Regal Rexnord Corp

NYSE:RRX

Earnings Call Transcript 2020-Q3

[Operator]

Hello, and welcome to the Regal Beloit's Third Quarter 2020 Earnings Call. [Operator Instructions]. Please note, today's event is being recorded.

I now would like to turn the conference over to your host today, Robert Barry. Mr. Barry, please go ahead.

[Robert Barry, executive]

Great. Thank you, Keith. Good morning, everybody. Welcome to Regal Beloit's Third Quarter 2020 Earnings Conference Call. Joining me today are Louis Pinkham, our Chief Executive Officer; and Rob Rehard, our Vice President and Chief Financial Officer.

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

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

Now let me briefly review the agenda for today's call. Louis will lead off with his opening comments, then Rob Rehard will provide our third quarter financial results in more detail, discuss our fourth quarter guidance as well as share some high-level thoughts on 2021 and on potential election impacts. 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. Thanks for joining us to discuss our third quarter earnings and to get an update on our business, and thank you for your interest in Regal.

For the second quarter in a row, this unprecedented global pandemic weighed on our orders and sales, impacted some of our key manufacturing operations and supply chain and further tested the endurance of our associates. So before getting started, I'd like to thank all my Regal colleagues around the world for their hard work and resourcefulness as they remain focused on serving our customers while remaining disciplined about keeping our workplace safe.

While many of our end markets remain challenged in the third quarter, I am encouraged that a number of bright spots also started to emerge, which we hope will prove sustainable. Order rates for the company turned positive in August and have remained so through October with notable material improvements in our North America residential HVAC business, which saw orders up 27% in September and tracking up 22% in October. While orders in our pool pump business rose 32% in the third quarter and are tracking up nearly 38% to date in October.

In addition, 2 of our businesses, Climate and Commercial returned to positive top line growth in the quarter, nicely exceeding our expectations. While Industrial was nearly flat and PTS narrowed its year-over-year rate of decline materially versus last quarter. With the recovery in North America short-cycle industrial showing early signs of momentum, but upside on that front still ahead of us.

We also made significant further progress on our 80/20 initiatives and on executing our multiyear restructuring program, which, as you may remember, we defined before the pandemic arose. Our cost-out plans are firmly on track. Indeed, despite seeing our top line decline just under 2% in the quarter as COVID impacts remain. Regal's adjusted income from operations rose by over 19%.

Contributing to that performance, our adjusted gross margin was up 300 basis points versus prior year. If we meet or exceed our fourth quarter adjusted EPS guidance midpoint will actually deliver EPS growth this year, despite the pandemic.

Our CFO, Rob Rehard, will share some initial thoughts on how we're thinking about 2021 later in the call. But on the margin front, I'm pleased to say we see some indications that the pace and scale of our cost-out opportunity may allow us to deliver ahead of schedule on our goal shared at Investor Day to achieve 300 basis points of adjusted operating margin expansion in 3 years or by 2022. Beyond margin, the story on cash flow is consistent. We generated $111 million of free cash in the third quarter for a conversion rate of over 170%.

Progress with gaining share also remains evident in key parts of our portfolio in data center, alternative energy, China commercial market and perhaps most notably, in our ModSort unit material handling business, where our innovative conveying solution is gaining traction in last mile package sorting and distribution applications.

Our ModSort team is also a great example of how Regal is using technology outside of our product development function, such as for marketing and lead generation. ModSort booked a nearly $2 million order during the third quarter, which originated with an end user's web search earlier in the quarter, improved digital customer experience activities have and will continue to receive significant investment at Regal.

To me, the message this performance sends is very clear. We are structurally improving this business, and I couldn't be more proud of our Regal associates who are learning, adapting and acting with a sense of urgency to drive these changes.

As I have stated on prior calls, at Regal, safety always comes first. As the pandemic's duration has tested our focus and resolve, I can assure you that our legal associates around the world remain disciplined about balancing the need to produce our essential products while keeping our workplaces safe.

From an operational standpoint, all of our facilities are currently functional, though our capacity levels in Mexico are still not quite where we'd like them to be. Conditions in Mexico seem to improve steadily during the third quarter with almost all of the states where Regal has operations moving to the lower risk yellow category in the Mexican government's color coding system for defining risk and regulating permissible activities. But in the last couple of weeks, several of these states have moved back to orange and one state to red. These changes typically result in more of our associates needing to remain out on a government-mandated health decree.

We were down to having only about 2% of our workforce in Mexico out on health decrees at the end of the third quarter. But as of today, that level has increased to roughly 4%. Of course, we are monitoring this daily and leveraging our global manufacturing network to best service our customers.

Shifting to orders. Declines of 6% in July turned to growth in August and September, which saw orders up 4% and 2%, respectively. October, with a few days remaining in the month, is tracking up roughly 11%. We are seeing strength in North American residential HVAC, pool pump and data center markets with order rates in our PTS segment just starting to show signs of better momentum as the North America short-cycle general industrial end markets begin to recover.

Consistent with recent data points such as the ISM order rates and capital goods orders, we see potential upside to recent order trends if restocking and PTS starts to occur in any meaningful way. For now, our best estimate is that stronger momentum starts to recur in early 2021, but many moving pieces remain regarding end user confidence and activity levels. Rob will share additional order details by segment in his remarks shortly.

