Earnings Call Transcript - AME Q2 2020

Operator, Operator

Thank you for being with us, and welcome to the Second Quarter 2020 AMETEK Inc Earnings Conference Call. It is now my pleasure to introduce Kevin Coleman, Vice President of Investor Relations.

Kevin Coleman, Vice President of Investor Relations

Thank you, Andrew. Good morning, and thank you for joining us for AMETEK's second quarter 2020 earnings conference call. With me today are Dave Zapico, Chairman and Chief Executive Officer; and Bill Burke, Executive Vice President and Chief Financial Officer. AMETEK's second quarter results were released earlier this morning and are available on market systems and in the Investors section of our website. This call is also being webcasted and can be accessed on our website. During the course of today's call, we will make forward-looking statements, which are subject to change based on various risk factors and uncertainties that may cause actual results to differ significantly from expectations. A detailed discussion of the risks and uncertainties that may affect our future results is contained in AMETEK's filings with the SEC, including in our 10-Q, which will be filed later today. AMETEK disclaims any intention or obligation to update or revise any forward-looking statements. Any references made on this call to 2019 or 2020 results will be on an adjusted basis, excluding after-tax, acquisition-related, intangible amortization and also excluding the gain from the sale of Reading Alloys in the first quarter of 2020 and the realignment charge taken in the first quarter of 2020. Reconciliations between GAAP and adjusted measures can be found in our press release and in the Investors section of our website. We'll begin today with prepared remarks by Dave and Bill and then open it up for questions. I'll now turn the meeting over to Dave.

