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Linamar Corp
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Good afternoon. My name is Kim and I will be your conference operator today. At this time, I would like to welcome everyone to the Linamar Q3 2018 Analyst Conference Call. [Operator Instructions] Linda Hasenfratz, CEO, you may begin your conference.
Good afternoon, everyone, and welcome to our third quarter conference call. Joining me this afternoon are members of my executive team, Jim Jarrell, Dale Schneider as well as members of our corporate marketing, finance and legal team. Before I begin, I'll draw your attention to the disclaimer currently being broadcast.I'll start off with sales, earnings and content. Sales for the quarter were $1.84 billion, up 18.6% from last year, which is fantastic to see. Earnings saw another strong level of performance in Q3 as well. Operating earnings were $171.6 million, normalized for balance sheet exchange impacts and any unusual items, which is up 13.7% over last year on a reported basis and 13% after normalizing in each quarter. Net earnings were $121.1 million normalized, up 5.5% over last year as reported or 4.1% when normalized in each quarter.A few factors were key in driving this solid performance. First, MacDon continued to perform well and made a great contribution to growth this quarter. Secondly, the access market experienced double-digit growth over last year in units sold, driving great performance at Skyjack particularly with our popular boom and telehandler products, which continue to build market share. And finally, launches in the Transportation business are running strong and doing a great job of driving top line growth in some challenging markets. It is exciting to see the continued growth of our Industrial segment. Our diversification has led us to a couple of excellent technology-driven businesses, which are leaders in their field, growing market share and generating solid returns. Earnings from our Industrial segment represent half of our operating earnings gain this quarter, a huge benefit to us in more challenging times on the auto front. I see this as a real differentiator for Linamar in our ability to generate consistent sustainable earnings growth and returns for our shareholders. A few factors were a challenge this quarter and hurt our results. Light vehicle markets for the 3 regions we serve were down 0.9% due mainly to a big decline in the light vehicle market in Europe thanks to WLTP cuts requirements, which significantly impacted the market. EU volumes were down 3.4% and key customers, such as Volkswagen, Renault and BMW, down as much as 5% to 10% in Europe this quarter. The primary impact was to Q3 for WLTP, but we do expect some hangover into Q4 for such. Higher commodity costs in our Industrial segment were a second key issue. We are addressing such with price increases to customers, which have already begun as of October, and will be in place with all customers by January 1 of next year. The third issue was a slight uptick in launch costs due to heavy launch activity in the Transportation segment, which we expect to see normalize over the next quarter or 2. Normalized net earnings as a percent of sales in Q3 were 6.6%, down from last year due to these factors. Transportation segment margins were impacted particularly by declines, as mentioned, in mature high-profit programs in Europe thanks to WLTP-related production cuts being replaced by sales of launching business with lower negative margins. Thank goodness for the launching business to mitigate these top line declines and also to position us for solid growth when the market does start to pick up. We target normalized margins for the Transportation segment of 7% to 10% and expect to be at midrange this year with expansion next year. It's worthwhile reminding you of our guidance, that a change in sales translates to a change in earnings at a level of 20% to 25% as a sales change on the net earnings line, which translates to 30% to 35% on the operating earnings line. The decline in sales from Q2 2018 this quarter in the Transportation segment of $154 million translated to an earnings decline of $50 million or 32%, exactly in line with this guidance. On the positive side, our Industrial segment is performing very strongly, in no small part thanks to MacDon, with normalized margins sitting at 17.5% for the quarter. We expect to be at the mid- to mid-high point of our target range of 14% to 18% in normalized margins this year with expansion in this segment next year as well. This will translate to strong full year net margin performance for 2018 in the range of 7.5% to 8%, slightly softer than expected thanks to those weak European volumes. But we do expect to see margin expansion next year to 8.25% to 8.75%, up slightly from our guidance last quarter. Investing in our future continues to be a priority for us at Linamar. CapEx in the quarter was $155.4 million or 8.5% of sales. We're expecting full year CapEx as a percent of sales to be higher this year than last year, reaching the mid-level of our normal range of 6% to 8%. We expect 2019 to see lower CapEx in both dollars and as a percent of sales, although still within our 6% to 8% range. Our net debt level continues to come down, now at $2.07 billion. Net debt to pro forma EBITDA is now 1.69x. We continue to expect to bring leverage back down under 1x by late 2019. In North America, content per vehicle for the quarter reached $169.52, up 4.3% from last year, thanks to launching business and a market that was up 3.7%. Q3 automotive sales in North America, as a result, were up 8.1% over Q3 last year at $718.4 million. In Europe, content per vehicle for the quarter was $78.44, up 6.6% over last year, again thanks to launching business in the region in a market that was down 3.4%. Growth in Europe for us has really been fantastic. It's actually only 5 years ago that content per vehicle in Europe was only $14.45. Our Q3 2018 automotive sales in Europe therefore grew 3% compared to last year to reach $376.1 million. In Asia Pacific, content per vehicle for the quarter was $9.13, down 3.3% from last year due to production declines with certain customers that are out of synch with the overall market. Our Q3 2018 automotive sales in Asia were down 4.9% to last year, reaching $108.4 million in a market that was down 1.7% in production volume. Linamar continues to target