Elringklinger AG

XETRA:ZIL2

Earnings Call Transcript 2019-Q3

[Operator]

Good day, and welcome to the ElringKlinger Group Analyst Conference Q3 2019. Today's conference is being recorded. And at this time, I'd like to turn the conference over to Stefan Wolf. Please go ahead.

[Stefan Wolf, Chairman of the Management Board & CEO]

Well, thank you very much. Hello, ladies and gentlemen. We welcome you to our conference call on the Q3 figures, 2019. Our agenda today is as follows: I will start with a quick wrap-up on markets and the most important headlines of the third quarter. In addition, I would like to say a few words about this year's international auto show in Frankfurt, where ElringKlinger participated in this show. Our CFO, Thomas Jessulat, will then walk you through the financial figures of Q3. Afterwards, I will close with the outlook. In the end, as usual, of course, you will have the opportunity to ask us your questions. For the third quarter, we noticed the following headlines with respect to our business. We saw a strong top line growth of 6.4% to EUR 432 million, organically by 4%. This represents an outperformance of global automotive production, which declined by 3.6% in the same period. EBIT pre-PPA stood at EUR 20.8 million. EBIT margin pre-PPA improved to 4.8% after 1.6% in Q1 and 2.5% in Q2 2019. The internal cost-cutting program had a positive impact here as well as the expected compensation of antidumping and [ countervailing ] duties in the U.S. Operating free cash flow improved considerably to EUR 3.8 million (sic) [ EUR 30.8 million ] in Q3 due to our very disciplined CapEx spendings and our consequent working capital management. In view of the challenging conditions which weigh [ on ] our global auto market, we have initiated restrictive cost-cutting measures throughout the whole ElringKlinger Group. Positive effects on earnings has been seen in the third quarter. Furthermore, we are leveraging synergies and bundling forces to improve productivity in our production location in locations in North America. Our action plan is being driven forward with success and according to our schedule. From an operational point of view, we are currently in the ramp-up phase of our new U.S. plant in Fort Wayne, which is in Indiana. Our new technology center for E-Mobility here in Dettingen, in our headquarter, is currently being equipped with machines and will be opened in 2020. Global production forecasts for 2019 have gradually been reduced to a noticeable decline, and estimates by automotive industry analysts, research houses and industry associates vary considerably. Based on the last assumptions, global vehicle production is expected to fall by 4% to 6% in 2019. We confirm the outlook, our outlook for the full year 2019 today despite increasing challenges in the market. We will limit the impact of the market weakness on EBIT pre-PPA through our cost reduction program within the entire ElringKlinger Group. Operational improvement, especially in NAFTA and Switzerland, and positive contribution of a real estate sale in the high single-digit million euro range. Let's first have a look on the market development of the third quarter. The global automotive industry has undergone a difficult year so far, hit by declining production figures in China, trade war worries between the world's 2 biggest economies, and the lasting need to invest heavily in new technologies. Based on the production volumes of light vehicles, global markets decreased by 3.6% in the third quarter, as I mentioned already. In China, trade disputes and the protest in Hong Kong burdened the economic prosperity. In addition, the government has reduced subsidies for e-vehicles. For ElringKlinger, a market downturn in such an important market like China directly impacts the earning figures. Nevertheless, ElringKlinger keeps sales in China robust in the third quarter 2019. In North America, we saw the markets down by 2%, while the truck market continued to expand on the basis of full order books and, again, exceeded the previous year's figures for heavy Class 8 trucks. The overall market was affected by the already mentioned trade conflicts between the U.S. and China in the third quarter. As in previous quarters, ElringKlinger outperformed the market also in the third quarter significantly but continues to operate still on a quite-high cost level. We will improve that significantly in 2020. In the European Union, we saw a slight increase of 1% partly due to the base effect as the introduction of the WLTP emission standards in September 2018 had led to supply bottlenecks. In contrast, the ongoing uncertainty regarding new drive concepts and diesel car bans burdens the entire industry in Europe. For ElringKlinger, this development is reflected in the sales increase of around 4% in Europe, excluding Germany, supported by a strong aftermarket business in Eastern Europe. By contrast, sales in Germany declined more than 6%. As I mentioned before, in September 2019, we were part of the international auto show in Frankfurt, one of the most important mobility affairs in the world. We were happy to present sophisticated solutions for customers' needs to our visitors and have welcomed not only OEMs or other supplier representatives but also capital market participants. Among others, they have seen a complete and ready-for-operation fuel cell system. Our range of different fuel cell stacks and electric drive unit, which showed the same as well as the classical and new components as value-added by ElringKlinger and new developments in the Shielding Technology, lightweighting and gaskets business units. The participation in the Frankfurt Auto Show has been a real success for ElringKlinger and proven the strategy to be an innovative powertrain supplier, providing sophisticated solutions for both sides of the transformation process, the classical products and the new E-Mobility business. Ladies and gentlemen, let me now hand over to Mr. Jessulat, my colleague, our CFO, for the explanation of the quarterly figures.