Dave Zapico, Chairman and CEO

Thank you, Kevin, and good morning, everyone. Despite an economic environment as challenging and uncertain as any we have ever faced in AMETEK, our businesses stood strong in the second quarter delivering outstanding operating performance that exceeded expectations. I wanted to start by thanking all AMETEK colleagues who are working tirelessly through this pandemic to provide our customers with great products and exceptional service. As our results attest, our employees are doing an amazing job. The safety of our employees remains our highest priority. We continue to implement our pandemic response plan, which provides guidance for our businesses to manage our facilities and workforce during this pandemic. We are following CDC and local health and safety guidelines and are adjusting and enhancing our safety protocols as required to ensure a safe working environment for our employees. Now let me turn to our results for the quarter. Sales in the second quarter were $1.01 billion, down 22% versus the second quarter of 2019. Organic sales were also down 22% with recent acquisitions contributing 4%, the divestiture of Reading Alloys a three-point headwind and foreign currency a one-point headwind. Despite substantial demand weakness, our business delivered exceptional operating performance. Operating income in the quarter was $227 million and operating margins were very strong at 22.4%, while decremental margins were an impressive 25%. EBITDA in the second quarter was $289.7 million and EBITDA margins were a record 28.6%, up 160 basis points over last year's second quarter. This drove earnings of $0.84 per diluted share, down 20% versus the second quarter of 2019. Our cash generation in the quarter was superb. Operating cash flow was up 28% year-over-year to $315 million. Free cash flow conversion was also exceptionally strong at 183% of net income. Our businesses are focused on controlling what they can. The operating performance in the quarter is validation of the strength and flexibility of our asset-light business model, the quality of our niche businesses, and most importantly, the talent and commitment of our workforce. Next, I will provide some additional details at the operating group level. Second quarter sales for the Electronic Instruments Group were $647.9 million, down 21% from the same period last year. Organic sales were down 26%, with the acquisition of Gatan and IntelliPower contributing 5%. Despite the impact COVID-19 had on sales, our EIG businesses delivered excellent operating performance. EIG's operating income in the second quarter was $159.6 million and operating margins remained strong at 24.6%. The Electromechanical Group also delivered excellent operating results, driven by better than expected organic sales and their operational excellence initiatives, which contributed to exceptional margin expansion. EMG's sales were $364 million, down 22% versus the prior year's second quarter. Organic sales were down 16%, with the recent acquisition of PDT adding 3%, the divestiture of Reading Alloys was an eight-point headwind and foreign currency was a one-point headwind. EMG's margin expansion was outstanding in the quarter. While operating income decreased to $84.3 million, operating margins expanded an impressive 170 basis points to a record 23.2%, driven by our proactive operational excellence initiatives. Truly exceptional work by our teams. Now let me provide some color on the different end market dynamics we are experiencing within our business. AMETEK serves a diverse set of end markets. And across these end markets, we are seeing very different levels of demand and COVID-19 impacts. As I did last quarter, I'll group our businesses into three buckets based on the levels of demand we are experiencing and provide some commentary on each. I'll start with the most challenging markets, commercial aerospace and oil and gas, which combined account for approximately 15% of AMETEK's sales. The weakness in commercial aerospace was largely as expected and driven by the impacts of COVID-19 on both our commercial OEM and aftermarket businesses. We expect these businesses to remain challenged for the balance of the year. Along with the impact from COVID-19, weakness in our oil and gas business was a result of difficult prior year comparisons given several large project shipments last year. As a result, we expect solid sequential improvements in this business during the third quarter and fourth quarters. Combined, sales for commercial aerospace and oil and gas were down approximately 45% in the quarter. Excluding these two markets, AMETEK's sales were down mid-teens on a percentage basis in the second quarter. Next, our strongest markets, defense and medical. Combining these markets accounts for over 20% of our sales, and we have been experiencing solid internal growth while also strategically expanding our portfolio in these areas through acquisitions. In the second quarter, sales were up low-single-digits for these businesses and we expect this strength to continue in the third quarter and fourth quarters. For the balance of our markets, which include power, industrial, automation, metals, food and beverage, and research, we were seeing demand levels somewhere in between those other two streams. We expect to see sequential improvements through the balance of the year for these businesses also. To offset these COVID-19-driven demand challenges, we remain focused on actively managing our cost structure through a mix of structural and temporary cost actions. Our executive office meets regularly with each of our businesses to review current market conditions, their demand outlook for the coming months, and their operational plans. It is critical that each of our businesses develops an operating plan customized for their business, and that this operating planning be adjusted if conditions change. This flexibility is key in our asset-light operating model where costs can be quickly variablized. This approach allows us to best align our cost structure with demand levels we are experiencing by market and by business. We have the flexibility to expand cost savings initiatives or, as demand conditions improve, we can add back costs as required. In the second