.4% from the prior year. After adjusting for the impact from businesses divested or to be exited and foreign currency, the organic sales in the quarter increased 2.3% from the prior year. The increase was primarily driven by the impact of the FER pre-buy along with moderate growth in the North American residential HVAC business, which was dampened by the cool weather in the quarter. The headwinds in the quarter primarily came from commercial refrigeration and the impacts from pruning accounts as we further deploy 80/20. The adjusted operating margin in the quarter for Climate was a record 17.6%, up 110 basis points compared to the prior year. The margin expansion was driven by productivity improvements, positive price cost, favorable mix from recent divestitures and our 80/20 pruning efforts. Orders in Climate for the quarter were up slightly. As previously mentioned, the cool quarter dampened our residential HVAC demand. We saw improvement in the distribution in Asia Pacific end markets, but they were more than offset by weakness in water heater and commercial refrigeration.

Turning to Power Transmission Solutions. Sales in the second quarter were down 4.4% from the prior year. After adjusting for the impact from businesses divested or to be exited and foreign currency, the organic sales in the quarter decreased 0.8% from the prior year. Our main challenge in the segment was a slowdown in North American industrial markets, which impacted our distribution sales due to the destocking of inventory in the channel. We did see positive growth from our gearing sales in the renewable energy end-market. The adjusted operating margin in the quarter for PTS was 12.4%, up 40 basis points compared to the prior year. The margin benefited from positive price cost and other actions we took to improve productivity. Orders in PTS for the quarter were down mid-single digit, again, the main driver for -- was a slowdown in the industrial distribution channel, but we also saw significant weakness in the upstream oil and gas, mainly fracking, agriculture, commercial HVAC and beverage end markets.

Now I will summarize a few key financial metrics for the second quarter. Our capital expenditures were $36 million in the quarter. We now expect capital expenditures of $85 million for the full year 2019, a reduction of $5 million from our prior guidance. We are focused on ensuring we deploy capital that drive shareholder value. Our simplification activities resulted in $3.6 million of restructuring and related costs in the quarter. With our reorganization effort underway, we now expect $13 million of restructuring and related costs for the full year 2019, an increase of $3 million from our prior guidance. Most of which is due to the recent reorganization actions. We expect the reorganization will lead to annual savings of at least $15 million. The adjusted effective tax rate in the quarter was 20.4%. We're adjusting both the second quarter and the full year ETR for the tax effect of the businesses divested and assets to be exited. We provided a table in the appendix of this presentation to reconcile the GAAP ETR to the adjusted ETR. We continue to expect our adjusted ETR to be approximately 21% for the full year 2019. Our total debt was $1,223,000,000, and our net debt was $932 million. We ended the quarter with our net debt to adjusted EBITDA ratio unchanged at 1.8. We achieved $76.3 million of free cash flow in the quarter, and our free cash flow as a percentage of net income was 121.9%. We continue to expect to be above 100% for the full year 2019. Also in the second quarter, we repurchased just over 731,000 of our shares for $55.9 million. We continue to execute on our balanced capital allocation strategy. And lastly, on July 2, 2019, we divested a noncore vapor recovery business, which was previously part of our C&I segment. Annualized sales in this business were approximately $50 million. Given the timing of the sale closing after the quarter end, the results of this business are included in our second quarter results, but their previously expected full year results of $0.12 have been removed from our 2019 guidance. Consistent with the way we've previously presented this information, additional details related to all divestitures are included in the appendix of this presentation. In these tables, we've included net sales and adjusted income from operations for each segment by quarter and for the full year as well as the impact on adjusted diluted earnings per share for the full year and by quarter, so you can clearly see the impact of these divestitures on our ongoing business for comparison purposes.

Now I will provide an update on our full year guidance for 2019. Our guidance now assumes organic sales growth to be down low to mid-single digit for the full year due to the ongoing impacts from unseasonal weather conditions, the global trade uncertainties, excess channel inventories, along with the continued overall economic slowdown in Asia and Europe. Specifically, on a segment basis, in C&I in the second half, we expect to see additional destocking in pool pump, further erosion in China and additional account pruning. Due primarily to the lumpiness in our engineered-to-order businesses and visibility to related backlog, coupled with the soft demand observed in July, we expect to see the majority of the headwinds within this segment in the third quarter. Partially offsetting this impact will be the benefits from our recent restructuring actions, localization efforts and improved service levels.

