Regal Rexnord Corp

NYSE:RRX

Earnings Call Transcript 2017-Q4

[Operator]

Hello, everyone, and welcome to the Regal Beloit Fourth Quarter 2017 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, Business Development and Investor Relations. Please go ahead.

[Robert Cherry, executive]

Thank you, operator. Good morning, and welcome to Regal Beloit's Fourth Quarter 2017 Earnings Conference Call. Joining me today are Mark Gliebe, Chairman and Chief Executive Officer; Jon Schlemmer, Chief Operating Officer; Chuck Hinrichs, Vice President and Chief Financial Officer; and Rob Rehard, Vice President of Financial Planning & Analysis.

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

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

Now I will turn the call over to Mark.

[Mark Gliebe, executive]

Thanks, Rob. Welcome, everyone. Thank you for joining our fourth quarter call and thank you for your interest in Regal. We'll follow our normal agenda. I'll make a few opening comments. Now normally, Chuck provides the overall financial update. But as you may recall, Chuck Hinrichs will be retiring at the end of March, and Rob Rehard will be Regal's CFO effective April 1. So Chuck will provide a financial update on our fourth quarter and total year results, and Rob will cover the impact of the U.S. Tax Reform as well as our 2018 guidance. Then Jon will provide color on markets, operations and the performance of our 3 segments. And then after that, I'll summarize and we'll move to Q&A.

Regal delivered a solid top line performance in the fourth quarter with organic sales up 6.9%. In fact, the fourth quarter was the eighth quarter in a row where the organic growth rate improved sequentially. At a segment level in Commercial and Industrial, organic sales were up 8.7%, with broad strength in the North American commercial and industrial end markets, oil and gas and in most Asian end markets.

In the Climate segment, organic sales were flat. Recall that in 2016, our residential HVAC sales were up double digits, making the fourth quarter 2017 comparison difficult.

Finally, in the PTS segment, organic sales were up a strong 11.9% for the quarter, with robust growth in oil and gas, renewable energy and distribution. From an operating profit perspective, the adjusted operating margin improved 20 basis points year-over-year. The operating margin benefited from strong volume, incremental price and productivity, but was held back by commodity inflation and tougher SG&A comparisons. The resulting adjusted earnings per share was up 9.6% year-over-year. As you may recall, we set a goal to repatriate $150 million of cash this year. We met that goal in the third quarter and exceeded that goal in the fourth quarter by repatriating an additional $90 million of cash in the quarter. We used the cash to help us pay down $74 million in debt, which yielded a year-end total debt-to-adjusted EBITDA ratio of 2.4. Overall, it was a solid quarter, with strong organic sales growth and further progress on our march to improve operating margins.

Looking forward as we enter the new year, we are encouraged that our orders remained up year-over-year in all 3 segments. Our price increases are sticking and our manufacturing facilities are performing. For 2018, our guidance assumes total year organic growth to be up low to mid-single digit. We are expecting our top line to benefit from continued growth in residential and light commercial HVAC end markets, robust commercial and industrial markets and positive incremental pricing. We are forecasting that organic growth rates will be stronger in the first half of the year versus the second half, simply due to the more difficult second half comparisons. On margin performance, we expect to see benefits from our Simplification efforts as well as from price increases that we have implemented on all 3 segments. Our total year adjusted earnings per share guidance for 2018 has been set at $5.35 to $5.75, up 14% at the midpoint over 2017.

I will now turn it over to Chuck.

[Chuck Hinrichs, executive]

Thank you, Mark, and good morning, everyone. Sales in the fourth quarter 2017 were $820.7 million, up 8.3% from the prior year. Foreign currency translation in the quarter was a positive 1.3%. Therefore, organic sales increased a solid 6.9% from the prior year. And for the full year 2017, our organic sales growth was 4.3% above the prior year. Looking at our 3 segments, the C&I segment had organic sales growth of 4.6%, the Climate segment had organic growth of 3.1% and the PTS segment had organic growth of 5.3%. In summary, we had solid organic sales growth in the fourth quarter and for the full year 2017.

Our adjusted operating margin in the fourth quarter was 9.7%. Compared to the prior year, our margin was up 20 basis points. This improvement was driven by volume growth with some offset from the price/cost headwind. In the quarter, we took $2.7 million in LIFO expense, consistent with our guidance from last quarter. The LIFO impact by segment is shown on this slide. As you can see, the C&I segment had a LIFO expense partially offset by the LIFO benefit in both the Climate and PTS segments.