[Thomas Jessulat, CFO & Member of Management Board]

Thank you, Dr. Wolf. Ladies and gentlemen, a warm welcome also from my side. I would like to comment the financial results for the third quarter, starting on Slide #6. Order intake increased by 6.3% to EUR 438 million in the third quarter and by 0.8% adjusted for currency effects. The order backlog rose to EUR 1.069 billion, a plus of 4%, respectively, 1.9% when adjusted for foreign exchange. Despite the challenging business conditions, we generated strong sales growth in the third quarter 2019. Q3 sales amounted to EUR 432 million after EUR 406 million in the third quarter of 2018. Foreign exchange effects drove sales by roughly 2%. And that was particularly [ reasoned by ] the U.S. dollar. All in all, we saw an organic sales increase of plus 4%. Coming to Slide #7, you will see our global sales split, which shows again a very strong growth in North America. The sales share in this region increased to 27% compared to previous year's quarter with 23%. This development was mainly driven by the supply of components used in vehicle for which demand in the American market was more [ buoyant ] than originally scheduled. Additionally, the start-up of the new production plant at Fort Wayne provided the basis for a number of new product rollouts that generated higher sales and tool-related revenues of roughly EUR 10 million in total. Regarding to our business divisions on the next slide, we realized a mixed performance within the Original Equipment segment. The lightweighting/Elastomer division, our largest business unit, grew further by 14% to EUR 125 million. Also, the Shielding division increased sales by 11% to EUR 101.2 million, while revenues in the Specialty and Cylinder-head Gaskets division declined due to the underlying market slowdown. The E-Mobility division recorded EUR 4.6 million in sales. Slide #9 presents the earnings figures for the third quarter. EBIT pre-PPA reached EUR 20.8 million, and the respective margins stood at 4.8% after 1.6% in Q1 and 2.5% in Q2. Let me outline the main drivers for this development. First, as already announced in the Q2 call, countervailing and antidumping duties have affected earnings in the first half of 2019 by EUR 6 million. Almost EUR 4 million now have been reimbursed by the group -- or to the group with a corresponding effect on revenue and earnings. Second, raw material prices remain on a high level. The third quarter of 2019 saw a rise in the price of nickel. In contrast, the price of aluminum, which had reached an all-time high in the third quarter of 2018, edged back slightly in the quarter [ under review. ] And third, although markets in North America are declining, we see still an extraordinary demand for our products as well as ramp-up development in our new entity in Fort Wayne, and this is continuing high demand results in high follow-up costs, which have been addressed by effective countermeasures. We could, for example, further reduce extra costs for special freights [ in sorting ] activities. Furthermore, the cost-cutting program contributed around EUR 2 million to Q3's EBIT, and it includes several measures such as the targeted reduction in overtime within the entire group. The position Others includes impacts from, among others, higher personnel costs, R&D capitalization. Sum up earnings situation in the quarter just ended. Higher foreign exchange losses and interest expenses led to net finance costs of minus EUR 5.0 million after minus EUR 1 million in Q3 2018. And therefore, the net income attributable to shareholders of ElringKlinger fell to EUR 6.7 million in the third quarter. The higher tax rate in Q3 2019 was attributable primarily to losses incurred by subsidiaries, for which deferred tax assets could not be recognized. Overall, the earnings per share stood at EUR 0.11 in the third quarter 2019 after EUR 0.17 in Q3 2018. Let me now turn to Slide #10, showing the performance of our segments. As we already have discussed the main issues of the original equipment business above, I will now focus on the remaining segments. In the aftermarket segment, after a temporary stagnation in the first half as a result of sluggish European markets and geopolitical tensions, the Aftermarket segment was prospering in the third quarter. ElringKlinger grew businesses in almost all regions but especially in Eastern Europe and the Middle East. Revenues stood at EUR 45 million. Furthermore, we made progress in tapping into Asia and North America. EBIT came in at EUR 8.5 million, represented a solid EBIT margin of 18.8%. Engineered Plastics. The Engineered Plastics segment felt market downturn across all industries but could resist in both top and bottom line. Segment revenue was close to prior year level at EUR 30 million, and segment earnings were again impacted by the latest dip in demand, persistently high flow polymer prices and more pronounced staff costs. Thanks to restrictive cost management and optimization measures, EBIT amounted to EUR 4.9 million and improved significantly compared to the prior quarter. The EBIT margin stood at 16.3% in Q3. We now come to Slide #11. As Dr. Wolf mentioned before, we have implemented a comprehensive program to optimize group's cash flow figures in the short and medium term, which is based on 3 building blocks: earnings, net working capital and CapEx. The program includes measures to improve earnings. For example, the group-wide cost-reduction program, the optimization of the performance in Switzerland and North America as well as the reimbursement of duties. In addition, we have clearly defined effective measures to reduce net working capital. This includes an extension of payment terms, a reduced level of trade receivables and the optimization of inventories. Last but not least, we continue the disciplined CapEx approach. We now come to Slide #12. As you can see here, our measures to reduce the high net working capital level had a positive [ FX ] effect so far. At the end of September, net working capital stood at EUR 478 million, and compared to the end of 2018, this represents an improvement of EUR 90 million. The decrease is a result of the effective working capital program and has been driven by inventories that improved by EUR 22 million also due to our clear focus on supplier-owned inventories referring to numerous ramp-ups in the reporting quarter, and for example, in Fort Wayne and in Kecskemét in Hungary. Trade receivables are optimized by EUR 46 million through reduction of share of overdue receivables and reduction of payment periods to less than 60 days. And last but not least, trade payables extended by EUR 26 million, and this is the result from the extension of the payment terms to a target of 60 days with suppliers. In addition to our net working capital improvements, we have reduced CapEx in the reporting period by more than half to EUR 25.4 million compared to previous year's quarter. The corresponding CapEx ratio was at 5.9%, well in line with our target of achieving a ratio below 9%. All in all, we are fully on track with regard to the optimization of the free cash flow, which improved considerably to EUR 30.8 million in the reporting period. Having said this, we are confident to achieve our full year target of a positive figure. Now let's have a look on Slide #14. Compared to December 2018, we were able to bring down net financial debt by EUR 43 million or 5.9%. If adjusted for the IFRS 16 impact, debt level has been reduced by EUR 93 million or 21.8%. In the second and third quarter of 2019, ElringKlinger managed to scale back net debt by EUR 114 million. Regarding our maturity structure, you can clearly see the positive effect of our syndicated loan with volume of EUR 350 million over a minimum term of 5 years. The loan improved our maturity structure, and while the share of long-term debt was at 60% by the end of 2018, it has now increased to 70%. Only EUR 3 million has been -- to be refinanced in the current year. So far, from my side, I will now hand back to Dr. Wolf for the outlook and some final remarks.