In Climate, in the second half, we expect to see an overhang from the FER pre-buy, which will start to reverse in the fourth quarter; pressure on margin from Mexican labor wage increases and additional account pruning. We will also start to see benefits from new innovations in commercial refrigeration, market penetration in Europe and our recent restructuring actions. In PTS in the second half, we expect to see continued destocking pressure from the industrial distribution channel. We also expect to see, as we often do, variability in margin by quarter due to mix shifts between OEM and distribution demand. However, we expect continued tailwinds in the renewable energy end market and expect to see benefits from our recent restructuring actions. We are lowering our full year 2019 GAAP EPS guidance to a range of $6 to $6.30. On an adjusted EPS basis, we are lowering our full year 2019 guidance to a range of $5.50 to $5.80. The reduction is driven in part by the divestiture that we announced this quarter and by the volume deleverage, which we look to partially offset with productivity, positive price/cost and our 80/20 efforts.

Although we are not anticipating the slowdown to be dramatic, to better align our cost structure with the near term dynamics, we are accelerating SG&A cost reductions. We will also see benefits from our reorganization to a more decentralized model, which will allow us to operate more efficiently and help offset some of our headwinds.

In summary, at the midpoint of our guidance, our full year adjusted EPS is expected to be flat to the prior year on a comparable basis after accounting for the impact of the divestitures and exits included in the appendix of this presentation.

Operator, we are now ready to take questions.

[Operator]

[Operator Instructions] And our first question comes from Jeff Hammond of KeyBanc Capital Markets.

[Patricia Gorman, analyst]

This is Trish on for Jeff. So maybe if we could start with just talking about C&I profitability looking at second half. Is the second quarter, is that margin run rate something we should be looking at for the second half and kind of what's moving within that?

[Robert Rehard, executive]

Trish, this is Rob. I can take that. From a C&I perspective, second half versus first half margins, we would expect C&I to be slightly up. But the third quarter should be flat to down.

[Patricia Gorman, analyst]

Okay. Great. And then just kind of within your updated guidance, which end markets are incrementally weaker than when you issued guidance last, 3 months ago, kind of where you've seen that fundamental weakness? Is there anything that's getting any better than you're expecting?

[Louis Pinkham, executive]

Yes, Trish. Maybe I'll take this one. If you look at incrementally weaker, definitely in second quarter, the weather was a challenge, and that had an impact on certainly our pool pump market as well as our HVAC market. Lesser in HVAC, but certainly in pool pump. In addition, slightly worse, although we were seeing challenges in the China market in particular in our industrial business. It's not getting better, and we're not forecasting it to get better. We are seeing some strength however in our commercial industrial distribution segment, and so we believe that, that will continue into the second half of the year. Another what we would say, an incremental change for us was the industrial distribution market, especially for our PTS business. We saw absolutely an approach in the quarter, a slowdown because of the current market uncertainties, a slowdown in demand. And therefore, our distribution partners bringing down their inventory levels. One area we are seeing some strength, however, is in renewable energy, quite a bit stronger than we anticipated in second quarter going into the second half. So hopefully that gives you a perspective of how we're thinking about some of the changes that we saw through Q2.

[Operator]

Our next question comes from Mike Halloran of Baird.

[Michael Halloran, analyst]

So just continuing on the question there, just trying to understand. From a guidance perspective, obviously there is inventory headwinds that are going to change with the core demand for you, looks like. But what is the assumption from the end-market perspective relative to the first half? Is this sequential stability from the run rate exiting 2Q, is it slight deterioration? How should we think about that end-market normalizing for inventory, normalizing for FER pre-buy and all those things across the 3 segments?

[Robert Rehard, executive]

Mike, this is Rob. I'll take that one. Let me answer your question in terms of what we're seeing from an order rate perspective. So overall, our orders in July were down from the prior year. But let me give you some color by segment. Climate orders in July were slightly above the prior year as they were in Q2 as well. And from a sequential basis, Climate orders are down mid- to high single digits, which is normal seasonality. FER pre-buy is contributing to this decline. In PTS, orders in July were below prior year by double-digit, which we believe is a continuation of the inventory correction in the channel as well as slightly lower industrial demand. Q2 orders were down mid-single digit, and sequentially, as compared to Q2, July orders were down double-digit. However, we do expect this will partially correct as we move through the third quarter. C&I orders in July were also below the prior year and slightly below second quarter. However, this is a lumpy business, which is highly impacted by project orders. As Louis mentioned, we're adding a level of fidelity to our orders in backlog management, which will improve our forecasting capability. You asked a little bit about what does this mean in terms of the inventory headwinds and others. As I mentioned from a margin standpoint, overall, we would expect to be relatively flat to the first half for overall Regal. C&I should be slightly up with pressure still in the third. Climate should be slightly down based on normal seasonality, and PTS should be relatively flat. So hopefully, that gets to most of your question there, Mike.