doubling our current footprint in Asia in the next 5 years. It's great to see continued content per vehicle growth in most regions despite lower production levels with key customers. Our expanding content per vehicle reflects our increasing market share thanks to large amounts of launching business, which is key to accelerating growth when volumes do start to pick up. Other automotive sales not captured in these content calculations were $60.4 million, in line with last year. Commercial and Industrial sales were up 66% in the quarter at $574.1 million compared to $345.8 million last year thanks, of course, to the acquisition of MacDon, which had a strong quarter, as well as a strong quarter for Skyjack with markets up nicely and continued market share growth. Turning to market outlook, we are seeing stability or moderate growth this year and next year in most of our markets. For the global light vehicle business, the forecast is for flat performance in light vehicle markets this year globally to 17.1 million, 22.4 million and 50.7 million vehicles in North America, Europe and Asia respectively. Next year is expected to generate small amounts of growth ranging from small increases in North America and Europe to 2.9% growth in Asia. Industry experts are predicting on-highway, medium and heavy truck volumes to grow this year in both North America and Europe at 11.8% and 4% respectively, but see a decline in Asia. Next year, we're going to see flat to moderately growing markets of up to 3% in North America and Europe, but another decline in Asia. Off-highway, medium duty and heavy duty volumes are continuing to show some signs of improvement. Turning to the access market. The industry is expecting double-digit growth in the global aerial work platform market this year, dropping back to mid- to low single digits next year. Performance is being driven by growth in each global market and each product group. We continue to see positive industry metrics with significant infrastructure spending planned for the next couple of years in every region at an ARA forecast of 4% to 5% rental revenue growth for the rental business. Skyjack's backlog is substantially higher than it was last year at this time. It's our goal to continue to outperform the market through market share growth at Skyjack, as we have so successfully done in the last several quarters and years. Our new agricultural business, MacDon, will benefit this year from an agricultural market at the early stages of a cyclical recovery. The industry expectation is for mid-single-digit growth in the ag market this year in North America and Asia and more moderate growth in Europe. It's early to get a solid read on 2019 for the ag market. China tariffs are a potential wildcard to disrupt this outlook given impact to commodity prices as is what is shaping up to be a bit of tough harvest this fall, which could impact farm revenues. On the positive side, we've launched our Linamar OROS corn head branded MacDon, which is getting a solid reception with our U.S. dealers. If we do see a reduction in soybean planting thanks to tariff, they are likely to be replaced by corn, which would bode well for this initiative. Turning to a strategic update and new business. We continue to see solid levels of new business wins and a strong book of business being quoted with win levels significantly higher than they were last year at this time. Q3 was another very strong quarter for us with quite a few notable strategic wins driven by continued acceleration of powertrain outsourcing, which is very exciting. Our addressable market across a range of vehicle propulsion types continued to look excellent, as you can see by this chart. Global vehicle growth is forecast to grow at a compound rate of 1.5% to 2% over the next 25 years. Each type of vehicle propulsion offers excellent and growing potential for us and our suite of products each continue to be developed and to grow. The total addressable market for us today is about $130 billion growing to more than $325 billion in the future. We have 212 programs in launch at Linamar today. Look for ramping volumes on launching transmission, engine and driveline and body platforms to reach 25% to 30% at mature levels this year, which will add another $600 million to $700 million in sales for 2018. These programs will peak at over $4.5 billion in sales. We saw a shift of about $80 million of programs moved from launch to production last quarter. Programs moved to production from launch, in total, will add about $90 million in incremental sales growth this year. So total business launch for 2018 is expected to be $700 million to $800 million. Launch programs will grow quite steeply next year to more than double this year's level for incremental growth in 2019 of between $1.2 billion and $1.3 billion. In addition, as noted, Skyjack is targeting solid growth driving out of growing markets in the double-digit range this year and high single-digit to low double-digit range next year as well. So again, outperforming the market. MacDon will be a key growth driver for us, of course, this year, and should provide growth next year as well depending on market performance. MacDon, if you recall the $600 million in sales on acquisition, the market is growing in mid-single digits this year, and we will have 11 months of results in 2018 for Linamar and, of course, 12 months of results next year, which in itself, will provide growth. Expect mid-single-digit growth for MacDon this year. It's important to remind you that both Skyjack and MacDon seasonal peak during Q2, meaning you should expect a significant seasonal dial-back in Q4 from Q3 levels. Temper all that growth with the loss of business that naturally ends each year, noting to expect such at the low end of our normal range of 5% to 10% this year and the high end of that range next year as well as normal productivity give-back. Our strong backlog of launching business and growth in our Industrial sector will do a great job of offsetting market softness in Europe and still drive double-digit top line growth for us this year. Next year, the launch book continues to build to drive an organic-only growth level at the high single-digit to low double-digit level. Sales growth with continued strong and, next year, expanding margin performance will result in double-digit normalized operating earnings growth this year and strong double-digit growth next