[Stefan Wolf, Chairman of the Management Board & CEO]

Well, thank you very much, Mr. Jessulat. When looking at the more near-term future and the outlook for 2019, we see that the forecasts for 2019 have gradually been reduced from slight growth estimates in January to a noticeable decline according to the latest estimates. China representing more than 1/4 of the global market is to be seen as main driver for this development. The originally expected recovery in the second half year 2019 will not take place. We know that today. Instead, China is expected to decline in the third quarter and to be more or less stable in the fourth quarter. As a result, global markets are also expected to continue to decrease. Looking at the development of the main markets, we expect the following: The market conditions in North America have worsened over the last month and visibility is quite weak. With regards to the strike of one large American OEM, there might have been some anticipatory effects in the preceding months. In this case, we would see some lower demand in the fourth quarter. Moreover, the heated trades disputes are not yet resolved. The economic environment in Europe still suffers from the pending Brexit and the EU commission not yet in office. The industry is going through an economic downturn phase. At the same time, it has to manage the tremendous transformation process. Overall, we expect a decrease in car production of around 1% to 3% in this region. China still is affected by the unsolved trade disputes and the weaker economic growth. In addition, expired subsidies are further reason for the softening. All in that -- all in all, we expect a decline of 7% to 9% in China for the fiscal year 2019. Overall, estimates by leading banks, research houses and industry associations vary considerably. While associations anticipate a decline of 4%, data and information services are more pessimistic, expecting a year-on-year contraction of over 5%. In the light of this new view on markets, we revised our original market expectation. We now expect a market downturn of 4% to 6%. This -- the results of the third quarter underpin the success of the cash flow optimization program, but we work hard to improve earnings situation as well. Compared to Q1 and Q2, we saw a sequential improvement of earnings, and we expect this to continue in Q4. First of all, further antidumping and conservating duties have been avoided due to the initiated countermeasures. Instead, we have received some reimbursements. Moreover, we do not see further tightening of raw material prices. Second, the locations in North America will be further shaped in order to improve operational performance. We already noticed an impact on our Q3 earnings and expect further optimization in the upcoming months. Third, the real estate sale has proceeded further. We expect the closing of the deal in the [ running ] year. As mentioned, it implies a higher single-digit million euro contribution to earnings. Last but not least, we are still following a strict cost-saving program in order to improve the earnings situation in the short term. For example, we are bringing down the personnel cost by reducing overtime of our workforce or by internationally scaling back leasing workforces. We also carefully manage any other material cost and reduce any discretionary cost. I will now turn to Slide #20. I have outlined the market conditions still remain challenging with regards to the numerous political and economical uncertainties and the volatile and strained environment. Based on this challenging business climate, we expect global vehicle production to fall by 4% to 6% in 2019. And overall, as a result of the various factors outlined before, the group continues to expect to achieve its annual target of EBIT margin before purchase price allocation of around 4% to 5%. This assumes that no further significant externalities emerge as drag on earnings and that markets do not weaken any further than already anticipated. Last but not least, our expectations for further indicators of 2019 and the mid-term remain unchanged. Ladies and gentlemen, I highly appreciate your attention and that you have joined us to this conference call. And Mr. Jessulat and myself are now ready, of course, to take your questions. Thank you very much.

[Operator]

[Operator Instructions] And we'll take our first question here from Akshat Kacker, JPMorgan.

[Akshat Kacker, Analyst]

For my questions, 2, please. The first one is that we're still seeing weakness in underlying earnings, especially when I look at the OE division, excluding the compensation and duties, you were roughly breakeven in the third quarter, and this is a division that obviously did EUR 20 million per quarter, historically. And the question is, and as you mentioned, Dr. Wolf, cost level to be improved significantly in 2020. What are the actions that you can take? Can you take additional structural cost actions in Europe? Or probably another way, how much of the extra cost that you're seeing in NAFTA can be a big swing that we can expect going into next year? That's the first question. And the second question is on Swiss cost streamlining. In your report, you mentioned that that's going as per plan. Can you just remind us, net of the weak demand environment, how much of that can you achieve this year?

[Thomas Jessulat, CFO & Member of Management Board]

Okay. Let me get to your first question. In regard to the cost-reduction programs, we have initiated the first part now in 2019 with a focus really on general cost and reduction of accruals for overtime vacation. We have initiated the sale of real estate. We have ongoing renegotiations with customers. And we mentioned here -- Dr. Wolf mentioned that we still understand -- we operate on a high-cost level -- on an output -- high output-related high-cost level. So the second part. In 2020, we'll focus more on the elimination of the special freight situation and output-related cost. I would differentiate between 3 main cost types we need to address here, which is general cost, of course, material cost and personnel costs. And we target here to answer your question in regard to how much we're going to be -- or we want to achieve a low to middle double-digit amount in 2020. When we look at the structural impact, we see it as the improvement on the percentage of sales in personnel costs, material costs and other costs. And there is, of course, from the cost-type perspective, there is the special trade in there, there's sorting costs in there, but there is also other costs, such as packaging, consumables and the reduction of output-related costs in a different environment. So we see that effort that, again, results into a low to middle double-digit figure for 2020 as really a general activity of the group, which is also part of the transformation process, of course. We have lower growth in the classic business, and we have to address it, and we have to set up and continue to set up the new business areas. So this is in regard to that. When we look at Abschirmtechnik in Switzerland when here, we are now in the final stage of reducing the used space at that location to the central entity, and we're going to be moving out of the last warehouse end of the year now so that this cost and also some of the associated costs, transportation costs and so forth is going to be reduced in 2020 going forward. And I'd say, when we see net of the weak environment here that we have a low double-digit figure improvement that we would have increased over the last 3-year period of optimization. But now we have, like you mentioned, also some compensating effects here based on lower sales. So as a 3-year activity, net effect, it's really a lower double-digit figure, if that answers your question.