And finally, SG&A expenses were higher in the fourth quarter 2017 compared to the prior year, primarily due to timing in our Climate and PTS segments. Our SG&A expenses for the second half of 2017 show only a modest increase over the prior year period.

In summary, we continued to show improvement in our adjusted operating margin in the fourth quarter.

Our fourth quarter 2017 earnings per share, reported on a GAAP basis, were $1.15. There were 3 adjustments to GAAP EPS in the fourth quarter: the first adjustment was restructuring and related costs of $1.6 million or $0.02 per share; the second adjustment was the gain on the sale of assets from a previously closed business of $400,000 or $0.01 per share; the third adjustment was the provisional benefit from the U.S. Tax Reform, which reduced our fourth quarter 2017 income tax provision by $1 million or $0.02 per share. Net of these adjustments, the adjusted earnings per share for the fourth quarter were $1.14, representing a 9.6% increase from the prior year. For the full year 2017, our adjusted earnings per share were $4.87, up 9.7% from the prior year.

Now I'll summarize a few key financial metrics. Our capital expenditures were $16.2 million in the fourth quarter. Our capital spending in the full year 2017 were $65.2 million. Our Simplification activities resulted in $1.6 million of restructuring and related costs in the fourth quarter. For the full year 2017, restructuring and related costs were $14.1 million, in line with our earlier guidance.

In the upper right quadrant, we show our effective tax rate information. The ETR in the fourth quarter was 21%, excluding the $1 million provisional benefit from tax reform. For the full year 2017, our ETR was 21.7%, again, excluding the $1 million benefit.

In the lower left quadrant, we provide data on our fourth quarter 2017 balance sheet. Our total debt was $1,141.1 million, and our net debt was $1,001.5 million. In the fourth quarter, we achieved good debt reduction, repaying $74.3 million of debt. For the full year 2017, we reduced our total debt by $274.7 million. Our total debt-to-adjusted EBITDA ratio declined to 2.4 at the end of the year, achieving our goal of a total debt-to-EBITDA ratio below 2.5.

In the lower right quadrant, we present information on our free cash flow. We generated $40.7 million of free cash flow in the quarter, representing 79% of net income for the quarter. Free cash flow was lower in the fourth quarter as we increased our investment in inventory to serve our customers. For the full year 2017, our free cash flow was 106.4% of net income, representing the seventh consecutive year that free cash flow exceeded 100% of net income. And finally, we were pleased with the additional amount of cash repatriation from our non-U.S. businesses. We repatriated $90 million in the fourth quarter and $244.3 million on a full year 2017 basis. This was a big success as we exceeded our stated goal for 2017 of $150 million.

Now I'll turn the call over to Rob.

[Robert Rehard, executive]

Thank you, Chuck. Let me walk you through how the new U.S. Tax Reform legislation impacts Regal. There are 2 main points I would like to make. The first point is that our fourth quarter 2017 results include the impact of a $1 million net benefit from the new tax reform legislation. There are large provisional estimates that make up this net benefit as noted on this slide. The combination of the transition tax on non-U.S. earnings and the withholding taxes on non-U.S. dividends is more than offset with the benefit from the revaluation of the deferred tax liabilities. As Chuck previously mentioned, this $0.02 per share benefit is included in our GAAP earnings, but excluded from our adjusted earnings. The second point is that we are estimating a nearly 1% decrease in our effective tax rate for 2018. You'll recall that Regal's 2017 effective tax rate was 21.7%, excluding the impact of the new tax reform legislation. We are estimating our 2018 effective tax rate to be approximately 21%.

Now I'll provide information on our full year guidance for 2018. Our guidance assumes low to mid-single-digit organic sales growth for the full year. We're expecting an improvement in our adjusted operating margin for the full year 2018, making this the third year in a row of improvement. We are expecting to see improvements in all 3 segments, from volume leverage, continued Simplification efforts and incremental price. Our full year 2018 GAAP EPS guidance is $5.19 to $5.59. On an adjusted EPS basis, our full year 2018 guidance is $5.35 to $5.75. The adjustments to convert the GAAP EPS to the adjusted EPS are restructuring and related costs of $10 million or $0.16 per share. Also shown on this slide for your reference are some key assumptions included in our 2018 guidance.

In summary, at the midpoint of our guidance, our full year adjusted EPS is expected to be up 14% over the prior year.

Now I'll turn the call over to Jon.

[Jonathan Schlemmer, executive]

Thanks, Rob. Good morning, everyone. I'll walk you through each of the segments and give more details on organic sales and operating margin performance.