Before concluding, I would like to discuss a couple of recent developments of investor interest. First, I'm very pleased that in September, we published our latest sustainability report. The report reaffirms Regal's commitment to increasing the energy-efficient benefit our products bring to our customers and to society, while reducing the impact of our manufacturing processes on the environment and also meaningfully contributing to the communities where our associates live and work.

My mandate to the team working on this year's sustainability report was to raise transparency around our ESG products and initiatives and in particular, do so by including more data. And I believe our team delivered. That said, one of the reports themes is Regal being on an ESG journey. So while I am pleased with our efforts around sustainability, governance and social responsibility have been advancing, there's much more we can do and will do. In particular, I'm challenging our business leaders to further refine their sustainability strategies and to create more specific road maps for driving year-over-year improvement on a select few business relevant metrics. I'd encourage you to read the report.

The next topic I'd like to cover is our portfolio. We're always evaluating our portfolio of businesses for their fit with Regal's long-term strategic objectives around growth, margins and return on capital. Indeed, at our Investor Day back in March, we had alluded to a cadence of portfolio review to ensure such alignment. With COVID, our focus has rightfully been elsewhere. But having just come out of an annual strategy review discussion with our Board, we are refreshing our evaluation of our portfolio.

We made a lot of changes since I joined the company roughly 18 months ago, including bringing on new leaders at over half of the 22 businesses that sit behind our 4 segments. And adding many new members to our executive leadership team. We also decentralized pushing operating control out to the businesses, rigorously started applying 80/20 principles to improve margins and growth, added P&L transparency down to the plant level, reorganized many of our go-to-market efforts and are increasing our investment and focus on innovative, sustainable products that solve our customers' challenges. And frankly, I've had a chance to personally get to know our businesses more intimately. So with the benefits of time, many fresh eyes and much more granular data, we think taking a fresh look at the portfolio would be valuable.

The last topic on which I'll share some thoughts is indoor air quality or IAQ, because it's getting a lot of attention with our customers and with investors. We believe it's early days on the IAQ front. But to the extent it gains traction, I think Regal has a large role to play and we're investing to ensure we're there for our customers as they help end users with IAQ solutions.

First, many of the IAQ initiatives being discussed involve stronger filtration and more frequently exchanging indoor for outdoor air. Both of these upgrades require more powerful motors. And if customers want to at least maintain the energy efficiency levels they saw before making any IAQ enhancements, these stronger motors will also need to be more efficient. Addressing these needs is right in Regal's technology sweet spot.

Second, Regal is already in the market with a blower product that helps introduce outdoor air into an office, classroom and restaurants. The Regal advantage is how we integrate the blower components, the motor, the wheel, the housing assembly into more of a plug-and-play offering, which accelerated the OEM's design cycle, expediting time to market and reducing development costs. We think this lead time advantage will be critical as property owners seek expedited upgrades to their buildings so tenants can feel safe inside.

We're also testing a patented UV light solution, which involves introducing a UV light strip into one of our blower housing. This system contains the UV light in the blower housing while continuously cleansing airborne pathogens from the air flowing through it. We believe this compact solution, which is easy to integrate with existing systems will be great for the retrofit market. Other products are also in the works, but I think these are a couple of representative examples of what we're doing.

The last point I'll make on IAQ is that it's an opportunity for Regal to leverage its technology expertise to be there for our customers as they seek to address evolving customer needs, and to do so in an expeditious and cost-effective manner. This is how Regal will win with our customers.

And with that, I'll turn it over to Rob, who will take you through our third quarter results in more detail and share our reintroduced guidance for fourth quarter and 2020.

[Robert Rehard, executive]

Thanks, Louis, and good morning, everyone. While the third quarter continued to be impacted by COVID-related pressures, our team turned in very strong performance on growth, margin expansion and free cash flow, including 230 basis points of adjusted operating margin improvement and 171% cash flow conversion. In addition, with our order rates now in positive territory and showing some signs of stabilization, we feel comfortable providing guidance for the fourth quarter and also ending the pause on our stock purchase program.

Before diving into our results by segment, I do want to preface that we won't be speaking about our profitability improvements in terms of leverage or deleverage rates on today's call, simply because they're not as meaningful this quarter when we're generating higher profit dollars despite lower sales. I will note, however, that our cost-out and productivity actions have been significant needle movers this year, resulting in 9% deleverage on a year-to-date basis.

Starting with Commercial Systems. Organic sales in the third quarter were up 1.3% from the prior year. The result was driven largely by strength in our pool pump business, which was up almost 20% in the quarter in addition to ongoing share gains in China and to a lesser extent, growth in our North America large commercial applied HVAC business.

As we enter October, momentum in pool remains strong with month-to-date orders tracking up almost 38%. Limiting the degree of growth we saw in the quarter were ongoing COVID-related operational disruptions in our Mexico operations, which prevented us from executing on as much of our backlog as we had hoped. But we're optimistic and expect to see greater progress on this front in the fourth quarter, which should provide a nice tailwind to Commercial's top line performance.