quarter, we generated $85 million in total cost savings with $35 million in structural savings and $50 million in temporary cost savings. This level of savings was above our initial estimate of $80 million total cost savings in the quarter. As we look ahead to the third quarter, we expect approximately $65 million in total cost savings with $35 million to $40 million in structural and $25 million to $30 million in temporary savings. For the full year, we now expect structural savings of $135 million and will flex our temporary cost savings either up or down based on volume levels in the fourth quarter. The spread of the coronavirus has forced companies to adapt and adjust how they do business. Work-from-home requirements and travel restrictions have changed how our company interacts and engages with customers. Our businesses have been proactive in developing and utilizing digital capabilities to help them stay engaged with our customers. Our sales and engineering teams are working side-by-side with our customers through digital channels to cultivate and build relationships. These initiatives have included virtual events through newly implemented digital platforms to provide product demos, webinars, and collaborative business meetings. Some of our teams are finding innovative ways to help provide aftermarket services for our customers through interactive technologies. I commend our teams for quickly adapting to the new reality and for embracing these new ways of doing business. We remain committed to investing in additional technologies to support our customer experience. Despite the global demand challenges, AMETEK continues to invest meaningfully in new product development initiatives. We are seeing great success from these investments as our businesses are introducing many new innovative solutions to help solve our customers' greatest challenges. Our vitality index, which measures the amount of sales generated from new products introduced during the last three years, was very strong at 26%. Here are just a few of the recent examples of new product introductions. AMETEK Land, a leading manufacturer of non-contact temperature measurement solutions, saw robust demand in the second quarter for their new VIRALERT 3. This newly developed non-contact temperature measurement solution is used to rapidly detect elevated skin temperature while allowing users to adhere to social distancing requirements. Given the product's ability to complete accurate temperature screenings at scale, the VIRALERT 3 is playing a role in reopening key facilities around the world. Creaform, a leader in 3D measurement technologies, released the latest solution in their MetraSCAN 3D line. The MetraSCAN Black is the fastest and most accurate 3D scanner in the world with four times the speed and resolution of its predecessor. It can withstand harsh production environments and is utilized in the most complex quality control and quality assurance applications. This versatile instrument can be used to scan various part sizes and surface finishes in real time, all with the same device. Additionally, MOCON, a leading global provider of food package testing instruments, released their latest version of the Dansensor CheckPoint. This new portable headspace gas analyzer provides quality control managers a more precise, faster, and more stable solution for measuring gases in specific food applications using Modified Atmosphere Packaging or MAP. MAPs are used to extend the shelf life for packaged foods and pharmaceutical products requiring specialized packaging. Congratulations to the Land, Creaform, and MOCON teams on these impressive new product developments. Now shifting to acquisitions. The overall M&A market remains relatively quiet given the high levels of uncertainty around the coronavirus and its impact on the economy. That being said, our M&A teams remain very active and we are managing several opportunities. We have a very strong balance sheet and liquidity position and the ability to deploy meaningful amounts of capital on acquisitions. Our preference remains deploying that capital on strategic acquisitions that provide us the ability to add high-quality companies to our portfolio and drive excellent returns for our shareholders. Now turning to the outlook for the remainder of the year. High levels of uncertainty remain given the continuing spread of the coronavirus, especially throughout parts of the U.S. While visibility has improved from this point last quarter, it is still limited as customers remain cautious. As a result, we will not be providing guidance for the third quarter or the full year. We will issue guidance as conditions stabilize and visibility improves. However, I did want to provide some high-level comments around the third quarter and the balance of the year given what we know now. First, we expect to see sequential improvements in the third quarter and fourth quarters with commercial aerospace being the only business not expected to see sequential improvements. Second, we still expect very strong decremental margins at approximately 30% in the third quarter. Lastly, we now expect full-year decremental margins in the 25% range versus our previous estimate of 25% to 30% decrementals. In summary, AMETEK managed well through what was an extraordinarily challenging environment during the second quarter. The strength of the AMETEK growth model was evident in our second quarter performance, and it will continue to allow us to operate at a high level through these dynamic market conditions. We are taking responsible cost actions and continuing to invest in our businesses to ensure they are poised to generate strong growth coming out of the downturn. We also have a robust balance sheet and liquidity position to allow us to capitalize on what we believe will be an opportunistic period for acquisitions. Finally, we're confident that AMETEK will emerge from these challenges a stronger organization, given the growth profiles of our differentiated businesses, the company's financial strength, and most importantly, the impressive level of talent within our world-class workforce. I will now turn it over to Bill Burke, who will cover some of the financial details of the quarter, then we'd be glad to take your questions.