In Commercial and Industrial Systems, sales were $408 million, with organic sales increasing 8.7% from prior year. In the quarter, we experienced broad-based sales strength across the C&I end markets. In North America, demand was strong in the commercial HVAC, pool pump and oil and gas end markets as well as in distribution. Our power generation businesses were up driven by strength in the data center market. Finally, we had strong demand in our China businesses.

During the quarter, we implemented a general price increase effective in December. Price in the quarter improved sequentially and was up over prior year. Adjusted operating margin was 6.1% of sales, up 30 basis points from prior year. Volume had a positive impact on our margins, but was partially offset by commodity inflation.

In summary, we had strong organic sales growth in the fourth quarter, 30 basis points of margin improvement and more margin improvement is on the way. On the next slide, I'll walk you through a number of actions we've taken to further improve the profitability of our C&I business in 2018. There are 3 areas we're focused on to improve the C&I margins. The first set of actions are related to the Simplification activities we undertook in 2017. As you recall, the majority of the 2017 restructuring programs were focused on the C&I segment. Most of these programs were completed in the second half of 2017. These programs will deliver approximately $6 million to $7 million of cost improvements in 2018.

The second area of improvement is focused on pricing. We will see improvements from the price increase we implemented in the fourth quarter of 2017 as well as the continued positive impact from the two-way material price formulas. Price/cost was a headwind to our margins in 2017. We expect price/cost to be neutral by the second quarter.

And finally, we expect a positive impact from volume and productivity improvements in our C&I manufacturing operations. As earlier reported, we experienced efficiency headwinds in 2017 as we ramped up our operations. However, as we exited the fourth quarter, we started to see nice improvements in our manufacturing efficiencies that we believe will carry over into 2018. We grew C&I margins 30 basis points in the fourth quarter and our guidance reflects continued margin expansion in our C&I segment in 2018.

In Climate Solutions, sales were $216 million, with organic sales flat versus prior year. In North America, sales to our residential HVAC OEM customers were flat to prior year. If you recall, in the fourth quarter 2016, we had a particularly strong North America HVAC quarter, with sales up low double digits to the prior year. In the fourth quarter of 2017, we faced the difficult HVAC comparison as well as weaker sales in our HVAC distribution business. In distribution, we started out slow in the quarter with a mild start to the heating season, but demand did pick up as we exited the quarter and orders have been strong in distribution as we've entered 2018. For the full year 2017, we grew organic sales by 3.1% in the Climate Solutions segment and we're expecting another year of organic sales growth in 2018. Adjusted operating margin was 14.3% of sales, up 150 basis points from prior year. The higher margins in the quarter were driven by higher factory volumes and solid productivity in our Climate operations. This improvement was partially offset by commodity inflation and higher SG&A. The higher SG&A was driven by investments in the business and also timing of expenses relative to the prior year. While price/cost was a headwind in the quarter, we did see sequential improvement as our two-way material price agreements continued to positively contribute. We expect price/cost to turn neutral by the second quarter of 2018. For the full year 2017, adjusted operating margins improved 60 basis points in our Climate Solutions segment. We had very strong incremental margins of 34% on the sales growth. Our guidance reflects slight improvements in Climate margins in 2018.

Before we review the PTS segment, I'd like to talk about the recent AHR Expo in Chicago. 2 weeks ago, we participated in this trade show. It was a very positive event for Regal, and gave us an opportunity to highlight our latest technologies across our residential and commercial HVAC businesses. There were 3 key themes to our booth: the first was about the innovations and new products we've developed to help our customers meet the upcoming FER energy efficiency legislation for gas furnaces. The timing was perfect as the U.S. legislation goes into effect in July of 2019, and we were able to show customers that Regal solutions will allow them to meet the new legislation.

The second theme was around IoT capabilities of our new HVAC products. A great example is our latest high-efficiency ECM product, Ensite, a new product that utilizes Near Field Communication. Our customers were very interested to see how this new product can help contractors assure that systems are correctly installed in the field, help contractors diagnose problems in the field and even help OEMs assemble and program their own equipment.

The third theme was all about our axial motor and control technology. This disruptive technology delivers improvements in reduced size, weight, noise and increased energy efficiency. If you visited our booth, you would've seen this technology utilized in our DEC Star HVAC system, the new UlteMAX motor and control, our new line of boiler premix blowers and in our latest commercial refrigeration product. A core element of our enterprise strategy is innovation to drive growth. For Regal, the show was all about the upcoming energy efficiency legislation, our IoT capabilities and our disruptive axial motor and control technology. We had many positive interactions with both our existing customers as well as new leads generated at the show, all fueling our future growth.