In addition, we saw a roughly 2-point headwind from our ongoing proactive pruning of low-margin accounts as we continue to execute on our 80/20 initiatives. As a reminder, while our pruning initiatives pose headwinds to the top line, they are also a factor contributing to margin expansion.

The adjusted operating margin in the quarter for Commercial Systems was 12%, up 310 basis points compared to the prior year. This margin was up due to favorable price/cost and mix benefits partially offset by freight headwinds incurred as we work to serve our customers as expeditiously as possible in the face of our Mexico manufacturing and supply chain disruptions. Orders in Commercial for the quarter were flat, reflecting strength in pool pump and Asia, net of weakness in our larger commercial HVAC business. For October, orders are tracking up 21%, with broad-based strength led by pool.

The continued upward momentum in Commercial orders gives further confidence that we may be entering a period of stability and a return to growth, albeit with an ounce of caution largely due to the uncertainty around the potential second wave of COVID-19 disruptions.

In Industrial Systems, organic sales in the third quarter were down 2.9% from the prior year. The segment saw continued sizable large COVID-related declines in the general industrial and oil and gas end markets, partially offset by strong sales into the data center market, where our product provides stand by power. Pruning actions were approximately 2 points of top line headwind in the quarter.

The adjusted operating margin in the quarter for Industrial was 6.7%, up 610 basis points compared to the prior year. The margin improvement was driven by 80/20, continued cost reductions, our supply chain optimization actions in North America, favorable mix and positive price/cost partially offset by the impact of lower volumes. We are very pleased with the significant improvement in profitability executed by our industrial team, especially given continued COVID-related headwinds on the top line. But we want to point out that benefits from mix and to a lesser extent, price/cost were particularly favorable in the third quarter.

So while the segment would have seen nice sequential and year-over-year margin gains even without these benefits, we would not expect to see the same degree of gains in this segment's operating margin in subsequent quarters. However, to be clear, we continue to expect to see meaningful year-over-year improvement in industrial margins as we deliver on our strategy as discussed during our Investor Day presentation just 8 months ago.

Orders in Industrial for the quarter were down 3%, but would have been down further were it not for the strength in the data center business. Currently, order rates for October are tracking up just over 2%, with continued strength in data center plus some early signs of improvement in the core North America industrial business, partially offset by mixed results across Europe and modest weakness in Asia. All of our facilities are operational in Europe and Asia, and we'll be closely monitoring COVID-related impacts on all of our businesses.

Turning to Climate Solutions. Organic sales in the third quarter were up 2.5% from the prior year. The increase was primarily driven by our North America residential HVAC business, which we'd attribute to a combination of favorable end user demand plus significant channel restocking. The strength in residential HVAC was partially offset by weakness in Europe, pressure on light commercial HVAC market and ongoing weakness in commercial refrigeration, which has a sizable exposure to the still struggling hospitality vertical. In addition, our proactive pruning actions were approximately 3 points of top line headwind in the quarter.

I'll provide a little more color on what we saw in residential HVAC as this has been an area of heightened investor interest. Orders in our HVAC business, which reflects products we sell into air conditioning and furnace markets, were up 12% in August, up 27% in September and are tracking up almost 22% month-to-date in October. We believe the strength largely reflects channel restocking after inventories became severely depleted during the second quarter, plus decent end user demand. We do expect further strong momentum in residential HVAC because it's our sense that OEMs are still working to rebuild channel inventories to more normalized levels. Indeed, we believe our strong orders in residential HVAC could have been materially stronger if OEMs had been able to fully meet desired restocking levels.

That said, any early cold weather could result in a shift by our OEM customers to producing more furnaces, leaving air conditioning inventory below normal until more robust stocking activity occurs in early next year, ahead of the 2021 cooling season. We see Regal benefiting from this air conditioning restock, whether it occurs in the fourth quarter or next year, and from any accelerated shift to building furnaces as we have leading positions in both markets. In addition, we remain optimistic that we'll see more mix benefits this winter from the mid-2019 mandated shift to higher efficiency furnaces, which did not occur last winter due to the warmer-than-normal weather.

The adjusted operating margin in the quarter for Climate was 17.1%, flat with the prior year period. Favorable mix, continued cost reductions and volume were margin tailwinds in the quarter, but offset by headwinds tied to FX, higher freight costs to serve our customers and slightly weaker price cost. While leverage on climates growth of 18% is below our run rate target level, it is still in line with our expectations for this quarter, given particularly strong lower-margin OEM demand, still elevated COVID-related costs and a recent decision to make some additional product development investments related to indoor air quality.

I'd also like to note that while we did see some pressure this quarter from price/cost, we expect this dynamic to improve as we exit fourth quarter, with further improvement in the first quarter and second quarter of 2021 as benefits from our material price formulas become more impactful.

Orders in climate for the quarter were up 3% largely on North America residential HVAC. Looking at month-to-date October, orders for this segment are tracking up almost 17%, again, on strong North America HVAC along with early signs of recovery in Europe, and commercial refrigeration.