[Michael Halloran, analyst]

No. That's really helpful. Great. And then just a question on the reorganization, the focus on 80/20, the decentralized approach. Maybe just talk a little bit about what steps you're taking now to implement that through the organization, receptivity. How long do you think it's going to take for the organization to [ stay on ] those principles and start really executing on it? And then in the context of the savings, when do those savings start ramping up?

[Louis Pinkham, executive]

Yes, Mike. I'll take this one. So we actually announced the reorganization in early June. And I believe the organization was very receptive. And we've now gone through -- a tough part of a reorganization, of course, is restructuring and reduction in force. We've announced that -- the majority of that already, and so we'll start seeing benefit -- some benefits in the third quarter, mostly fourth and then full year next year. Now from a timing perspective, Regal had already started down the path around 80/20 product plant rationalization, which we believe is a big part of that for us. All we're doing is we're accelerating it. And so it's understood by our organization. We're certainly ensuring that it's a big part of our culture and a way of doing that is setting clear objectives and then having a cadence of review of those objectives. And so part of this reorganization is a strong cadence of follow-up and follow-through that each one of our businesses have. So I feel good. I think -- again, like I said, you'll start seeing some benefit in '19, more benefit in 2020. Hopefully that answers your question.

[Operator]

Our next question comes from Joe Ritchie of Goldman Sachs.

[Joseph Ritchie, analyst]

So maybe just touching on C&I for a second. Just the commentary around the, call it, flattish, maybe slightly better margins in the fourth quarter at a time and like the growth rate is probably going to remain down, call it, mid-single digits. Can you maybe just discuss a little bit the puts and takes that could keep this to flattish-type margin in the second half of the year?

[Louis Pinkham, executive]

Yes. I think it's fairly simple. It's on the cost side, Joe. So the restructuring will help. We are laser focused on accelerating our productivity initiatives, and that's going to help with the margin improvement for Q4.

[Jonathan Schlemmer, executive]

And Joe, this is Jon. One other that I would add is the mitigation actions that both Louis and Rob talked about earlier around the tariffs and what we're doing to stabilize in that area, and help us win back some of the share that we've -- experienced share loss that we experienced in the first half.

[Joseph Ritchie, analyst]

Got it. Okay. That's helpful. And then maybe my follow-on here. You guys cited a few different areas in C&I again that obviously deteriorated. We're down double digits in the quarter. Some of it was weather-related. I'm just wondering if -- does that just basically become lost revenue for the year? Or is there an opportunity, let's say, this quarter to pick up some of that revenue if weather normalizes?

[Louis Pinkham, executive]

Yes, Joe. I'll take that one. It could, especially if we see a heat wave come through and Regal likes heat. We also like really cold in the winter as I'm learning, but we're not seeing it. Not to the extent that we'd recover the decline of Q2.

[Operator]

Our next question comes from Julian Mitchell of Barclays.

[Julian Mitchell, analyst]

Maybe firstly just clarify in PTS, should we assume there a pretty similar rate of revenue decline in Q3 and Q4 when you're looking at the order intake? Or are you assuming a big dip in Q3 and then a less bad decline exiting the year?

[Robert Rehard, executive]

So I can tell you, Julian, this is Rob, that we do expect -- on PTS, as I said in July, the order rates in July that we saw versus the prior year were down double digits and sequentially versus Q2 were also down double digits. As we said, we do expect this to partially correct throughout the third quarter, but certainly continue to see pressure based on those order rates as we go through the remainder of the year.

[Louis Pinkham, executive]

The way I'd answer it, Julian, is that -- just to expand on what Rob just said is we are going to see in the PTS segment a slight reduction in orders -- sorry, in sales in Q3 to prior year as well as a slight reduction in Q4 to prior year.

[Julian Mitchell, analyst]

Understood. And then just my follow-up would be looking at the second half adjusted operating margin. I think based on what Rob had said about the second half margin versus the first half, it looks like you're assuming maybe a decremental margin year-on-year in the low teens against 16% in Q2. Just wanted to check if that math is roughly right. And then what impact, if any, price net of cost is having on the margins in the second half?

[Robert Rehard, executive]

So Julian, this is Rob. So first of all, yes, you are directionally correct in your calculation there. Price, we do expect price to be -- price/cost to be positive for the remainder of the year as we've seen in the first half of the year. So yes. So I think you have your math correct from that perspective.