Now let's talk about performance in our PTS segment. Sales in Power Transmission Solutions were $197 million, with organic sales increasing nearly 12% from prior year. The sales growth was driven by strength in oil and gas, renewable energy, industrial distribution and the aerospace and marine end markets. Adjusted operating margin was 12.2% of sales, down 110 basis points from prior year, but up 30 basis points sequentially. The higher volume positively contributed to the margins, but was offset in the quarter by higher SG&A expenses. If you recall, we previously commented that it would be best to compare the second half 2017 margins with the second half 2016 margins due to the timing of SG&A expenses in the prior year. The second half 2017 adjusted operating margin in PTS was 12% of sales, up 170 basis points as compared to the second half prior year. For the full year 2017, adjusted operating margin improved 90 basis points in our PTS segment. The incremental margins on the sales growth were 32% on the full year. Overall, we feel good about the PTS business with the strong performance in 2017.

I'll now turn the call back over to Mark

[Mark Gliebe, executive]

Thanks, Jon. Now before we go to Q&A, I'd like to briefly summarize our fourth quarter results and our 2017 total year results.

First, the fourth quarter. Organic sales increased 6.9%. Our operating margins were up 20 basis points for the quarter and our adjusted earnings per share were up 9.6% as compared to prior year.

Now let's look at the full year. Organic sales were up 4.3% for 2017. Adjusted operating margins increased 40 basis points in spite of the significant commodity headwinds. Adjusted earnings per share increased 9.7% and, for the seventh consecutive year, we finished with free cash flow to net income greater than 100%. In total, for 2017, we repatriated $244 million of cash. We used a portion of that cash to repurchase $45 million of our shares. For the year, we paid down $275 million of debt and reduced our total debt-to-adjusted EBITDA to 2.4.

Finally, you may recall at the March 2017 Investor Day, we laid out our enterprise strategy and communicated our expected performance over the next 3 years in 4 key metrics: organic growth, operating margin, return on invested capital and free cash flow to net income. We are pleased that in 2017, we made meaningful progress on all 4 metrics.

In closing, we expect that 2017 momentum will continue into 2018. We are off to a good start and encouraged that orders were up in all 3 segments as we entered the year. Our 2018 guidance reflects continued organic growth, our third consecutive year of margin improvement and a 14% increase in adjusted earnings per share at the center point of our guidance. We will now take your questions.

[Operator]

[Operator Instructions] And our first question comes from Christopher Glynn with Oppenheimer.

[Christopher Glynn, analyst]

On the view towards price/cost neutral by the second quarter '18, what was the negative gap in 2017 for C&I specifically?

[Mark Gliebe, executive]

Are you -- you're asking us what was the value of the price/cost variance for the quarter?

[Christopher Glynn, analyst]

No. For 2017, you're expecting to get to neutral by the second quarter of '18, which is good. We've been talking about a negative gap throughout 2017. I'm wondering what that gap might have been for the year?

[Mark Gliebe, executive]

Yes. We haven't sized it for the year, Chris. But what we can tell you is this, we saw a big jump in inflation at the front end of 2017 and then midway through the year. So the way that the two-way material price formulas work is there's a 3 to 6 months gap; and then secondly, we announced our price increase in December. So we were in catch-up mode from the second half going forward, and it got sequentially better as we move from quarter-to-quarter throughout the year, and we expect it to continue to get sequentially better right through the second quarter where we believe it'll go to neutral.

[Christopher Glynn, analyst]

Okay, great. And then the midpoint EPS, up 14%. You gave below-the-line guidance, so that implies about 9% operating profit improvement at the midpoint. I'm just wondering if you could discuss the general or directional thoughts by segments around that midpoint OP growth?

[Mark Gliebe, executive]

Well, we're expecting improvement in all 3 segments. Jon laid out for you our views on C&I. The C&I business is obviously a big chunk of the company and, from an operating margin perspective, the weaker performer. So we're quite focused on that, and Jon laid that out. Jon also made the comment that we expect slight OP margin improvement in our Climate segment. So that should give you directionally how we're thinking about it.

[Operator]

Our next question comes from Scott Graham with BMO Capital Markets.

[Robert Graham, analyst]

I wanted to maybe ask you to fill in a couple of the blanks for us. You've talked about in the -- you didn't give the same information for all 3 segments is what I mean. I was hoping you can kind of give us simplification for all 3 segments, and maybe the price/cost expectation, sort of along the lines of what Chris just asked, by segment for '18, because I think you only gave that in the 1 segment. Is it -- are you able to fill in the other 2 segments?