Turning to Power Transmission Solutions, or PTS. Organic sales in the third quarter were down 8.9% from the prior year, significantly narrowing the rate of decline compared to the 21.1% decline posted last quarter. The organic decline reflects continued pressure on the North America general industrial end market and to a lesser extent, headwinds in oil and gas, lumpiness in the alternative energy market and our proactive approach to -- proactive actions to prune lower-margin business. In the third quarter, our pruning actions weighed on sales by roughly 70 basis points. Partially offsetting these headwinds were nice share gains in our ModSort unit material handling business, which Louis discussed earlier.

Adjusted operating margin in the quarter for PTS was 12.8%, up 90 basis points compared to the prior year. Favorable price/cost, continued cost reductions and to a lesser extent, favorable mix more than offset volume-related pressures. Orders in PTS for the quarter were down approximately 7%, largely on headwinds in the general industrial and oil and gas end markets. Looking at month-to-date October, orders are tracking up slightly to last year, with improvements in our short-cycle businesses, partially offset by oil and gas headwinds.

I'll remind you, our short-cycle general industrial-focused bearings business stabilized during second quarter, but customers have tended to order at demand versus showing an appetite to restock. We did finally start to see some evidence of restocking in September, but at a very modest pace despite channel inventories that remain lean. So we expect nice tailwinds in this business when end user confidence rises enough for more meaningful restocking to occur.

On this slide, we highlight some key financial metrics for your review. A few notable highlights: First, our strong free cash flow of $111 million or 171% of adjusted net income, bringing our year-to-date conversion to almost 200%; second, the continued balance sheet deleverage with our net debt to adjusted EBITDA down to 1.3x at the end of the third quarter. Finally, with some stability in our orders, our cost actions are on track and our strong free cash flow, we felt it made sense to end the pause on our stock repurchase program. Consistent with our past practice, we will not be making any forward-looking comments about our stock purchase plans and no stock purchases are assumed in our current guidance.

Moving on to the outlook for the remainder of this year 2020. With a couple of months left in the year, our order rates back in positive territory and evidencing some level of stability, we feel prepared to provide more detailed guidance. We expect fourth quarter adjusted diluted earnings per share in a range of $1.46 to $1.66, up almost 25% year-over-year at the midpoint. That implies 2020 annual adjusted diluted earnings per share in a range of $5.45 to $5.65, which at the midpoint is actually up, albeit modestly versus our 2019 adjusted EPS. We are very pleased that we can provide guidance showing year-over-year growth in annual adjusted EPS despite the severe COVID-related headwinds we've battled throughout 2020.

A few modeling considerations to keep in mind: First, the fourth quarter is typically weaker for us due to seasonality, in particular, in our HVAC and pool pump businesses; second, we're assuming no material negative impacts from a second wave of COVID-19; third, we do expect relative weakness at industrial as we lap some sizable projects in the prior year fourth quarter and complete a large data center project that benefited the third quarter of this year. Finally, We're not assuming a significant tailwind from restocking in the short-cycle industrial channel in PTS, which we think is more likely to occur in the first half of 2021.

Speaking of 2021, we aim to provide more detailed guidance when we report fourth quarter results. However, there are a few themes you should keep in mind as you start to model next year. First, the vast majority of the cost cutting we have done this year is resulting in permanent savings with the exception of $6 million related to temporary pay cuts and furloughs in the second quarter. Second, we have indicated previously that through our 80/20 initiatives, our supply chain moves and our other restructuring actions, we are in a position to achieve leverage rates above 30% when the business is consistently growing again.

Finally, our top 3 end markets are consumer, general industrial and nonresidential construction, which represent roughly 20%, 20% and 15% of our total sales, respectively. We believe the consumer market relevant to our products has been fairly resilient this year and will continue to be in 2021. The general industrial market has been under pressure this year, and we would expect some recovery in 2021, but we would not assume returning to pre COVID levels.

We do see some risk to the nonresidential construction market, in particular, for roughly half of our exposure that is in the U.S. While we are not prepared to start forecasting end market growth rates, we would note that various analysts have been setting the nonresidential growth bar in a range of flat to down for next year. In these cases, we challenge the business leaders to adjust their strategies accordingly either through more aggressive cost actions and/or greater urgency around pursuing share gains. We've clearly demonstrated the success of this approach throughout 2020.

Next, as Louis alluded to earlier, we feel very good about how our cost out 80/20 and best value country sourcing initiatives are tracking. While we're still finalizing our operating plans for 2021, we're increasingly confident that we can track ahead on our goal of delivering 300 basis points of adjusted operating margin expansion by 2022. We'll look to share more details on this front when we report our fourth quarter and provide guidance for 2021.

At the bottom of this page, we've included some additional assumptions that can used when modeling the remainder of this year.

I'd also like to touch briefly on a topic that is surely top of mind for many of us, which is the upcoming U.S. election. 3 significant themes that stand out include potential changes to our -- to corporate tax rates, impacts on investment spending for alternative energy and infrastructure and China trade policy.

Regarding tax rate, those who are following us when the current administration passed lower corporate tax rates may remember that our already low tax rate changed very little, only by about 1 percentage point. Therefore, while we do believe that an unwinding of the 2018 Tax Cuts and Jobs Act would have minimal impact on Regal, it's impossible at this point to anticipate how tax policy in the U.S. might evolve from here.