[Stefan Wolf, Chairman of the Management Board & CEO]

And let me add one thing. As you know, I'm in charge of sales here in the company, and we have analyzed all our prices for the products that we deliver to our customers. And we have found out that we have [ quite ] a lot of products where the price is, from my point of view, are not sufficient. And we are working very hard on that, confronting the customer with price increases, and wherever it is possible, we really get those price increases. So that is our main focus in sales right now to increase prices for certain products which have not a sufficient margin in the OE business.

[Operator]

And we'll take our next question here from Marc Tonn with Warburg Research.

[Marc-René Tonn]

A couple of question from my side, please. Firstly, on free cash flow. I think you have generate tremendous improvement in working capital, bringing that down from close to 34% to 27-something. I think also looking at what you had guided in mid-term and also, I think, was missed the guidance of the past that you're expecting slight step-by-step improvement and that we haven't seen any improvement for years before. So that's a bit -- could you shed some light why you have been so successful this year? Is there anything which is like a big step forward for 2019, which may presumably not be repeatable so that we see less [indiscernible] of significant improvement in the years ahead. Is there anything special we should be aware of, any factoring, any reverse factoring, anything which was, let's say, particularly helpful here. And also related to free cash flow, you have a guidance of achieving positive free cash flow in the full year, and also admittedly after the strong result of the 3 quarters, that is not particularly ambitious. So if you could give us some indication whether you would also expect a positive free cash flow in Q4 stand-alone or whether we should be aware of any things which might lead to a negative free cash flow in the last quarter. Third question would be, I think, when we look on the year-on-year comparison or when you look at the earnings in the third quarter, aftermarket, I think, was a big positive surprise, which we've seen there with this tremendous increase in revenues and correspondingly high increase in earnings with even the margin improvement. Has there been any, let's say, effects of demand having been pulled forward so that Q4 should be, let's say, less dynamic? Or is this, let's say, was it just simply a very strong quarter? And lastly, reimbursements, we have received EUR 4 million now in Q3. I think a [ reimbursement ] of a total of EUR 6 million in the first half. Would you expect another -- the remaining EUR 2 million to be reimbursed in Q4? Or is -- or will you end the year with, let's say, a net negative of EUR 2 million from this tariff effect?

[Thomas Jessulat, CFO & Member of Management Board]

Okay. To your first question. I think the improvement here on the free cash flow has various layers. As I mentioned also in the last call, ElringKlinger is using instruments to improve working capital as percentage of sales, but it is only a portion of it -- of the successful execution on this. The lesser growth relative to previous periods is another factor, so from a structural perspective, the levels of inventory for tools comes down step-by-step heading into terrain with lower growth in classic. Besides that, we have been working very hard on the receivables side. And we must say that, in some areas, we have reached here really significant improvements. We are also successful in regard to the improvement in inventory. But nevertheless, we have to keep in mind that, despite the net lower inventory, we still have entities that are increasing inventories, for example, the new entity in Indiana, and we have also the new business fields, some entities that are ramping up. So this is really the net effect and still takes into account that we still have some ramp-up effects in the group. And third, in regard to the payables, this is something where we really see continuous improvement based on new management here in sourcing, and we really make some good progress. So from a structural perspective, the basic ability to reach free cash flow is the lower level of CapEx given the current earnings level that ElringKlinger has. And when we look into Q4, I, right now, would see also positive free cash flow in Q4. There is some payments that I see in regard to new business years that are going to be going into fixed assets. But in a general way also with the expected sale of real estate, I would imagine that the fourth quarter would be positive. Earnings quality we have to say that we really come out, in particular, North America off a high-demand situation, and whether this high-demand situation is going to be persisting going forward, I think this would need to be confirmed, but the possibility is there that we face now a period with lesser demand, but I think maybe Dr. Wolf can add something to that, but I think it's difficult to say that, that is definitely going to be the case.

[Stefan Wolf, Chairman of the Management Board & CEO]

Yes. Well, let me say something to the aftermarket first. We had good performance basically in all regions but especially in Eastern Europe, which is a very important market for us. We are absolute market leader with our distribution partner there, a company by the name of Inter Cars in Eastern Europe. And especially also in the Middle East, you have to see our best market in the aftermarket with the highest margins [ is ] Saudi Arabia, and the Middle East countries have been quite reluctant because they were lacking some money because the oil prices were pretty low. So their earnings is not that high any more based on the oil that they sell. But as we expected it, sooner or later, you have to repair the cars and they need the [ aftermarket ] parts. So that's why the Middle East was quite running well. So -- and that, of course, we see that also in the future. With regard to the reimbursement of our countervailing duties and the tariffs. To be honest, one of our customers needed desperately a part for a new transmission -- transmission plate and since -- an oil separator plate for a transmission. And we were the only company that is able to supply that worldwide. And that is how we could force them to pay those reimbursements for tariffs and for countervailing duties. So it's harder to get the rest, but we are working on it. And we also have applied for reimbursements by the government. There's a possibility to do that. We have some of our applications approved. Some are not approved. So it is still hard work. But of course, we are not giving up on that. We want to [ be a ] reimbursement for all what we have paid in tariffs and countervailing duties.