year. New business wins are, of course, also filling in growth for us in the midterm as well. Our current estimate is for between $8.5 billion and $9 billion in booked business for 2022 based on current industry volume forecasts layered with those new business wins and adjusting for any business that is leaving. I would like to highlight a couple of our more interesting wins this quarter. First, we won another structural component in the quarter, this one a steering hangar beam. Volume will be 280,000 units per year. These structural and body component programs are quite important strategically to us as they're required regardless of vehicle propulsion, meaning they add to our portfolio for alternatively powered vehicle. We've won more than $60 million this year alone already in these types of structural and body components. Secondly, we picked up an uplift for an existing crankcase assembly program of another 120,000 units per year, taking total program volume to 1 million units per year. We picked up a variety of engine, camshaft and gear programs in the quarter for next-generation trucks worth, in aggregate, more than $25 million in annual sales. We also saw a couple of other gear-related programs, which I'd like to highlight, which by the way, is rapidly becoming a massive global business for us. First, the balance shaft gear program representing more than 700,000 units per year. This program is for China. It's for the Asia market. And we have seen enormous success, actually, in terms of business wins outside of North America this year as we penetrate global markets. In fact, new business wins outside of North America year-to-date represent more than 60% of our total wins. Finally, another driveline gear program. Actually, this is a package, again, of different programs for both forged gears and machine gears. Aggregate volume more than 1 million units per year. These wins were all actually with a Japanese OEM with whom we have been rapidly building a strong portfolio of business. Total gear business wins this year are already at more than $130 million in annual sales. Turning to an innovation update, we have launched several key innovations for MacDon this year that I wanted to share with you. First, MacDon has adapted Discrete Element Method modeling to simulate crop flow. We feel this gives us a huge advantage. Crop properties and the interaction between the header and a crop can be tuned based on this material testing. They can use DEM to visualize and optimize the crop flow path through a variety of other systems and concepts to really optimize them before validating with field testing and gives us, we feel, a real advantage to the team. Another great example is a unique attachment that they developed they've coined the ContourBuddy, which enables MacDon's FlexDraper headers to flex and follow ground contours even when they're cutting off the ground. This significantly enhances performance. It can actually be incorporated into any existing FlexDraper unit that was produced post-2007 as an aftermarket item. Lastly, the team developed innovations to create a 20% increase in capacity with an innovative new windrower and draper technology that was also launched this year. We're also continuing to make great progress across the organization on our digitization initiative with impressive numbers already in terms of systems implemented. There is a huge amount of opportunity in these technologies to dramatically improve efficiencies of our operations, both on the shop floor and in the back office as well, which we can deploy on a global basis. In other areas of operations, our plants continue to perform well both on mature business metrics and in terms of launch. Our launch systems are excellent and plant controls world-class. The recent blip in launch costs is really more related to the volume of launches than any system issue, and we are confident to see normal launch costs resume in a quarter or 2. In terms of plant launches, our new casting facility in China is complete. This is our first casting facility in China, for which we've already secured 3 programs, one for a domestic Chinese OEM, and the facility is ready to run initial samples. In fact, you can see pictures of the first sample run. In Hungary, we have broken ground for our new facility dedicated to a brand-new high-volume e-axle gearbox program we are launching for a customer in Europe, and we are about to start construction. Finally, a quick NAFTA and tariffs update. Great news, obviously, that NAFTA, or now USMCA, terms were agreed to this fall by all the parties. I think this is great news for all companies in North America. The terms are not significantly different than NAFTA, which is very positive. We see potential upside to Linamar with the higher regional value content requirements as well as the high labor value content requirements, which can help us grow our business particularly in our U.S. and Canadian facilities. We see no key areas of concern to us at Linamar. Frankly, I think it's fantastic to have it behind us so everybody can get back to business. Now the one concern, of course, is that the metal tariffs remain in place, and we now, as well, have Chinese tariffs to deal with. The good news is the impact, although not zero, is certainly not close to material for us. So it's a very small impact. On the China tariff side, this is impacting mainly our Industrial business in cost increases from material suppliers in the U.S. that are buying some components from China. Again, not material levels. On the metal tariff side, the concern, of course, is not so much for us, which again, we have minimal impact, no direct impact to our U.S. facilities, any direct impact to our Canadian facilities is 100% reclaimable, and a handful of price increases that were legitimately imposed from suppliers based on material levels. So the impact to us is small, but the concern, of course, is the impact is building in many American companies, more so American companies that don't have the opportunity to do the duty drawback. Ford, for instance, announced $1 billion of impact from tariffs. Many companies have been quoting higher costs and we can see that they're hitting their Q3 results. Pain is obviously building so it's imperative that these tariffs be dropped as soon as possible. So with that, I'm going to turn it over to our CFO, Dale, to lead us through a more in-depth financial review. Dale?