Regarding investments spending on alternative energy and/or infrastructure more broadly, we'd expect any increase in spending to benefit Regal. We have growing direct exposure to solar and wind in our PTS and motor businesses, which also have potential exposure to infrastructure investment, especially to the extent such investments are focused on commercial construction.

Finally, as it relates to China trade policy, we believe what's most relevant for investors to consider is our flexible global manufacturing presence, which enables us to serve our global customers profitably while under a wide variety of potential tariff scenarios.

Before moving to Q&A, I want to once again thank all of our Regal associates for everything they are doing to deliver for our various constituents, our customers, our shareholders and our fellow associates during these very difficult times. Our results in Q3 showed very strong execution and material progress on our journey to structurally improving the through-the-cycle profitability of our business.

And with that, I'll turn it back over to the operator. Operator, we are now ready to take questions.

[Operator]

[Operator Instructions] And the first question comes from Mike Halloran with Baird.

[Michael Halloran, analyst]

Excellent quarter. Great to see the progress. So first question, lots of information there really appreciated. Just want to make sure I understand how you guys are thinking about the trajectory by the various business units going into next year. Hoping you could weave in what you think is sustainable based on what we're seeing today, where you think you have maybe a little excess in the short term with restocking versus where you've got more restocking that's on the come. I know you gave a lot of that content in the prepared remarks. But if you wouldn't mind just going piece by piece and how you're thinking about the momentum of each of the businesses heading into next year? Just on the top line side.

[Louis Pinkham, executive]

Just on the top line, yes, sure. This is Louis. I'll take it and then Rob will likely jump in as well. But I'll do it by business and then I'll do it a little bit by market. So we're cautiously optimistic. We still see in the PTS segment, it's early days, and there would need to be a rebuild of inventory in the channel. Climate, it's -- that's a consumer-driven market for us. We -- certainly, our OEMs have reported some nice momentum. We're seeing that momentum in our order rates. They continue to be strong.

Right now, we would also say that there's a need for restocking in that space where our OEMs are just meeting demand levels, but there's a need to restock as well. Commercial pool, stay-at-home markets are certainly on the upswing. You've seen that reported with some of our peers as well. We feel very good there. We're even more excited there because of the regulation that comes out in the middle of next year that drives further energy efficiency, which is perfect for our product and our technology. But then I would tell you, Industrial, a little bit more conservative. And not in the data center space, which we're definitely gaining share. But in anything that has a significant capital investment and whether it's metals, paper, the large motor applications, we're just not seeing that kind of rebound.

And so I'll go in too quickly in the market. General industrial broadly under pressure mostly from COVID, but we definitely see with ISM being above 50, some momentum, and we would expect 2021 stronger. Industrial distribution, certainly, there was plenty of channel destocking until mid-June. We're seeing some modest signs of restocking at this point and expect some upside. As I said, pool pump, anything work-from-home is strong and so strong demand.

Residential HVAC, with the warm weather of the summer as well, that certainly helped. And there's certainly consumer strength and restocking activity. Oil and gas, both midstream and upstream is very weak. And so that again impacts our industrial business and a bit of our PTS business.

And then other verticals that we would highlight, data center, material handling, bright spots. Some bright spots in agriculture, China, commercial and Australia. Asia Pacific weak construction markets for us right now. And then EMEA is still slow. And I certainly think COVID is having an impact there, some market uncertainties and then where we play as well. Our business there is in hospitality with our Commercial Refrigeration space, oil and gas and marine all markets there are under pressure, and we would expect to continue under pressure into 2021.

So hopefully, Mike, that gives you a perspective and helps you understand how we're thinking about it.

[Michael Halloran, analyst]

No, no, it does. And then on the cost-out side, obviously, really good progress here. Maybe give some context on what's next and what you're seeing that provides the incremental confidence to pull forward the 300 basis points of improvement? And what are the steps that you need to take from here to drive to that goal at a sooner date?

[Louis Pinkham, executive]

Mike, I think we were a bit in an enviable position because we outlined a 3-year cost reduction program as we put together our strategies for 2020. And so we were in again an enviable position that we had started some momentum. And so to answer your question, why we see the opportunity to perhaps pull this forward is, we still have room to improve here. Manufacturing plant consolidations as we aligned in our Investor Day, would take us 2 to 3 years. 80/20 is a driver of everything we're doing. We have significant simplification around product rationalization that's going to help us. And we're continuing to work on, again, a 2- to 3-year plan. And then our focus on best value country sourcing is really paying off, and we believe will benefit our segments going forward.

The last that we really haven't baked in, in any significant way, but we're spinning up with is our focus on lean. So my first 18 months with Regal, 80/20 was absolutely the right place to focus. Decentralizing the organization, getting more accountability and ownership of the P&L, right place to refocus. We are now ready to really emphasize driving lean, focused on process, removing waste, variation and overburden.

I commented on the last earnings call that we hired an individual who is a subject matter expert in this space, who now reports directly to me. This is an initiative that we are driving from the executive leadership team. And I think will provide -- it's a marathon. It's not a sprint. It's not a -- we get it done tomorrow. But over the next 3 to 5 years, It will further help us transform our manufacturing and capabilities.

So all of these things, Mike, on the cost side, give us confidence that we're transforming this business. And hey, our fighting team is doing an excellent job.