[Operator]

Our next question comes from Christopher Glynn of Oppenheimer.

[Christopher Glynn, analyst]

So looking at your North America where the HVAC sales up slightly, just curious what your best gauge of what the end market did in the quarter.

[Louis Pinkham, executive]

Yes. Chris, this is Louis. I would say the end market in North American resi was up mid-single digits in the quarter. We were up slightly below that. I would say for -- although we saw the FER pre-buy, we had done some -- taken some pruning actions in that business that had a positive impact on margins. But of course, some headwind on sales.

[Christopher Glynn, analyst]

Makes sense. And then C&I distribution gains, wondering just what's enabling that, where you are on the curve. What's the runway from the gains that started in the second quarter? And then putting that into the context of what you think you can do with the distribution channel over a longer horizon.

[Jonathan Schlemmer, executive]

Chris, this is Jon. I'll take that. So distribution for C&I certainly was one of the positives in the quarter in terms of top line strength. And we do believe there is share gain through that channel. We would attribute that to the investments that we've been making in the sales force as well as on the digital side of the business. We put a lot more focus on the distribution channel in general. And we've seen year-to-date growth in that part of the business and again, we believe that a good part of that is definitely gaining some share in the channel. We would expect that to continue through the second half. We continue to place investments in that area and feel good about the progress that we're making there.

[Christopher Glynn, analyst]

Okay. Last one from me is, you're looking at the inventory reduction. Is there any material impacts from under-absorption of manufacturing overhead contemplated in the third quarter?

[Robert Rehard, executive]

So this is Rob. The quick answer is no. We have -- this inventory adjustment, as I said, was really an engineered-to-order project business, and we've been discussing this over the past 3 quarters, and this...

[Christopher Glynn, analyst]

I'm sorry. I meant the reduction in the overall Regal inventory.

[Robert Rehard, executive]

Oh, okay. I'm sorry. Yes. Okay. Sorry. So the answer is no, we wouldn't expect it to have a material impact in the third quarter.

[Operator]

Our next question comes from Robert McCarthy of Stephens.

[Robert McCarthy, analyst]

I promise not to get quite as riled up about inventory. I guess the first question I have is, maybe stepping back, Louis, just talking about what you've been impressed with in this kind of managing a more chaotic -- not chaotic, more volatile environment and the downturn and how your organization has responded. Where have you seen kind of the bright points? And where do you see really the need to improve upon as you manage a more cyclically volatile environment?

[Louis Pinkham, executive]

Yes. Happy to share perspective here, Rob. I believe that the reorganization that we talked about earlier is really going to get our team very focused on the markets that they serve and how to bring value to our customers. I think that's going to be a significant benefit for us. The team's already been working on 80/20, and we're accelerating that activity and driving it deeper into the organization and a focus on a P&L management at every manufacturing site and every business unit is helping to ensure that we're driving gross margin improvements. I believe there's opportunity, as I said before in my remarks, to evaluate our margin situation especially, if you will, in that fourth quartile of 80/20. And that's something the team is working on. And then lastly, opportunities, there is no question that the Regal team has done a fantastic job in time of looking at our footprint, but there's more opportunities around plant consolidation and product rationalization that we are evaluating. All of these things as well as the portfolio that I talked to you about earlier and our approach to evaluating our portfolio, we are discussing with my leadership team and we're considering options with the Board and we'll be in a better position towards the end of this year to come out with a clear path forward.

[Robert McCarthy, analyst]

Okay. Fair enough. And then your current guidance, does it include some concern or some additional debit in association with the most recent tariffs announced? In other words, did you bake it before the tariffs announcement or after?

[Louis Pinkham, executive]

Yes. Actually, interestingly enough, the latest tariff announcement has very little impact on Regal. We have less than $500,000 in spend that was already excluded in the first 3 tariff lists. So it's going to have very little impact directly. However, the impact is clearly going to be felt from further market uncertainty due to the ongoing trade tensions. That's where we're going to see the impact, and we believe we've put that -- we've considered that in our guidance.

[Robert McCarthy, analyst]

No. That's very helpful. And then finally, in terms of the cadence of exposure in terms of your contemplated plan, we're going to get a lot more detail presumably on the fourth quarter call, which will be in early January, then followed up by a clear articulation in the March time frame at the Analyst Day?

[Louis Pinkham, executive]

That's exactly the way it's dated. Thank you.