[Marc-René Tonn]

If I may follow up. Coming back to working capital and the reduction in the working capital regimen, 34% to 27.5%, could you give us some kind of a split on how much of this is really structural and how much of this is, let's say, more due to instruments is that the opportunity? And another question would be, when we now think about the disposal of the building which you will have in the fourth quarter, which is presumably more of a one-off factor which we will enjoy there, looking into next year, do you think, from today's perspective, looking at what you're expecting for the industry that you have, let's say, sufficient earnings improvement headroom to make up for these 7 -- for the, let's say, higher single-digit million amount, which you will, let's say, not have next year as earnings. [ As ] we will look on a year-on-year comparison for 2020.

[Thomas Jessulat, CFO & Member of Management Board]

The overall amount, when we look at over the year now, the roughly EUR 110 million free cash flow, then it's less than 50% that comes from instruments. Most of it is really coming out of our management activity to that question. And going forward, structurally, we will have lower level of CapEx. And the structure of how we go into 2020 is such that without the improvements that we want to achieve, we have to be safe in regard to achieving free cash flow. Therefore, we'll manage the group forward in a way that we keep CapEx level really low. And when we look at the difference between EBITDA and the CapEx level for 2020, which we intend to reduce a little bit further relative to this year then from a structural perspective, yes, I think we're going to be able to reach sustainability here. But again, in the long run, it will be important for ElringKlinger to be able to invest more again. And therefore, we really need to work on further improvement in regard to earnings quality. This is very clear, but everything else in regard to guidance topics is going to be followed up in March 2020.

[Operator]

We'll take our next question here from Christian Ludwig with Bankhaus Lampe.

[Christian Ludwig, Head of Research & Analyst]

Also a couple of questions from my side. First of all, just a quick one. The margin in the Engineered Plastics division also was a positive surprise. Again, could you elaborate. Is this a one-off due to a mix effect? Or is this something that you believe is going to be more sustainable? That's question #1. And then on the CapEx side, already -- I understood that your target is below 9%. Now after 9 months, we're even below 7%. So for this year, is below 7% a fair assumption? And then you will -- you should expect a gradual increase towards 9% over the next 2 to 3 years? Or how should we expect you to manage that? Those are my questions.

[Thomas Jessulat, CFO & Member of Management Board]

Margin Engineered Plastics is good, but the Engineered Plastics business is, of course, exposed to some areas in the industry where we see a lot of weakness. When we look at mechanical engineering, the chemical industry, the company is exposed to those parts of the industry. And therefore, we have to execute on cost-reduction measures here in order to compensate for that. Going forward, it's hard to say because the outlook is very much uncertain. In regard to CapEx target below 9% and your longer-term question, we really have a target to get into the area of 2 in regard to net debt to EBITDA. And I think this should answer at least part of your question. In the short term, we are going to be steering the group in terms of lower levels of CapEx. And in the longer run, when we have achieved, again, higher levels of EBITDA, this is really -- and I guess we have to answer that question a little bit later. Then there's going to be a point when ElringKlinger is going to be increasing again levels of CapEx, but to give you more information on timing at this point in time, I cannot do that.

[Christian Ludwig, Head of Research & Analyst]

Okay, fair enough. And then just a final question. This real estate sale, how sure are you that it's actually going to happen in 2019? Or could it also slip into the next quarter of 2020?

[Stefan Wolf, Chairman of the Management Board & CEO]

The contract is signed, and closing, we see that end of November, beginning of December. You never know in those things, yes, but I would say it's -- sure -- sure that this will happen in 2019.

[Operator]

And we'll take our next question here from Felix Eisel with CCA.

[Felix Eisel, Founder and Partner]

A question on your gross margin, which has declined a bit. How much of that has actually been driven by raw materials? And if any, has there been -- has it been driven by the shift in product mix? And maybe related to that, is -- are your lightweighting products as profitable as your gasket products, just to get an understanding [ of ] your business moves more towards that direction. Is the structural profitability going to change over business? That's the first one.

[Thomas Jessulat, CFO & Member of Management Board]

Okay. We have had, in the first 2 quarters 2019, relative to last year, a higher amount in terms of material cost. Despite that, over the last 3 quarters now, we have seen an improvement in gross margin, and the improvement in gross margin is coming essentially from improvements here in process-related costs -- output-related costs. Now it is still a little bit of mix. We have to say what's in there because we have, again, some start-up situations and so forth, but the expectation is that, as we are going to be going into further cost reductions in 2020, the expectation is that we have a further positive development here. And the new products, they are profitable. They are meeting group targets for return on sales and also for return on capital. So the answer is yes.

[Stefan Wolf, Chairman of the Management Board & CEO]

And one thing, I think it's not right to compare the gross margin in Q3 2018 with the gross margin in Q3 2019 because there can always be in a quarter, you know, a quarter is only 12 weeks, 3 months. There can be so many effects on the gross margin that I think it's not comparable. You have to see the development and the development, as Mr. Jessulat mentioned, it's even the last 3 quarters, it was -- we were round about at 19%, and that improved now to 21.3%. I think that is the important point, not comparing last year's third quarter because last year's third quarter, to be honest, was totally different to this year's third quarter.

[Felix Eisel, Founder and Partner]

Okay. But is there a structural difference? Because like it seems as if your gasket products seem a bit more complex and you would be able to charge some higher prices on that or higher margins than versus lightweighting products. Is that correct?