[Michael Halloran, analyst]

Last one for me. Really strong cash generation is always really good cash position. You've taken the buybacks -- the buyback pause off the table. You're now going to be back in the market potentially. How are you balancing the opportunity set to buy back your own shares versus what's available in the marketplace? What's the thought process today? And then how aggressive do you think you could be with either of those external capital allocation decisions?

[Robert Rehard, executive]

Yes, Mike, this is Rob. I'll take that one. So as you know, right now, we're talking about -- we're going to revert back to our strategy of being balanced in our capital allocation approach. Obviously, including dividends and CapEx on projects that have short paybacks. And as you said, opportunistically buying back shares and also looking for inorganic at the same time. We're -- we can be and will be at the right opportunity aggressive in our approach to organic investment that meets our acquisition target metrics. It's a disciplined approach.

We talked about it at Investor Day, we want to see opportunities with gross margins at 35% range. We want a differentiated product offerings. We want leading market positions. And we're going to look for opportunities to give us an opportunity to see ROIC above 200 basis points above our WACC by 3 to 5 years depending on the asset.

So that's kind of how we're looking at it, and we will absolutely be balanced, and we can be aggressive at the same time. And both of the -- in all of those categories, quite frankly, but in share buybacks and as well as M&A, which was specific to your question.

[Louis Pinkham, executive]

Let me add on to the M&A theme there too, Mike. Hey, I'm very conscious that this will be my first acquisition, anything that we do in this space. And that valuations must make sense, that there needs to be significant synergies and a clear strategic fit. We've seen many opportunities. The funnel is strong. We've invested in working a more structured program around the funnel, and we feel good about our funnel. Valuations are elevated, and we're not going to overpay. But I am sure there are options out there for us. And so to Rob's point, we will be balanced in our deployment of capital, and I think there will be opportunities in the future.

[Operator]

And the next question comes from Julian Mitchell with Barclays.

[Julian Mitchell, analyst]

Maybe just trying to keep the questions a little brief. I see, I guess, on the portfolio, Louis, I think you'd mentioned a fresh look. So that was somewhat intriguing, I suppose. I mean, I had thought that perhaps you might try and push the margins up across the board before perhaps looking to divest some businesses.

I wondered if anything had changed in your mind on that front. Or is it simply that the macro environment today is more conducive to assets changing hands and that sort of thing? And how broad or substantive that portfolio of fresh look might be?

[Louis Pinkham, executive]

Yes. So really, the point of bringing it up, Julian, was that it was brought up at our Investor Day. We just came out of a strategy review with our Board. We are constantly evaluating the position of our businesses, the performance of our businesses. And so I just wanted to emphasize that this is something that is top of mind for me and my leadership team as we think about strategy. I couldn't agree with you more that there is still significant value creation, shareholder value creation in our ability to run margins up and especially in a couple of our less-performing businesses, certainly industrial. And I couldn't be more proud of what our industrial business has done to date and believe that there's more runway there.

But at the same time, I think it's healthy for us to constantly challenge ourselves and say, is the best business -- is it -- are our businesses best suited with us at Regal or perhaps elsewhere.

So it was, yes, perhaps a little intriguing to put that paragraph into my prepared remarks, but it was done in just simply intentionally to reinforce to the investment community that we are focused on portfolio management, We are looking for growth, earnings growth as well as good return on our invested capital, which I think is our responsibilities for shareholders. And so that was the point. Hopefully, that's clear.

[Julian Mitchell, analyst]

Yes. And then maybe my second question, just circling back to margins. You mentioned restructuring charges this year of $29 million. Is that kind of the peak year and that drifts down next year? And then on the Industrial business, you mentioned some tailwinds specific to Q3. So what do you think the real sort of baseline margin is today in that segment?

[Robert Rehard, executive]

Yes, Julian, this is Rob. So first of all, you asked about the restructuring, is it a peak. We're still working through our plans for next year, but this year was certainly one that's higher than what we may normally experience. Again, it's certainly tied into some great cost actions that we've taken, and we're reaping those benefits. I wouldn't expect it to continue at a pace above where we are today, just to answer your question. But certainly, we will continue to have restructuring as we enter '21.

Now how do we think about industrial margins and progression from here? Hey, we had a -- we did have particularly good project levels in the third quarter as we talked about. And a lot of that's in our data center business, which also helped our mix. And we still see further margin improvements year-over-year in the fourth quarter, but as we said, maybe not sequentially, you may not see that level of improvement. And we will talk more about this on the fourth quarter call. But we laid out a framework at Investor Day that called for 8% to 11% margins for the industrial business. And we absolutely believe that's the right range to think about industrial margins going forward.

We're tracking as we talked about, ahead of that pace. So maybe see the higher side of that range. But that's the range that we laid out, and we're still tied into that at this point.

[Operator]

And the next question comes from Nigel Coe of Wolfe Research.

[Nigel Coe, analyst]

Nice quarter, absolutely. So you mentioned there's obviously a lot of noise around IAQ and you talked about the need for more sort of larger and more efficient motors in that kind of scenario. And Carrier laid out a pretty aggressive sort of opportunity set for that. But I'm just wondering, are you seeing any signs at all that perhaps '21, we might see a mix up around that issue? And then the second part of that question is a 2-part question is as we go from 14 to 15 SEER in a couple of years' time, does that have any implications for the motor system within the equipment to achieve that?