Thank you, Linda, and good afternoon, everyone. As Linda noted, Q3 was a solid quarter as sales grew by 18.6% and operating earnings grew by 13.7% in an environment where the European light vehicle market was down over 3% driven primarily by the new worldwide harmonized light vehicle testing procedure. For the quarter, sales were $1.8 billion, up $288 million from $1.5 billion in Q3 last year. Operating earnings for the quarter were $161 million. This compares to $141.9 million in Q3 2017, an increase of $19.5 million or 13.7%. Normalizing the operating earnings for the net FX loss from the revaluation of the balance sheet resulted in normalized operating earnings of $171.6 million. Net earnings increased $5.9 million, or 5.5%, in the quarter to $113.2 million, and normalized net earnings increased to $121.1 million. As a result, the fully diluted earnings per share increased by $0.09, or 5.6%, to $1.71, and normalized fully diluted EPS increased to $1.83. Included in earnings for the quarter was a foreign exchange loss of $10.1 million, which related to a $10.2 million loss from the revaluation of operating balances and $100,000 gain from the revaluation of financing balances. The net FX impact impacted the quarter EPS by $0.12. From a business segment perspective, the Q3 FX impact from the revaluation of operating balances of $10.2 million resulted in a $300,000 loss in Transportation and a $9.9 million loss in Industrial. Further looking at the segments, sales for Transportation increased $163.1 million or 4.9% over Q3 last year to reach $1.4 billion. The sales increase in the third quarter was driven by the strong volumes from our light vehicle automotive customers outside of Europe, a favorable impact from the changes in FX rates since last year and higher sales from our North American launching programs, which were partly offset by sales declines in Europe related to WLTP. Q3 normalized operating earnings for Transportation were lower by $27.1 million, or 23.8%, over last year. In the quarter, Transportation earnings were impacted by the European sales declines on high-margin mature programs that were only partially compensated by the sales from launching programs that naturally have lower margins. Additionally, costs related to heavy launch activity and the increased costs that are supporting the growth such as management, R&D and sales costs. These were partially offset by increased volumes on the North American light vehicle customers and from more favorable changes in FX rates. Turning to Industrial, sales increased by 86.2%, or $224.5 million, to reach $484.8 million in the quarter. The sales increase for the quarter was due to additional sales from the acquisition of MacDon, strong volume increases in access equipment in addition to market share gains in booms, telehandlers and scissors in certain regions, and favorable changes in foreign exchange rates since Q3 2017. Normalized Industrial operating earnings in the quarter increased $47 million or 123% over last year. The primary drivers for the Industrial operating earnings results were the additional earnings from MacDon, the increase in access equipment volumes and the favorable impact of FX rate changes since Q3 last year. These are partially offset by the increased commodity prices, the unfavorable customer and product mix towards more launching products that are not quite at mature volumes yet and increased management, R&D and sales costs that are supporting the growth. Returning to the overall Linamar results, the company's gross margin increased by $43.7 million due to the acquisition of MacDon, the increased volumes in both segments and the favorable changes in FX rates. But these were partly offset by the lower volumes in Europe and the unfavorable product mix that was towards the lower-margin launching programs versus higher-margin mature programs, additional costs related to the heavy launch activity within the Transportation segment and, finally, the increased commodity costs that we did see in the Industrial segment. Cost of goods sold amortization increased for the third quarter by $88.3 million. COGS amortization as a percent of sales decreased slightly to 4.8%. Selling and general administration costs increased in the quarter up to $103 million from $79.4 million. The increase is mainly due to the additional SG&A costs from the MacDon acquisition and the higher management, R&D and sales costs that were incurred in the quarter. Financing expenses increased $11.1 million since last year due to the increase in debt and spreads as a result of the MacDon acquisition, higher interest rates due to the Bank of Canada hike rates partially offset by higher interest earned on the investment of excess cash and on the long-term receivable balances in addition to the repayment of the private placement notes in Q3 last year, which were replaced with lower interest rate debt. The consolidated effect of interest rate for Q3 increased to 2.9% primarily due to the acquisition and its impacts on spreads in addition to the Bank of Canada rate hikes. Effective tax rate for the third quarter decreased to 22.2% compared to last year. The effective tax rate in Q3 was reduced by a favorable mix of foreign tax rate and reduced due to one-time future tax rate reductions last year, which did not reoccur this year, and were partially offset by an increase in the effective tax rate on the income in MacDon. We are expecting the effective tax rate for 2018 to be in the range of 22% to 24%. Linamar's cash position was $424.6 million on September 30, a decrease of $100.3 million compared to September last year. The third quarter generated $252 million in cash from operating activities, which was used to fund CapEx, debt repayments and interest payments. Net debt to pro forma EBITDA decreased to 1.69x since Q1 2018 and we expect net debt to pro forma EBITDA to be back under 1x in the next 12 to 15 months. Debt to capitalization also decreased since Q1 2018 to 41.8%. The amount of available credit on our credit facilities was $679.7 million at the end of the quarter. So to recap, Linamar ended a solid quarter with sales growing 19% and operating earnings growing 14%. The strong sales led to solid earnings performance despite the issues within the European light vehicle market. That concludes my commentary. I'd now like to open it up for questions.