[Mark Gliebe, executive]

Well, I can add a little bit of color there, Scott. We've previously disclosed that we spent $14 million -- roughly $14 million in restructuring in 2017. Typically, we have a 2-year payback on that kind of investment. We've commented in the past that 70% of our 2017 restructuring was focused on the C&I segment, so that will give you some direction. And then Jon commented that we expect a benefit of $6 million to $7 million in the C&I segment. So that'll help you kind of figure out where the rest of the spending went, and what kind of benefit we would expect by segment.

[Jonathan Schlemmer, executive]

And that other 30%, Mark, was spent in programs in both Climate and PTS.

[Robert Graham, analyst]

Okay. All right, I'll do some of those calculations. And then you've given us some price/cost for 2 of the segments. Could you kind of tell us where you expect to be -- where you are right now in PTS? And if that's negative, when you expect to turn positive -- or neutral in 2018?

[Jonathan Schlemmer, executive]

Scott, this is Jon. Sure. So in PTS, price/cost would've been a little bit of a tailwind in 2017, unlike what we saw in Climate and C&I, and we're expecting the same in 2018.

[Robert Graham, analyst]

Great. Last question. Maybe to look at things a little bit more holistically you, a year ago at your meeting, indicated that your operating margin expansion target for, I believe, the legacy businesses, to 11% to 12%. If my calculations are right, we ended '17 at about a 9.7%, up only 20 basis points. And so I'm wondering if the thinking there is sort of -- even if you did a pro rata on that, you would obviously be behind where you'd want to be. Does that mean that this works sort of like an accordion, we got a little squeeze this year on price/cost, but then in 2018, we could expect a catch-up to get to where your goal would land... your 3-year goal would land?

[Mark Gliebe, executive]

Yes, I understand your question, Scott. So you're right, in March of 2017, we laid out 4 metrics. One of them, the good news is we made great progress -- or meaningful progress, I should say, on all 4 of them. With regards to adjusted operating margins, for the total year, our adjusted operating margins this year improved 40 basis points. We did improve adjusted operating margins last year and we expect to improve adjusted operating margins in '18. The goal we laid out for ourselves back in March was 200 to 250 basis points of margin improvement over a 3-year period. And you are right to say that the second half inflation, we had a 26% increase in copper spot in the back half of the year. And you're right that, that slowed down our progress. So we do have margin improvement included in our guidance, and we did comment that we would have low- to mid-single-digit revenue growth. So the margin improvement we are planning for this year or expecting this year is baked into that guidance.

[Robert Graham, analyst]

I'm sorry, Mark. It's just that -- I'll try to maybe get a little bit more granular with you there, because it does appear as if the legacy business' margin was only up 20 basis points, not -- excluding PTS. And the issue there obviously continues to be C&I. So I guess, I was hoping to hear a little bit more about how we get C&I away from -- beyond the $6 million or $7 million worth of sort of costs that were taken out that benefit '18, what's next there? It's just that, that margin is just really kind of holding you guys back.

[Mark Gliebe, executive]

Yes, I understand. I apologize, I got what you're saying. So you're right, Jon did lay out the 3 things that we're focused on in 2018 to try to drive the improvement in the C&I segment. So he commented on the fact that our Simplification programs, a majority of our investment there is focused on C&I. He commented on incremental pricing actions. And Jon, do you want to finish up on that one?

[Jonathan Schlemmer, executive]

Yes. So the price increase that we implemented in December, we expect to see the benefit of that in our 2018 margins as well as the part of the business that is exposed to the two-way material price formulas, that those will continue to improve with the lag of the copper increase that we saw in the second half of 2017. That will help our pricing in the first half of 2018. We expect price/cost to turn neutral by the second quarter, so no longer being a headwind to our margins. That'll be a big help in C&I. And then the last piece of it is the efficiencies, the productivity from our manufacturing operations. We had some challenges, clearly, in 2017 that hurt us. We are expecting better performance. We have a lot of focus in that area in 2018. So the $6 million to $7 million from Simplification is just a portion of the benefits we're expecting to see in the C&I segment this year.

[Operator]

Our next question comes from Robert McCarthy with Stifel.

[Robert McCarthy, analyst]

Can you hear me okay?

[Mark Gliebe, executive]

Yes, thank you.

[Robert McCarthy, analyst]

I guess -- and I've been jumping off a couple of other calls, so there's been some excellent questioning, which -- some of which I probably missed. But in any event, in terms of getting my arms around price/cost, is there anything you can say about kind of organic growth rate? How much will be price for the full year '18? And any kind of cadence around that for the year? In other words, how much of a contributor will pricing actions be 1Q, 2Q, 3Q, 4Q? I know it's probably something you're not going to really comment on, but I want to see if I can get any kind of texture around that, because it might just help level set the model.