Bill Burke, Executive Vice President and CFO

Thank you, Dave. I'd like to echo Dave's comments on the outstanding efforts of our employees around the world. They continue to deliver exceptional performance during these challenging times. Let me provide some additional financial highlights for the quarter. Second quarter general and administrative expenses were down $1.7 million compared to the same period in 2019 due to lower compensation costs and other discretionary spending cuts. The effective tax rate in the quarter was 19.5%, down from 20.4% in the same period last year. The lower rate in the quarter was due to tax planning initiatives. For 2020, we now expect our effective tax rate to be approximately 19.5%. As we've stated in the past, actual quarterly tax rates can differ dramatically either positively or negatively from this full-year estimated rate. Working capital in the quarter was 19.6% versus 18.3% in last year's second quarter. Capital expenditures in the second quarter were $10 million. We continue to expect full-year capital expenditures to be approximately $75 million, down from our initial expectations to start the year of $100 million. Depreciation and amortization expense in the quarter was $61 million. For the full year, we expect depreciation and amortization to be approximately $260 million, which includes after-tax acquisition-related intangible amortization of approximately $117 million or $0.51 per diluted share. Our businesses continue to generate high levels of cash. Operating cash flow in the quarter was excellent at $315 million, up 20% over last year's comparable quarter. Free cash flow was also outstanding at $305 million, up 36% over the same period last year, and free cash flow conversion was superb at 183% of net income. Total debt at the end of the quarter was $2.87 billion, up modestly from $2.77 billion at the end of 2019 and down $383 million from the end of the first quarter as we repaid a portion of the borrowings under our revolving credit facility. Offsetting this debt is cash and cash equivalents of $1.13 billion. Our gross debt to EBITDA ratio at the end of the second quarter was 2.1 times, as we are intentionally holding higher than normal cash balances. This ratio was comfortably below our debt covenants of 3.5 times. Our net debt to EBITDA ratio was 1.3 times at quarter end, and both our gross and net debt to EBITDA ratios improved by 0.1 turns in the quarter. AMETEK remains well positioned to manage this economic downturn with approximately $2.1 billion in liquidity to support our operations and growth initiatives. This includes over $950 million in available revolver capacity. As we highlighted on our last call, AMETEK has a robust balance sheet with no material debt maturities due until 2023. To conclude, our ability to deliver solid results with outstanding cash generation despite these unprecedented challenges is a testament to the strength of our businesses and the dedication of our world-class workforce. The AMETEK growth model and our financial strength firmly position us to manage this economic environment and invest in future growth to deliver long-term success.

Kevin Coleman, Vice President of Investor Relations

Thank you, Bill. Andrew, could we please open the line for questions?

Operator, Operator

Certainly. And our first question comes from the line of Matt Summerville with D.A. Davidson.

Matt Summerville, Analyst

Thanks. Good morning. A couple of questions. First, Dave, can you talk about what you saw from an organic order standpoint in the quarter and maybe provide some color on kind of what the monthly year-over-year cadence may have looked like from April into July?

Dave Zapico, Chairman and CEO

Right. Our overall orders were down 22%, and organic was down about the same, so really aligned with our sales. Both of our groups were down and really followed sales. We ended up with a book-to-bill of about 0.99. For orders, April was a low point in the quarter; it grew nicely in May and then again in June, following the same trend for sales.

Matt Summerville, Analyst

And then can you talk about your expectation for second-half decrementals? You indicated in Q3 you may be expecting something a little worse than what you had in Q2. So maybe what's driving that? And then maybe put that in the context of the sustainability you see for the record EMG margin performance you generated in the quarter? Thank you.

Dave Zapico, Chairman and CEO

The first point is to address your second question first. The EMG margins were outstanding, primarily due to strong operational performance. We experienced a favorable mix in our defense sectors, and the divestiture of Reading Alloys added 50 basis points at the EMG level. EMG had an excellent quarter, with most of the margin growth attributed to outstanding operational efficiency. Regarding decrementals, we saw good results in both divisions, with 16% decrementals in EMG and 31% in EIG, which are quite commendable. For our Q3 guidance, we are reintegrating some costs as we prepare for a larger fourth quarter. For the entire year, we have revised our decrementals from 30% to 25%. We are focusing on cash management and exploring key growth opportunities.

Operator, Operator

Thank you. And our next question comes from the line of Allison Poliniak with Wells Fargo.

Allison Poliniak, Analyst

Hi guys, good morning. Dave, could you explain the structural cost savings you're implementing? Are these savings being applied across all areas or are they mainly targeted at the more challenged sectors like aerospace?