[Operator Instructions] Your first question comes from Mark Neville from Scotiabank.
Maybe just first, just a point of clarification. The $1.71 in earnings you're not adjusting for the FX loss. Is that correct?
$1.83 is normalized so that's where we adjust for the balance sheet impact. $1.71 is as reported.
Yes, okay. Okay. So on the automotive margin, it looks about 6.5% in the quarter. I'm just trying to get a feel for how much was from the new emissions standards in Europe. And maybe talk about volume impacts in the quarter. And I guess we can do the math from there.
Yes. So I mean, really, that's the key story for the quarter is the impact in Europe thanks to WLTP. So I mean just to put the numbers around it, if you take a look from content per vehicle what our E.U. automotive sales were, last year in Q3, E.U. automotive sales declined $30 million compared to prior quarter, compared to Q2, or 8%, due to the Q3 shutdown. And this year, they declined $100 million or 22%. So it just gives you a bit of sense for like what we would normally see and what we did see this year.But happily, I mean the issue is short-term and is going to rectify. I mean it's going to drag into Q4, for sure, as they're still like figuring out where they are on the volume side. But it will rectify and we'll be back to a normal level in Europe. So it is a short-term issue.
Okay. And just sorry, Linda. Just I didn't fully catch or understand, I guess, the -- your explanation on the sales, the $100 million. And I'm just -- I didn't catch that.
Yes. So I was just illustrating for you what a normal decline in sales Q3 versus Q2 would be. So I'd given you the example that in 2017 in Q3 European automotive sales declined $30 million or 8.2% of what it was in Q2. Whereas this year, the decline in Q3 compared to Q2 was $100 million or 22% of sales. So obviously, not at all what a normal Q3 shutdown would be.
Got it. And I guess to complete the math, the 20%-25% sort of decremental margin that you spoke to early sort of would help us get to an EBIT normalized number, if you will.
The 20% to 25% is at the net earnings level. So at the operating earnings EBIT level, you're looking at more like 30-ish%, right? And I gave you the math for the whole segment of about 150 as down 32% is what we really experienced.
Okay, yes. No, that's all very helpful. Maybe just on Industrial. The price increases that you announced, I assume it's for both MacDon and Skyjack and it's maybe an order of magnitude. And is it sort of enough to fully offset any commodity inflation that you're feeling?
Okay. So first with Skyjack, we have input those, really, late summer, and that would not be across all of the customers because we have annual deals specifically with customers. So those would get introduced into next year. But the plan is to cover most, if not all, just depending on making deals for volumes and increasing revenue with some customers. So that would be on the Skyjack side.With MacDon, we're smack-dab into order-writing season right now for next year. So obviously, anything we do, any impact on the materials we will put into the new cost model and obviously into the new pricing.
Your next question comes from Peter Sklar from BMO Capital Markets.
This is Chang filling in for Peter. A follow-up question to the earlier question. You mentioned that a lot of the WTP issues in Europe would probably trickle into Q4 and it will normalize. So like what timeframe do you believe in 2019 will it normalize?
I think by early 2019 we should be fully recovered from the situation.
Yes. I think we're seeing Q4 pick up a little bit on releases and then we see that, by the end of Q1, as Linda said, releases should be back to normal.
Got it. Got it. And in terms of outlook for Skyjack, are you seeing a lot of backlog increase or decrease. Kind of can you just give a little bit more of color on the competitive pricing dynamics?
Yes. I mean Skyjack is still in a very solid position. Their backlog is significantly higher than what it was last year at this time both in dollars and in sort of months of expected sales. So we feel good about where we're going. We do expect the overall market to not be growing as robustly as this year. Like it's growing double digits this year, and next year the market is expecting to see mid- to low-single-digit growth. But we feel we will outperform the market and that's why we talked about high-single-digit to low-double-digit growth of Skyjack.