[Mark Gliebe, executive]

Okay. So first, let's break it into the 2 pieces. The first one is the two-way material price formulas. So we typically have a 3- to 6-month gap on the two-way material price formulas, which represent 30% of the total revenue of the company. And so as we head into the second quarter, those will be -- have caught up from the second half big increase in copper that we saw. Those will have caught up. And then there's the second piece of it, which is the general price increase, which went into effect in December, and we'll see the benefit of that throughout the year. The price increase was in all 3 segments. And Jon, 3% to 5% was the...

[Jonathan Schlemmer, executive]

Yes, typical range of the price increases did vary by product, but it was in the 3% to 4% range. And as Mark said, Rob, we talked a lot about this price increase that it went into effect in December in C&I, but we also had price increase -- general price increase in our Climate and our PTS segment as well, but it was in that same range in the fourth quarter...

[Robert McCarthy, analyst]

Well, I guess on the basis of the material -- well, 2 follow-up questions there, what will be your effective -- on the general price increases, what will be your typically effective realization historically?

[Mark Gliebe, executive]

On the two-way material price formulas, they're contractual. So...

[Robert McCarthy, analyst]

No, no, no. I'm talking about the general price increases. What is your just typical experience with price realization?

[Mark Gliebe, executive]

Yes, I'm not going to get into anything and specifically related to price. However, I made a comment earlier that the price increases are sticking. So that should help you out, given...

[Robert McCarthy, analyst]

All right, nice try. Moving on. Maybe you can just talk about in the context of obviously a lot of conversation around C&I and Simplification and incremental margins. Can you just level set for us what should we be expecting for incremental margins kind of the next couple of years, across each one of the segments? And level set us for -- that's the word of the day, I guess, for '18 in terms of how we're thinking about what's embedded in the guidance for incrementals?

[Mark Gliebe, executive]

Yes, so there's 2 key drivers that kind of held us back on incremental margins in 2017. The first was the big jump in inflation, again, that happened in the second half of the year; and the second one is the demand was very robust and we did, as we mentioned back in the second quarter, have some efficiency challenges ramping up our facilities. So as we head into 2018, without those 2 headwinds, we would expect our normal incrementals which is 20 to 25 -- quite roughly 25% in the Climate business, roughly 30% in the C&I business, and roughly 35% in the PTS segment.

[Robert McCarthy, analyst]

Okay. And last question and then I'll move on. Obviously, there's been a lot of talk around trade rhetoric and withdrawal from NAFTA. I mean, any kind of conceptual view of how you're looking at that risk and what that would mean for you in terms of plant, footprint, pricing, that kind of thing?

[Mark Gliebe, executive]

Obviously, anything that deals with NAFTA has definitely got our attention because we have a relatively large footprint in Mexico serving our customers. But I would say this, that our view is we look at who we compete with, and we don't tend to compete with people that are in the U.S. We tend to compete with people who are also located in Mexico or who are located outside of Mexico. So our senses is that our competition would have similar challenges coming out of the NAFTA agreements, and my guess is it would result in inflation. If there was significant tariffs put on us or put on our competition, that would simply result in inflation. That's our best view.

[Operator]

Our next question comes from Joshua Pokrzywinski with Wolfe Research.

[Joshua Pokrzywinski, analyst]

So I know we've came after this price/cost question maybe a few ways, but I guess, at the midpoint of your guidance, EBIT is possibly up somewhere in the neighborhood of $20 million, and I don't know if it's right to think about LIFO as [indiscernible] but it doesn't seem like it has to recur. So call it, $6 million of LIFO, $6 million of restructuring benefits, I think a few million dollars from supply chain interruptions in Climate. The core number there really isn't that large EBIT growth year-over-year. If I think about a normal incremental margin across the business of say 20%, it seems to imply that there's a price/cost headwind of roughly $25 million and you're saying it's all in the first half? Is that arithmetic correct, I guess, just as a starting point?

[Mark Gliebe, executive]

Well, you're right to say that we expect that the price/cost will be neutral and there will be a headwind in the front half of the year. So assuming no more inflation, that should burn off throughout the year. But we had 40 basis points of improvement in 2017, commodity inflation held us back and, as we included in our guidance, continued margin improvement with low- to mid-single-digit organic growth rates for the year. So everything that we're assuming from a commodity headwind is baked into that guidance.