[Robert McCarthy, analyst]

And then last question then is, what have you done in terms of thinking about your cost base and your geographic base for sourcing and production, particularly Mexico, and elsewhere, in light of what we've seen these global trade concerns? Do you think you have to have more investments to change your footprint there or alter your footprint in any way? How are you thinking about that?

[Louis Pinkham, executive]

One of the benefits of Regal is our scale and our global footprint. I do not believe there's going to be a need for any significant capital -- further capital investment to be able to best leverage and manage our footprint. Where I do believe there will be opportunity is consolidation of footprint in the multiple regions where we produce, and that is something that we're evaluating as part of our strategy.

[Operator]

[Operator Instructions] And our next question will come from Nigel Coe of Wolfe Research.

[Nigel Coe, analyst]

I wanted to dig into C&I. You called out some weakness in China. No surprise there, but you also called out weakness in commercial HVAC. And sorry if I missed your commentary around that market, but maybe just dig into where you've seen weakness there and how you see that developing.

[Jonathan Schlemmer, executive]

Nigel, this is Jon. So I'd say that it was a bit mixed for commercial HVAC. There were parts of the commercial HVAC business where we actually saw some strength in the quarter; in other parts where we saw weakness. We participate on, what I'll call, kind of light commercial through heavy commercial kind of the applied side as well -- and both in Asia and in North America. So some of that was geographic -- based geographically in terms of where we saw weakness in particular in Asia. And then also on the transport refrigeration side is another aspect of our commercial HVAC business so it was -- parts of that vertical were up for us in the quarter while parts were down, and I would put it around the larger applied side, the Asia side of the business and also on the transport refrigeration side.

[Louis Pinkham, executive]

Being down.

[Jonathan Schlemmer, executive]

Being down. Correct.

[Louis Pinkham, executive]

Down.

[Nigel Coe, analyst]

So a lot of clients down. Okay. That's a little bit different to what we're hearing from the OEMs. They call it applied's being up, but we can certainly dig in off-line on that. And then understand the comments about List 4 not being a major direct impact. But List 3, 10%, 25%, how is that impacting the cost side of the equation of the price/cost? And then how is it impacting your competitors that are importing from Asia? Are they facing more tariff headwinds? Any comment on that would be helpful.

[Jonathan Schlemmer, executive]

So I'll take that one also, Nigel. So I think that, first of all, on the List 3 going from 10% to 25%, the important thing to remember for us is, we had assumed the increase to 25% in terms of the mitigation actions we were taking, which was the combination of footprint and price as we entered the year. So -- while there is some incremental headwind for us clearly because with the tariffs increasing to 25%, we have pretty much planned for that and have that embedded in our guidance. In terms of competition, I think that we would see that as a bit of a larger impact on our competition. In our C&I business, that was more of a List 1, List 2 challenge for us. List 3, I think, is a little bit less of an impact for us and we believe a bit more of an impact for some of our global competition.

[Nigel Coe, analyst]

Okay. Then finally -- well, maybe one for Louis here. When you [indiscernible], you talked about maybe a more meaningful C&I restructuring potentially. How -- kind of where are we in that process? And could that be a 2020 event?

[Louis Pinkham, executive]

Nigel, I'll take that. As I've said before, we're evaluating different options. I certainly think that the reorganization, our approach to portfolio review, the comments I made in my prepared remarks around looking at it from a shareholder value creation perspective of ROIC and EBITDA, as well as our focus on 80/20, that's going to be our drive for our strategy moving forward. Now giving you much more clarity on that around product rationalization, plant rationalizations and portfolio management, I'm not able to do that at this time. We're evaluating options. We're talking with our Board, discuss a path forward and we'll be better prepared in the January and March time frame to come out with clarity.

[Operator]

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

[Louis Pinkham, executive]

Thank you, operator. To summarize, it was a tougher quarter where we faced difficult comparisons and challenging end markets. We feel that we met those challenges and delevered far below our normal deleverage rate. Regal continues to make our customer the priority of everything we do. In Q2, we conducted a survey on customer satisfaction using the Net Promoter methodology. Our overall score improved 15% from the prior year, and we saw improvement in all performance factor categories. Looking forward, we are energized about leveraging our reorganization and driving a P&L focus deeper into the business. We will further deploy our 80/20 approach throughout the organization and drive improvement in product profitability, while staying laser focused on exceeding customer needs and driving profitable organic growth. And of course later this year, I will be providing more clarity on our strategy and portfolio management.

Thank you for joining the call and your interest in Regal.

[Operator]

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