[Operator Instructions] Your next question comes from Michael Glen from Macquarie.
Linda, just to go back to the WLTP issue. Was this something that -- has this been sort of an over-and-above a negative pressure on your margins versus what you were looking when you reported your Q2?
Well, yes, absolutely. I mean you don't see $100 million float out of sales without feeling some impact from that. And our customers absolutely were not giving visibility on the depth of the issue at the mid-year point. In fact, they're still catching up in terms of giving us real reliable information of what their needs are going to be. So I think that the market for sure, our customers absolutely and, as a result, us, underestimated the impact of this situation.But again, I'll emphasize that it is a short-term one. I mean it's hurting Q3. It's going to -- we'll feel some impact in Q4, not nearly the same level. And then we'll be back in business. So this is not a long-term issue to be too concerned about.
And what exactly -- could you just spell out like what's creating the significantly higher-than-expected slowdown or bottleneck?
It's basically the vehicles being tested for a new emissions standard in Europe -- or it's a global standard. And I think Volkswagen just had a backup to these vehicle architectures getting put through that system.
Michael, the implementation date was August 1 and there was a higher level of registrations that -- kind of a pre-buy, if you will, that took effect. And then Q3 is really the payback to that. So there's actually just a bottleneck around that August 1 date of getting those new registrations done based on the new requirement.
Okay. And then like for your margin guidance for the year, you're sort of pointing at midpoint of 7% to 10%. I don't think that that's different than what you were talking about at Q2. So I mean should we be thinking about a pretty sizeable pickup then in Q4 to meet that range?
No, I don't think so. I mean I think that the math is probably pretty easy at this point, because there's only one variable left, to figure out what -- where Q4 might come in.
Okay. And then when you look at expansion for next year, I guess you highlighted the launch activity and you do go more aggressive into the launch next year. So are you -- do you anticipate some of this front-end margin compression? Or is that something that you don't think will be as significant as you saw this year?
So can you repeat that again? I didn't quite understand your question.
So when you talked about launch activity, you talked about the $1.2 billion to $1.3 billion launch activity in 2019 versus the $700 million to $800 million here. Like that's a pretty substantial amount of launch work. Are you comfortable that you can build through that without -- would you see any margin compression as you work into that big backlog?
Well I think that's what we're seeing right now, but our expectation is that this small spike in launch cost will resolve over the next 1 to 2 quarters. So we're kind of getting through the hump of it over the next couple of quarters.
Yes. We're in ramp-up mode volumes right now for some of the new transmissions, new engines. So the higher ramp-ups are coming in. We're adding shifts, adding more capital. So those are when you get the highest launch costs. And once those come in, those new shifts, you get the productivity that comes out a quarter or 2 quarters afterwards.
Okay. And then when you talk about the some of this higher-margin older programs rolling off, do you think that we've worked beyond the peak of that right now? Or is there more of that to come?
Well I think that's what we work through over the next 1 or 2 quarters.
There's still 1 or 2 quarters of that to come then?
Well as I noted, the spike in launch costs will settle out over the next 1 to 2 quarters. I think what you're seeing as well is the impact of the launching business and its lower margins being magnified by the fact that in the first half of the year North American volumes with key customers like GM and Ford were quite low and therefore mature business that normally delivers at a higher level of margin and helps absorb those lower launching business margins were impacted.So the first half of the year, we had customer production cuts at GM and Ford. In the back half of the year, we're seeing it in Europe. So as a result, the issue is being magnified. So again, that resolves as Europe gets back to a normal level of volume, which should happen over the next, also, 1 to 2 quarters.
Okay. And just one more on the powertrain business in North America, just to clarify. You're not facing any, with the cross-border, you're not facing any steel tariffs as you ship back and forth from U.S. into Canada and back into the U.S.?
Yes. So the tariffs are strictly on steel and aluminum. So it only is impacted if we buy steel in our Canadian plants in the U.S. from the U.S. or our American plants are buying steel or aluminum outside of the U.S. So our American plants don't buy steel or aluminum outside of the U.S. so zero impact to those facilities. And then our Canadian plants are, for the most part, buying castings and forgings and there's no tariffs on those. They buy a small amount of steel and a little bit from American sources, but we subsequently export 100% of what we import and pay those tariffs on, and we can fully reclaim that through the duty drawback program here in Canada. So that means zero impact from that perspective.Where we see a small amount of impact is from Tier 2 suppliers. So suppliers who are buying steel and aluminum and incurring tariffs for such, there's a small amount of impact from that. And we're also seeing a small amount of impact from the Chinese tariffs that the U.S. has imposed on China. So we have some American suppliers, mainly for our Industrial operations, that are buying some components or parts out of China and that is creating some costs. So as I look at our overall tariff impact, nothing close to material. More than half is related to China as opposed to metal. But not a significant enough number for me to even call out for you. So it's not much of an issue for us.