[Louis Pinkham, executive]

Yes. So Nigel, I'll take that. So first of all, are we seeing any indications that there will be a significant upside in 2021 from IAQ? I'd say it's fairly early days. Now we are in discussions with OEMs. We do think our product and technology positions us very well to help solve the energy consumption and efficiency issues that will come along with IAQ.

We've already talked a little bit about this of having what we think are some plug-and-play solutions that will position us well with OEMs, and we've already got one on the market today with an OEM. But I think it's early days. So I'm not quite ready to comment on, do we think that we'll have a significant uptick for 2021.

With regards to the SEER regulation, absolutely. The next SEER regulation just drives another level of energy efficiency requirements. And again, this is where our technology is, and we're a technology leader in our variable speed motors and solutions. And so, we think we're going to be well suited to benefit from that. So we see that as a positive tailwind for us.

[Nigel Coe, analyst]

Great. And then a quick follow-on with free cash flow. You've been sort of seeing trade working capital tailwinds now for about 6 quarters. As we sort of turn the corner on volumes, do we need to rebuild working capital into '21? Or do you think you are steady here?

[Robert Rehard, executive]

I will tell you, Nigel, that free cash flow has been very strong, as you've seen. Trade working capital has been a source of cash through most of the year. In the third quarter, it was a use of cash, but we do expect it to be a source of cash for the year as we exit the year. And we have more runway to go here, especially in the area of inventory, and we've made that point very clear in the way we've talked about trade working capital in the past.

And so, we are not taking our foot off the gas. We have plenty of runway, and we expect it to be a source of cash as we move forward. Now obviously, that depends on volumes. You always have to build back for volumes, but we would expect steady state -- that inventory and trade working capital will be a nice source moving forward.

[Louis Pinkham, executive]

I think we've gained some momentum here. Just to add on. I agree with Rob's comments. It's all about now measuring days on hand. And we've put a lot more discipline in our organization around inventory management, but there's still opportunity there. So I couldn't agree more this will be -- should be a benefit for us.

[Operator]

And the next question comes from Jeff Hammond with KeyBanc.

[Jeffrey Hammond, analyst]

Just on fourth quarter -- good color on the orders and certainly the guide. But just trying to pinpoint how you're thinking about sales into 4Q, either kind of all in? Do we grow organically? Or it looks like maybe 2 of the 4 segments would see growth and maybe 2 of the 4 would still be down? Any help there would be great.

[Robert Rehard, executive]

Sure, Jeff. First of all, we would expect further progress on industrial on a year-over-year basis, maybe not a quarter -- not necessarily quarter-over-quarter sequentially after the third quarter saw such nice tailwinds from project activity and that sort of thing. But all of our segments are expecting tailwinds in fourth quarter related to the bottom line, cost actions, productivity, 80/20. But volumes are a little bit uncertain and so could pose some degrees of offset.

One consideration for Climate is the strong momentum we've seen with the large HVAC OEMs and to the lesser -- and to the extent that, that continues through the quarter, especially on the AC side, that would benefit volume leverage. It could be a mix headwind for us because OEMs are lower on the margin side. But from a top line perspective, we would still expect to see some nice momentum going forward into the fourth quarter on a year-over-year basis, where we will see pressure is certainly we would expect pressure in both our Industrial and PTS segments to be clear and on a year-over-year basis.

[Jeffrey Hammond, analyst]

Okay. That's real helpful, Rob. Just on the long-term margin targets, I mean, we would have thought maybe with the pandemic in between that those get pushed out, but it just seems like you've made a ton of progress this year. So just maybe level set us on more broadly? I know you touched on industrial more broadly, how you're thinking about progress on hitting those?

[Louis Pinkham, executive]

Yes. So Jeff, I'll take that. It's -- again, it's -- we believe we are driving the transformation of the business. And 80/20 was the starting point to help us do so and really have dug into a quad perspective of ensuring that we're providing the maximum value to our highly valued customers that buy a product, serving them better, providing better solutions in that space. So that has gained momentum across the board, a little bit faster than we anticipated. Plus as we said, we outlined a 3-year program to transform, which included plant consolidation, product rationalization and now we're accelerating our lean efforts.

We outlined those at Investor Day, except for lean and lean has now added additional tailwind. So we are feeling more confident and notice most of that is cost centric opportunities. And then with growth, we believe that the margin potential is there, the potential is there to pull forward the $303 million because that 80/20 is driving us to value the right segments and to put our focus of our sales force on those segments. And then as we talked about in Investor Day, our investment in additional R&D, 100 basis points over the next 3 years is allowing us to produce -- to better understand our customer needs and help solve their problems and develop products that position us for accelerated growth. So all of these things are giving us more and more confidence that we should be able to pull forward the $303 million.

[Jeffrey Hammond, analyst]

Okay. And then just to sneak one more in there on the 80/20. Certainly, that's a top line headwind and additive to margins. But as we look into '21, do you still think that 80/20 top line headwind continues? Or is that maturing?