[Jonathan Schlemmer, executive]

And I would just say, Josh, this is Jon, the math that you've walked through there -- I didn't catch all the pieces, but the number you quoted for a price/cost headwind in the first half seems too high.

[Joshua Pokrzywinski, analyst]

Okay, we can follow up online on maybe what some of those deltas look like. And then just, I guess, circling back on the Climate business, how should we think about mix from here? I know that there's been some share wiggle over the past few years, and you had the Middle East flare-up more recently. Is that business kind of, to use Rob's word, again, level set on some of the share, mix and regional dynamics as we enter '18?

[Mark Gliebe, executive]

Well, we feel like we're in a good position as we go into the FER world. '18, at the back, our customers are -- at the back half of the year, our customers are going to start thinking about how to position their furnace business for the 2019 legislation. And with the products we're putting out, we think like we're positioned well for that battle with our competition in that substantial change in energy legislation. So we had a pretty good year with 3.1% growth in 2017, and we're expecting another year of growth in 2018.

[Joshua Pokrzywinski, analyst]

Got you. And then just one final one, might help us calibrate some moves going forward. I think HRC is around $730 a ton today, up a lot in January, obviously. Is that roughly the level that you guys have contemplated in your guidance?

[Mark Gliebe, executive]

Yes, you're thinking about it the right way. The good news is that our two-way material price formulas will adjust regardless of what the price is. But yes, the copper price that we're at today is what is assumed in our guidance. We've taken that into... I should say we've taken that into consideration.

[Operator]

Our next question comes from Jeff Hammond with KeyBanc.

[Jeffrey Hammond, analyst]

Just on the LIFO, can you just explain where you had a couple with benefits and a couple -- and then the one with the big expense? And then do we build any kind of LIFO adjustment into 1Q?

[Robert Rehard, executive]

Jeff, this is Rob Rehard, I'll take that one. So as we explained in our remarks, we had a $2.7 million LIFO impact. That's similar to what we had guided. Chuck mentioned there were some variations in the impact of LIFO by segment. Obviously, when you have inflation, you expect the LIFO expense, but what happened. The good news -- and that's what happened in C&I. The good news is that our Climate business was able to offset the inflation, in fact, have a LIFO benefit because the manufacturing facilities performed well. The impact going forward from a guidance perspective, we're not at this point anticipating a LIFO impact for '18.

[Jeffrey Hammond, analyst]

Okay. And then can you quantify what you think the efficiency headwind was in '17 that goes away?

[Mark Gliebe, executive]

We haven't done that work, Jeff, but we did comment that our manufacturing facilities in both C&I and Climate were performing well as we exited the year.

[Jeffrey Hammond, analyst]

Okay. And then the 30% incremental in Climate that you called out as normal, does that include the $6 million to $7 million saves and -- because it just seems like that hasn't been achieved in quite some time, and it seems like you're certainly putting something lower than that into the guide.

[Mark Gliebe, executive]

I think, Jeff, I'll let Jon answer this. But you used the term Climate, I think you meant C&I.

[Jeffrey Hammond, analyst]

Yes, yes, C&I, sorry.

[Mark Gliebe, executive]

Yes, I'll let Jon answer the question.

[Jonathan Schlemmer, executive]

Yes. I think, clearly, in 2017, we didn't get the incrementals that we expected to get in our C&I segment. So as Mark said, we're very focused on improving the margin performance of our C&I segment in 2018. That is the way we're thinking about the incrementals for C&I on a go-forward basis. The same expectation we've had historically is what we expect to see, even though we didn't perform to that level in 2017.

[Operator]

Our next question comes from Walter Liptak with Seaport Global.

[Walter Liptak, analyst]

I wanted to ask about C&I and just if you could refresh our memories on how much is general price and how much is two-way price formulas?

[Mark Gliebe, executive]

So I'll take a shot at this and then Jon can follow up. On the two-way material price formula is about 30% of the company, and it's split -- that 30% is split between Climate and C&I. So it has -- since C&I is a bigger segment, it has more of an impact on Climate than it does C&I. You want to -- is there anything else I'm...

[Jonathan Schlemmer, executive]

No, that sizes it up right. 30% of the total company's revenue, driven by the two-way material price formula is roughly split -- that revenue is roughly split between the C&I segment and the Climate segment, so the rest of C&I is exposed to what we do with general pricing.

[Walter Liptak, analyst]

Okay. In the December general pricing, you mentioned that it was being affected by the market. So presumably, the rest of the competitors are taking up price as well. I'm wondering if you can talk about where you're getting the best flow-through on price. Is it on O&G, is it in general distribution?