[Stefan Wolf, Chairman of the Management Board & CEO]

No. It's wrong. Completely wrong.

[Felix Eisel, Founder and Partner]

Okay. And then last question. The strong demand in the U.S. and I guess, this is -- a lot of this is driven by lightweighting products, is that what -- are there any specific customers or specific car categories, which are driving this? Or couldn't you put your finger on what's driving the strong demand?

[Stefan Wolf, Chairman of the Management Board & CEO]

Yes, there is still a strong demand in the U.S. for big SUVs. If you look at Ford, the main product that they sell is the F-150. And we have parts, be it cylinder gaskets for engines that go in those big SUVs or be it heat shields or be it plastic [ housing ] parts, so we have an overproportional number of parts for those engines and applications that go into those big SUVs that are still sold in large numbers in the U.S.

[Operator]

We'll take our next question here from Michael Punzet with DZB.

[Michael Punzet, Analyst]

I have 2 questions. First one is on your sales expectations for the fourth quarter, given your lower outlook for the full year overall market by minus 4% to 6%, and we expected outperformance of 2% to 4% would imply that you expect a negative organic sales development in Q4. Maybe you can say something on that? And the second one is on your comments on the -- I would say, that you have some products which do not see adequate margin. So what went wrong with these products, where they make some mistakes by the calculation of the product? Or they have -- there were some changes in the input parameters like personnel costs, like raw materials, which now leads to these lower margins?

[Stefan Wolf, Chairman of the Management Board & CEO]

Let me start at the end. Some of that is homemade. There was -- contract was signed, let's say, 5 years ago, lifetime contract with price reductions that are fixed already in the contract. And now we have material price increases or other kind of price increases, and we have to give those price reductions to the customer. So that, of course, makes a product that originally was really had a good profit in the start, makes it not profitable -- brings it below the target profit -- percentage of profit that we want to have and that we need. So a lot of -- of course, is related to material cost increase -- material cost increases. So there are a lot of different reasons, but I have to admit, some of it is also homemade, yes. That's why we have to straighten it out. And it's pretty clear that -- it's a pretty clear order that the salespeople have, go to the customer and get higher prices, and they are already quite successful, but in those issues, normally you see in the results, let's say, a quarter later or half a year later or 9 months later because at first, the customer are not really -- are not willing to pay right away those higher prices. So that is a process that you will see that margins improve also by better prices over the next quarters to come. So that is the fact. We don't expect negative organic sales. You never know what happens there, of course, in this very volatile situation, in this very uncertain world, where you never know what happens geopolitical. I don't know if the customers, they announced, let's say, end of November that they closed down their productions for 2 weeks or 3 weeks over Christmas, so you never know. But as of today, we don't expect negative organic sales.

[Operator]

And we'll take our next question here from Christoph Laskawi of Deutsche Bank.

[Christoph Laskawi, Research Analyst]

The first one would indeed be also on Q4 and markets to some degree. You kept guidance also on the margin side, which still is then looking for an improvement organically [ ensure ] aside from the real estate sale. Just looking at the markets that have supported in Q3 like China and Europe, to some degree. VW, for example, is commenting on production cuts going forward, so German production will likely be quite negative also in the fourth quarter. Do you think you will have the same tailwinds that you saw in Q3 also in Q4 so that your underlying regional mix will be a support on earnings? Or do you think there might be changes which could put that risk?

[Thomas Jessulat, CFO & Member of Management Board]

What I calculate with is, of course, the sale here of the real estate, single digit amount. And I also calculate with a sale of development in the fourth quarter, also single-digit amount before I come to the organic EBIT.

[Christoph Laskawi, Research Analyst]

So second item, the sale of...

[Thomas Jessulat, CFO & Member of Management Board]

Development packages. So those are the 3 components, and of course, the last component was the organic EBIT, which -- yes, which could be impacted. So this is also the reason why I wouldn't be too relaxed here in regard to Q4 because we still have to improve here in a quarter that may not be easy, but given the topics that I have here that play into my internal forecast relative to the guidance, I think we will be able to achieve.

[Christoph Laskawi, Research Analyst]

And on the numbers that you said could be cost cuts into 2020, which I understand is low double-digit to mid double-digit euro million amount, do you see that ramping up in Q4 already to some degree? Or is it really only 2020? And thinking about the bridge into 2020. I get this is -- I understand this is a net cost-cutting amount that you will see and you would potentially, when doing the bridge takeout, the gain on the real estate so that your, say, net from both would be really rather, say, EUR 10 million to EUR 15 million, and that includes already some positive operating leverage for improving NAFTA? Or is that not included?

[Thomas Jessulat, CFO & Member of Management Board]

From a guidance bridge, again, this is going to be communicated in March next year, but the indication here, the sale of real estate and also further reduction an accrual from personnel and vacation time and so forth, this is going to be going into Q4. So the answer to that is yes. When we -- and hopefully, we can achieve here the sale of real estate, and this would be the conclusion, so to say, of the 2019 plan. The [ other ] 2020 plan is separate. I would not expect significant contributions here in the fourth quarter. This would be a focus really on 2020. And again, the low to middle double-digit is for your sort of information that we continue to try to improve the structure of P&L. Now when we look at the past development of how ratios in regard to personnel costs, material costs, some other cost as percentage of sales in the run up during the last years, how that evolved, there was a lot of growth built into that. And therefore, the clear focus is that we have now to improve in a lower-growth environment. We have to improve here the structure of the individual positions as percentage of sales. This is the clear target, but again, more information I'm very happy to give that to you beginning of next year.