Your next question comes from Raj Singla from Arrow.
My question is regarding the MacDon acquisition. So according to me, you did a very expensive acquisition MacDon, it’s $2 billion. And you paid, I guess, you are getting an EBITDA of around $100 million per quarter. So can you explain how or why you did this expensive acquisition?
Yes. So in fact, the valuation of MacDon, which was roughly 8x EBITDA, was actually a very fair valuation if you look at precedent transactions that have been going on in the space. It's actually at the mid to low end of what deals are being done for.We think MacDon has huge opportunity to grow their business. If you look at the markets for harvesting equipment, North America versus Europe, South America and Eastern Europe, each of the latter 3 are of equivalent size to the North American market, which is where MacDon primarily sells. What that means is if we get the same kind of market share in South America, Europe and Eastern Europe as we have in North America, we have the potential to quadruple the business. And Linamar has the depth to be able to make that happen. We already have a global footprint. We have existing operations in Europe. And we can work with the MacDon team to develop the right products and the right distribution strategies to make that happen. So we see this as a huge long-term opportunity for us to grow a substantial agricultural business for Linamar.
Yes. And maybe just to add to that. Keep in mind that the MacDon distribution has over 1,100 dealerships around the world, which obviously they can support other products going through. In fact, in the commentary that Linda brought up, we've just launched our corn header that we had started in Hungary now over in North America and globally through the MacDon branding. So this is a good start of doing this improvement and increasing of the portfolio.
And ma'am, my second question is regarding the same MacDon. Actually, the acquisition of MacDon is having a drag on our share price, right? We have to have a balanced debt [ B ]. We never [indiscernible] the shares, like repurchase the share, so the share price is going down because the MacDon acquisition. We had other expenses are going up. So don't we have to have a balanced debt [ C ], share purchase and global acquisition. But we have only one objective, grow by acquisition. But our share price in the last 2-3 years is at $50, $52. Don't the management have a duty to get it to the shareholders?
Yes. I don't agree with your conclusion that our share price is dragging because of the MacDon acquisition. In fact, I think that MacDon is doing a great job of driving earnings growth for us and the strategy of diversifying our business is absolutely paying off. I mean at this point, 50% of our earnings are being generated from non-automotive businesses. And I think that's a great long-term strategy for us to grow our business.I think there is a lot of other issues in the marketplace that, unfortunately, are weighing on not just our stock, but all the auto stock that are probably more to blame than MacDon. And believe me; nobody is more frustrated with the level of the share price than me. So as the largest -- my family is the largest shareholder in this company so, believe me, we've lost more value than anybody else on this phone call. So we're more frustrated than anyone. All we can do is continue to deliver the results. We have delivered double-digit normalized net earnings growth for 8 years running. We continue to deliver solid top- and bottom-line growth despite challenging market. And that's what's going to drive our share price in the long term.
Your next question comes from David Tyerman from Cormark Securities.
My first question is on the launches in Transportation and the margin effect. So it was pointed out earlier, your launches are a lot more next year than this year and yet it sounds like the impact on the margins is not going to be as large as this year. Am I correct in understanding that the launches that turn that $1.2 billion to $1.3 billion are mostly happening right now? Or how do we reconcile that?
Yes. I think that you are misinterpreting the fact that launch costs are somehow responsible for the lower margins. That is not the case. Margins are lower because significant volume declines have been experienced this year. In the first half of the year it was North American customers and in the back half of the year it was European customers on mature programs that are, by definition, going to be higher-margin. That's the issue. Okay? When we get back to normal levels of volume in Europe, we are already back in North America, then that is what fixes the margin issue.This is not a launch issue. Launch costs were slightly higher as a percent of sales this quarter than they were last quarter. It is not, not that significant -- not that significantly higher and we do expect to see that normalize back down. The much bigger issue is the decline in mature sales due to significant production cuts with mature volumes. Again, the first half in North America, back half in Europe. And that is what we'll rectify next year and that's why margins are going to expand next year.
Okay. That's very clear and helpful. And then on the Industrial side, you expect some margin expansion next year. What would be the main driver there or main drivers?
I think revenue out of Skyjack and margin improvement on the costs on both Skyjack and MacDon.
Okay. So some operating leverage at Skyjack and cost improvement on both sides.
Yes.
Okay, perfect. And then -- sorry.
And David, I was just going to mention one other thing on the launch side. It's a little bit of a seesaw, right? Like it's as we're coming down in mature volumes, we're going up in new volumes. And so as we go up, you add a shift, you get into a higher-cost time, but you're just doing more of the same stuff. So as you start up a shift, your costs are a little higher and then that will pass out. And that's what we're right now going through that curve.