[Mark Gliebe, executive]

I would just say we have -- it's broadly implemented, and we're getting progress on our price increases broadly. I wouldn't say it's any better or worse in any particular segment.

[Jonathan Schlemmer, executive]

And on a global basis as well.

[Walter Liptak, analyst]

Okay. And what's your flexibility here in 2018? The markets are recovering. Hopefully, the markets are tightening up a little bit for supply. Can you take up prices later on in the year?

[Mark Gliebe, executive]

Well, if we had a big jump in -- another big jump in commodities, we certainly would be looking at it.

[Operator]

Our next question comes from Chris Dankert with Longbow Research.

[Chris Dankert, analyst]

I guess, just looking at Climate, I know the organic growth rate you're facing, you have some stiffer comps there, but I guess I was expecting a bit more benefit from the increased commercial efficiency standards in the U.S. I guess that's just not a huge part of the mix, or kind of how should we think about those increasing standards helping out Climate through the rest of '18 here?

[Jonathan Schlemmer, executive]

Yes, I would say -- Chris, this is Jon. I would say that we did see a little bit of positive mix in the quarter in our Climate business, which was nice to see. So we look at high-efficiency products versus our standard products, that was a little favorable in the fourth quarter. So even though we didn't see overall revenue growth in the quarter, we did see that as a positive contribution. I would say that those standards are probably a bit more impactful to our C&I segment than to our Climate segment because of the commercial equipment aspect and the kinds of products that go into that equipment. With the upcoming change for gas furnaces, we'll see that impact in our Climate segment. However, depending on what happens potentially with the prebuild, we're expecting more of that to be in 2019.

[Chris Dankert, analyst]

Got it, got it. And then, I guess, looking at PTS, even if you kind of adjust out the big, I think it was like $5 million of FX benefit in the fourth quarter last year on the EBIT line, it looks like the incrementals were closer to like 25%. I guess, is the gap between the 25% and your kind of target of 35%, is that just labor inflation? Or can you kind of help us bridge that difference?

[Mark Gliebe, executive]

I would say that a big part of it was the timing of the SG&A expenses. For the year, our incrementals were 30% in PTS. So not quite where we'd like them to be because we are targeting more in the line of 35% incrementals in PTS. So we were held back a little bit in 2017 from that target. We did make some investments of course in SG&A to help grow the business. And by the way, we feel very good about those investments and helping to drive organic growth in the segment as well as in the company. But in the fourth quarter, our view is that the margins in the fourth quarter were really more related to the timing especially in prior year with the SG&A expenses.

[Operator]

[Operator Instructions] And our next question comes from Ryan O'Donnell with Baird.

[Ryan O'Donnell, analyst]

So just taking a step back on the 2018 margin. If you could think about first half versus second half in terms of year-over-year expansion with volumes being better in the first half, but price/cost probably better in the second half, is there any way you can kind of parse that out for us?

[Jonathan Schlemmer, executive]

We haven't laid it out in terms of any particular guidance on a quarterly or a half-to-half basis, Ryan. But the way we -- as Mark mentioned, we are expecting to see a little better organic sales growth in the first half as compared to the second half of 2018 simply because of the comparisons to prior year. On margin expansion, we're expecting to see margin improvement throughout the year as you look at margins on a year-over-year basis.

[Ryan O'Donnell, analyst]

Got you. That's helpful. And then last one for me, just any prebuy that you guys may have seen around kind of the price increase in December? Obviously, on the nonmaterial price formula side.

[Mark Gliebe, executive]

Are you talking about for 2017, Ryan?

[Ryan O'Donnell, analyst]

Right. So yes, in the fourth quarter, any prebuy that you may have seen kind of ahead of that December price increase?

[Jonathan Schlemmer, executive]

Ryan, our view would be, if there was one, it was small, not significant impact to revenues.

[Operator]

And this concludes our question-and-answer session. I'd like to turn the conference back over to Mark Gliebe for any closing remarks.

[Mark Gliebe, executive]

Thank you, operator. I would like to add 1 comment before we close today. This will be the last Regal earnings call where Chuck Hinrichs will be a participant. Chuck has been a key part of the Regal team for nearly 8 years, and we sincerely appreciate his contributions and dedication to Regal. We wish Chuck and his wife, Linda, all the best in retirement. Chuck will be with us through the end of March, so you can reach Chuck at his Regal e-mail until that time. Chuck, thank you very much for all that you have done for Regal. And to everyone on the call, thank you for your questions and for your interest in Regal. Have a great day.

[Operator]

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