[Louis Pinkham, executive]

Yes. I'd say it's -- it will continue, but it will not continue at the extent that we saw in '20. So it will temper a bit, and then '22 will temper even a little bit further. We modeled the 80/20 pruning effect to be stronger in year 1, but then decline over that period.

Again, as I've said to the investment community, as I said, say to every one of our associates, we need to provide differentiated products and solutions that solve our customers' challenging problems cost competitively. And so that's our focus at Regal.

[Operator]

And the next question comes from Walter Liptak with Seaport.

[Walter Liptak, analyst]

A great quarter, especially on the margin.

[Robert Rehard, executive]

Thank you.

[Walter Liptak, analyst]

Just to follow-on from Jeff's question with the 80/20 pruning that was nicely aggressive, I guess, it was a little bit more, I think, than we thought. But why -- in the PTS segment, it didn't look like there was as much, are they just better? They don't have as many pruning situations they have to go through? Why was the pruning less in that segment?

[Louis Pinkham, executive]

Yes. I'd say that's a fair, very simple assessment. Our gross margins, and we've been pretty clear on this. Our gross margins in our power transmission business are stronger than the rest of the portfolio. And so that likely gives you a first indication that they should have less pruning. And we sell more through distribution in the power transmission business. So of course, that helps the uplift in the margins there. And so, I think that's really the main driver.

[Walter Liptak, analyst]

Okay. Great. Switching over to the comments about climate with the HVAC OEMs. Considering that a lot of the manufacturing is done down in Mexico, and you've got the strong residential market going on, is it there a chance for a change in the seasonality where you see more of that inventory build in the fourth quarter and first quarter, just kind of safety stock building in the channel?

[Louis Pinkham, executive]

It's really hard to say right now because there are quite a few variables out there. One variable is weather. And if weather -- if we have a cold winter, there's going to be a turn pretty quickly to furnace build. Another variable is COVID and the ability for the OEMs as well as us that matter to ramp up the production to be able to meet the demand as well as meet the inventory levels.

So I'm not quite ready to give a clear picture of that there could be a change here. What I can say is that we've got some nice momentum. The trailing 3-month order rate in the HVAC space is 20% for us, and that's going to propel us strongly, we believe, through Q4 and should into next year.

[Walter Liptak, analyst]

Okay. Great. And then the last one for me is just on the restructuring from plant consolidation. Has that started yet? Are you -- are there are plants -- or is that something that happens in 2021, 2022?

[Louis Pinkham, executive]

No, no. Absolutely, it has started. We've communicated that there would be 5 manufacturing plants that would be announced or closed through 2020. We have not yet communicated the impacts for 2021. So Walter, it has definitely started.

[Operator]

And the next question comes from Joe Ritchie with Goldman Sachs.

[Joseph Ritchie, analyst]

Just a couple of quick ones for me. As you think about the 30%-plus incrementals in 2021. Is there a certain amount of volume that you need to come through the system in order to achieve that? And then secondly, as you kind of think about those margin targets as 300 basis points by 2022, again, similar comment in terms of what you already have within your own control to drive strong margins if the volume doesn't come back?

[Louis Pinkham, executive]

Yes. So the significant part of the $303 million was a cost focus. And so Joe, we feel pretty good about keeping that momentum. Of course, we do need some volume to return, but we think the markets are going to provide that kind of tailwind.

You asked are we doing -- do we need a certain amount of volume to get the leverage going forward? And I'd say it shouldn't be. We should be able to see volume leverage year-over-year going into by segment. Now we'd tell you that we'd probably lever a little bit stronger in PTS. We'd lever less in Climate, a little less in Industrial, a little stronger in Commercial. But overall, no, I don't think it's going to be highly tied to a minimum level of volume that comes with it.

[Joseph Ritchie, analyst]

Okay. Great. That's good to hear, Louis. And then maybe my quick follow-on question. You talked a lot about the work that you're doing on the products that you have for data centers and the share gains that you're experiencing. Maybe talk a little bit more about what you think is allowing you to gain share in the data center market?

[Louis Pinkham, executive]

I'm excited about this business, and I believe that we have further growth opportunities. I've got a team that understands the application that is able to easily and with speed customize solutions to better meet the requirements of their customer. This is where we want to drive more at Regal. Deeper understanding of the application and being able to provide solutions that differentiate us and do it with speed and cost competitively. And that team, is doing it very well for us. And so, I believe there's runway for us to gain further share in this space.

[Operator]

And as there are no more questions, I would like to return the floor to management for any closing comments.

[Louis Pinkham, executive]

Thank you, operator. To summarize, while our third quarter results continued to be impacted by COVID-19, a number of bright spots also emerged on orders and sales performance. And I feel extremely good about how the Regal team is executing on our restructuring actions, leveraging 80/20, managing our working capital and selectively pursuing share gain opportunities.

We continue to transform this business, and I believe it's increasingly evident in our results. Most notably, we drove year-over-year operating profit improvement on down sales with 300 basis points of adjusted gross margin improvement, and we see a path to material further upside.

While we're still not out of the woods on COVID-19, we're remaining focused on keeping everyone at Regal safe and on executing what's under our control to keep moving down the path towards our longer-term gross margin and ROIC goals.

Thank you again for your interest in Regal.

[Operator]

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