[Stefan Wolf, Chairman of the Management Board & CEO]

And one thing, a cost-cutting process is a process. It's ongoing. It's not something that is in one quarter and then it stops in the next quarter. It's an ongoing process that we started already in the first quarter. And of course, it's ongoing in the fourth quarter, and it's ongoing in 2020. I give you an example. If you have signed up already in 2018, let's say, for a participation in a fair for 2019, you have a contract. You don't get out of that. But you have the possibility to not sign this contract in 2019. And then you don't have the cost in 2020. We have frame agreements, for example, with magazines -- automotive magazines, where we have -- you get a price reduction if you book, let's say, 5 ads or 6 ads or 8 ads for 1 year already in 2018 for 2019. When you start a cost-cutting program in January or February 2019, you don't get out of this contract, but of course, you don't sign this contract in 2019. So you will not have those costs in 2020. This is a dynamic ongoing process, which is not related to quarters. We cannot think in quarters here. We have to think in ongoing time frame. There's no time frame. We -- also, we have, for example, we have temporary people in the production. Of course, we cannot terminate their contract when we think now we are going to cut personnel costs. We don't cannot terminate their contract because they have -- if they have a temporary contract until December 31, 2019. But believe me, we have looked very closely at all our temporary people, and we have told them that a lot of them will not get a contract up from January 1, 2020. So again, a position that we have in the cost in 2019, but we have not in the cost in 2020. That's how it works.

[Christoph Laskawi, Research Analyst]

Yes, I think that's well understood. A follow-up still on that, if I may. Do you have a specific underlying market assumption that you've put in, in order to give a specific range [ or ] the programs that you have initiated? And would that still have flex in the sense that other suppliers are already pointing towards follow-up production on this end, IHS, for example, forecast currently, so it's still a very volatile environment. I assume you would still have room to maneuver, in case you have lower production numbers for that program and you could even tighten it going forward.

[Thomas Jessulat, CFO & Member of Management Board]

I think the measure -- the reason why I mentioned that with a percentage of sales numbers is that, independent on how the market is going, we have to improve the structure of P&L. So it's not really talking about the amounts, and you have fixed amount and variable amounts, but the target is to improve the structure of P&L. So if the market is weaker, then we have, of course, even to do more in the total amount, but again, the target of this activity is to improve P&L structure. And we have given uncertainty now in terms of the volumes for 2020. So it's really hard to say. But what's for me important to tell you that the target is the P&L structure and to reverse the run up in terms of the individual share of sales of the functional areas of the P&L.

[Christoph Laskawi, Research Analyst]

Last question from my side is on free cash flow. You pointed towards Q4 free cash flow being positive, but that includes the sale of the real estate, right? So on an underlying basis, depending on also what the customers like the OEMs do and if they manage their free cash flow a bit tighter, it might be also negative. Is that correct?

[Thomas Jessulat, CFO & Member of Management Board]

No. To be clear, and we may have, as Dr. Wolf was saying, some items that slipped from one quarter to the next. My expectation is that I don't have a peak in terms of CapEx spending in Q4. We continue with our operation. We continue with the improvements. And based on that, the opinion that we can, outside of exceptional items, such as the sale of real estate, maintain a free level of free cash flow. [ Not ] now. There may be a quarter here and there, I have to say that, where items slip from one quarter to the next, and they may be small items, but per the design of the relation EBITDA to CapEx, we should be in a position now to achieve a sustainable level of free cash flow.

[Operator]

We'll take our next question here from Frank Biller with LBBW.

[Frank Biller, Investment Analyst]

It's some questions on the order side here. So order intake was quite strong in the third quarter with plus of more than 6%. Maybe you can talk about the products and which fields you got these orders, which products, which customers? And the other thing is on order volume in total. So we see more than EUR 1 billion in orders on hand. Is there any risk of writing down these orders because they are based maybe on a bit too high assumptions so Continental is estimating nearly no growth for the next 4 to 5 years. And is there a risk for you on this order book?

[Stefan Wolf, Chairman of the Management Board & CEO]

Let me make one remark to this 5 years -- for the next 5 years expecting no growth. To be honest, I think this is something that is unacceptable because who can say what happens the next 5 years. And to give an explanation, if I have to write down EUR 2.5 billion just to explain it with the market for the next 5 years, I think this is something that is not acceptable because it affects the whole market and it affects us. It affect other suppliers. And in this -- in those real uncertain times, you don't know what happens between China and the U.S. You don't know what happens with the Brexit. You don't know if we get maybe an economical upturn in the next 6 months or next 10 months or next 12 months. Everything is quite unsure, and to say that we don't see an increase in car production and in car sales for the next 5 years, this is something that I think is completely wrong. I think that we see an increase within the next 5 years. We never -- we don't know when, but there will be an increase in car sales. We see already in China, an improvement, and there is a better situation in China, has been in September and in October. And I would say the visibility is really, really not that good anymore as it was 10 years ago and 15 years ago. And again, it is unacceptable to say something for the next 5 years because you don't know. We don't know. Nobody knows. But I'm sure that people will buy cars again, be it cars with a combustion engine, be it cars with a battery electric system, albeit cars with a fuel cell electric system. We will see an increase in car sales, I tell you, within the next 5 years, maybe not in 2020, but I see already in 2021 that the markets are going to pick up because people will see that all those electrical cars that are in the market are not really ready for their needs, and they will buy again cars with a combustion engine. I think that's the situation that we have. And I think we will benefit from that, and we will benefit from the situation, be it the battery electric car, be it the fuel cell electric car, albeit a car with a normal combustion engine. And that is what is going to happen. And nobody can say the next 5 years we don't see increases in car sales. We don't really know.