So as an example, like you'd put an extra shift in now, but you may not see the volume on that extra shift until next year because you're bringing those people in early to train them and develop them and make sure they're ready when the volume comes in.
Yes.
Right. No, I hear all that. But from what Linda said, this is small potatoes. The real problem is volumes and that's really --
Exactly. Exactly.
Okay, fair enough. My last question is just sort of -- this is a much bigger, broader question. So your, by my calculations, return on invested capital has come down quite a bit since 2015, which would imply that that's value-destroying since the spread between return on invested capital and WACC are really your value driver. So I'm wondering what your thoughts are on that, whether you can get it back up? Or was it just inflated to an unusually high level in 2015 and where we are today is a more normal number? Because when I run through your broad guidance, I don't see ROIC changing much going forward.
Yes. I think that the biggest impact to return on invested capital and return equity over the last couple years has been the big acquisitions we've made. So when you make an acquisition, obviously it's a big lumpy investment and then the return on that comes sort of over time. So different to normal sort of investing new programs and generating those returns in a more reasonable timeframe.So you don't pay 6x or 8x EBITDA, which is where deals get done, and get 20% return, right? I mean not like right out of the gate. You have to grow the business and achieve the strategic objectives in order to make that happen. So yes, that's the biggest impact to return. We do expect to see returns starting to improve as soon as next year in terms of return on capital employed, return on equity. And frankly, I think anything in the high teens is actually pretty fantastic.
Okay. So when I think of this, like when I run through my model of your guidance, so your CapEx guidance, your margin guidance, et cetera, I don't -- I see you go up a little bit, but it's not very much and definitely not back to where it was. Is there some lever there that I'm misunderstanding that will improve quite a bit? Like are margins going to go up significantly or the CapEx falls off?
Yes. So I mean, as I talked about, we do expect CapEx to tail down next year both in terms of dollars spent and in terms of as a percent of sales. So that is going to be obviously -- and with margins, with top line growth, as discussed, in the high-single-digit to low-double-digit level next year and margin expansion, we're going to see some pretty solid cash generation next year. So that will definitely make an improvement. Is it going to bulk back up to 2015 levels in one year? I mean probably not. But you're definitely going to see it starting to trend back up.
Your next question comes from Brian Morrison from TD Securities.
Just a couple of clarification questions. I didn't really catch what the 2018 guide for Transportation was. Did you say the middle of 7% to 10%?
Yes.
Okay. And I'm just trying to reconcile the increase in the net margin. I think you took it up to 8.25% to 8.75%. But if I hear you correctly, you said the Transportation margin should be unchanged, really in the middle of the range. The interest leverage and tax is unchanged. Is it simply the MacDon weighting and margin improvement? Because I thought that I did hear you say something with respect to next year that you're still unclear on the growth rate on MacDon because of harvesting issues and a potential impact from China. Can you just clarify the increase in the net margin?
Yes. The increase in net margin is next year, not this year.
Understood.
Yes. So that's 2019. And I do expect margins to expand in both the Transportation and the Industrial segment next year. So we're going to have margin expansion there and that will translate to net margin expansion as well.
Right. So just to be clear, the net margin last quarter for Transportation -- pardon me -- the operating margin for Transportation last quarter is unchanged for the outlook for next year. So it's simply the MacDon weighting and margin improvement.
No, no. That's not what I said. I said the Transportation segment will see margin expansion next year. We'll be at the midpoint of 7% to 10% this year and it will expand next year. So it will be higher than that. It will be higher in the range next year. And the Industrial segment will also grow in its margin next year. So this is not -- we are not only growing at MacDon. In fact, we feel the overall Industrial segment will grow in margins next year. Both will be growing.
Right. I just want to be clear here. You increased the margin from last quarter. Your outlook for Transportation margin for next year is unchanged, at 8.5%, from where it was last quarter.
No, that's not correct. That's not correct. So our expectation for 2018 margins for the Transportation sector is mid-range. Next year, we expect it to grow. Okay? So it's going to be higher next year. It is not unchanged. It is higher.
Okay, that's fair. I thought you had said, quote, that it was middle of the range for next year as well. Middle of the higher end of the range.
No.
No, that was for this year. That was for this year.
There are no further questions at this time. I turn the call back over to the presenters.
Okay, thanks very much. So to conclude this evening, I'd like to leave you with 3 key messages. First, we are thrilled with another quarter of double-digit sales and earnings growth and solid cash generation adding to our fantastic track record of consistent sustainable growth for 8 years running. We are delighted to see our diversification strategy continuing to pay off for us by driving significant growth in our business. And finally, we're excited about the continued strong new business plan well above levels seen in prior years in the most opportunistic sourcing environment in automotive that we've ever seen. Thanks very much and have a great evening.
This concludes today's conference call. You may now disconnect.