[Thomas Jessulat, CFO & Member of Management Board]

In addition to that, from a technical perspective, we have normally orders over a couple of months in the system so, say, 4 to 6 months, maybe. What we see here, we still see a little bit of the momentum of start-up projects in our portfolio, such as the new plant in Indiana. And as we move on, more orders are being released from the customer side. So you see a little bit of the momentum here in the development of the order stock. Going forward, we have the risk that customers cancel that, but that, like Dr. Wolf said, is very uncertain. We don't know. But technically speaking, from the momentum -- growth momentum that we have with new projects, this is typically the amount that is being added to the ElringKlinger Group order stock.

[Frank Biller, Investment Analyst]

And which new orders you got then, which products, which customers? What is driving the business here?

[Thomas Jessulat, CFO & Member of Management Board]

But when we talk about Indiana, in particular, this is thermal shields, heat shield products with North American customers.

[Stefan Wolf, Chairman of the Management Board & CEO]

It's a buildup, to be honest. If we tell you all the orders that we got and all the customers -- the orders from the customers that we got, we still sit here tonight at 10 o'clock. It's so diversified and there's so many customers and so many orders, if we got -- we're talking about 1 billion.

[Frank Biller, Investment Analyst]

So it's not coming from the E-Mobility business then because E-Mobility was down a bit...

[Stefan Wolf, Chairman of the Management Board & CEO]

Part of it. Part of it, of course,

[Frank Biller, Investment Analyst]

But it's not the major driver.

[Stefan Wolf, Chairman of the Management Board & CEO]

No, of course not. Of course, not. I tell you one thing. We will have the combustion engine for the next 50 years, and we will have parts for the combustion engine for the next 50 years because our customers are going to sell cars with combustion engines for the next 50 years, and we will benefit from that because capacities will be decreased constantly over the years to come. And that gives us a good possibility to increase prices remarkably because nobody is investing anymore in technology and in equipment -- production equipment for parts for the combustion engine. And that means that somebody that is well positioned already with a high-quality and high-technical position also with regard to production technology will benefit from that. And our markets are highly consolidated, and there are American groups that are our competitors, and they will not invest in that business anymore, and we will invest [ under proportional ] that we will keep this company on a very high level with regard to parts for the combustion engine, and we will really make really good money with those parts in the years to come because we will have reduced capacities in the customers. They will ask us -- they will beg for parts that they get parts from us.

[Thomas Jessulat, CFO & Member of Management Board]

But again, from a technical perspective, what we have in the order stock is releases. If we have projects -- development projects that go on, they are not part of order stock, just to make that clear.

[Operator]

We'll take our next question here from Pushkar Tendolkar with HSBC.

[Pushkar Tendolkar, Analyst of Global Autos]

This is Pushkar from HSBC. My first question is on the cost savings that you see from Switzerland. How much of that have you achieved in 2018/2019? And what do you expect for 2020? My second question, and sorry to come back on the FCF issue. A large portion of your FCF for the first 9 months has come from the net working capital improvement. Do you see that it has stabilized now? Or do you expect further improvement from this in 2020? What I want to understand is that, going forward into 2020 and beyond that, whether you see improvements coming from net working capital again or your positive free cash flow will come primarily from the earnings improvement?

[Thomas Jessulat, CFO & Member of Management Board]

Okay. Second question first. The primary free cash flow is coming from the difference between EBITDA and CapEx. Earnings improvement would be on top of that. The working capital, as we go more into a period with less growth, from the classic business, we'll see more opportunity here, but as we all know, working capital improvements are not endless. There's an end to that, but yes, the answer is, I see more improvement potential in 2020 in regard to that, but we need to structure the spending -- CapEx spending in a way that we are not dependent on the working capital improvement, but it is another component of the free cash flow. That [indiscernible] to the second question. To the first question, cost savings in Switzerland, I mentioned between 2017 to 2019, net of now the market development, this is a sort of lower double-digit amount that we have saved in general. And I see a single-digit improvement for 2020 because, between 2019 and '20, again, we have the relocation, elimination of warehouse and some of the cost types that are associated with that. So that is the final, let's say, structural cost saving out of that between '19 and '20.

[Operator]

We'll take our next question here from Akshat Kacker with JPMorgan.

[Akshat Kacker, Analyst]

One follow-up. As you look at your order intake and projects that you're going to deliver into next year, you're still at the lower end of your R&D guidance of 5% to 6%. Do you expect a pickup or again some optimization and cost rationalization on that aspect as well?

[Thomas Jessulat, CFO & Member of Management Board]

No, I would not expect any change in regard to the 5% to 6%. Right now, we're at the lower end [ of it ] but we stick to that.

[Akshat Kacker, Analyst]

So staying at the lower end or probably in that range or a pickup depending on the order book?

[Thomas Jessulat, CFO & Member of Management Board]

In that range. I'd say in that range. When we look at Q3 R&D, we've got 16.1%. We have capitalization, 2.6%. We have a capitalization ratio of 16.1%. So in between the 5% and 6%,

[Operator]

And as there are no further questions, I'd now like to hand the call back to Dr. Wolf.

[Stefan Wolf, Chairman of the Management Board & CEO]

Yes, thank you very much for attending our conference call and for your interesting questions. I hope the answers were sufficient and satisfying. As you know, Investor Relations always is willing to take further questions, so please call them. So thank you very much, and then, with each other at -- we hear each other at our conference call in the beginning of 2020 when we have preliminary figures for you. So thank you very much for joining us. Bye-bye.

[Operator]

This concludes today's call. Thank you for your participation. You may now disconnect.