Dave Zapico, Chairman and CEO

I would say the structural costs are more focused on the more challenged markets. We're resizing those businesses to the new demand level that we have, and they will remain profitable on the way down. The way we're looking at it is that as the businesses started to grow, they will be very profitable on the way up. There was also an element of those structural savings that are pulled forward from projects in our strategic plan. We look forward every three years, and if we encounter a time like this, we pull forward some projects that enhance efficiency and lead to plant consolidations. While the structural savings were across the board, they were mainly targeted at the commercial aerospace and oil and gas business.

Allison Poliniak, Analyst

Great. And then just turning to M&A given you know obviously it's still challenged there. But could you give us a little color on your pipeline in terms of size? Have you pivoted to specific end market verticals? And I guess even just comfort level, just given the uncertainty relative to the size of potential deals you're likely looking at?

Dave Zapico, Chairman and CEO

M&A remains our first priority. We feel there is going to be a substantial opportunity for us to get through this crisis because there's going to be pent-up demand on deals. We have the balance sheet and cash flow capabilities to execute on the opportunity. While the broader deal activity is down right now, we're very active in pipeline development. We actually have a couple of deals we're looking at right now that are larger and smaller. I'm quite optimistic about the pipeline, but you have to realize that to finalize a deal, buyers and sellers have to agree on new pricing expectations. We're adjusting our process because of the difficulty performing face-to-face diligence that we used to take for granted. We still think it will be late 2020 before the market returns to some kind of normal, but we are active on some properties right now. I'm pleased with how hard the team is driving the pipeline, and there are good candidates in our pipeline.

Operator, Operator

Thank you. Your next question comes from the line of Josh Pokrzywinski with Morgan Stanley.

Josh Pokrzywinski, Analyst

Hi, good morning. Dave, can you just remind us with all of the structural and temporary cost elements coming in, and I know you're still kind of leaving it open on the fourth quarter based on demand, how should we think about incremental margins for next year? Gross margins are high, so volume recovery would feel pretty good. But if I had to cross-check that against maybe some of the temporary costs that come out, should we think about that differently? Or is it fair to say that incrementals can start with a three next year?

Dave Zapico, Chairman and CEO

Right. That's a great question. I don't think there's any doubt that incrementals can start with a three. If you look at past downturns, AMETEK has really driven margin expansion as we come out of the downturns. The temporary costs we're going to put back in as we progress throughout the year, but that’s not stopping us from putting up positive incrementals. So I think largely, you're going to end up with contribution margins in 2021 in that kind of range, and I’m optimistic about that.

Josh Pokrzywinski, Analyst

Got it. That's helpful. And then kind of a two-part second question. First, anything on July, I think Matt Summerville asked about it, but I don't know if there is anything specific? And maybe talk around the role of backlog in some of the momentum? Are you feeling like you're living hand to mouth in most of the businesses or was backlog kind of distorting 2Q where there are still some longer cycle businesses that need to run off?

Dave Zapico, Chairman and CEO

No, our backlog is pretty flat at $1.7 billion. If you start with Q2, our sales, April was the worst and improved in May and further improvement in June. July looks supportive, but we think we'll be down roughly 50% in the third quarter. That’s our current estimate, but there are many uncertainties.

Operator, Operator

Thank you. And our next question comes from the line of Nigel Coe with Wolfe Research.

Nigel Coe, Analyst

Thanks. Good morning. You mentioned research. I'm just curious how your research end markets performed. Can't imagine the stay-at-home, work-from-home trend is really helpful there. So just curious what you're seeing there, because I know that's more of an EIG kind of exposure?

Dave Zapico, Chairman and CEO

I'll break the research market into a couple of different areas. In the material science area of research, both university and corporate R&D, it was weak; those projects have been pushed to the right. But in the life sciences area, the market is holding up very well. Gatan has performed very well, slightly ahead of our expectations, and actually had flat revenue year-over-year in the second quarter. Gatan products have been influential in the fight against COVID. In fact, researchers at the University of Texas used the Gatan K3 camera to structurally image the spike protein on the coronavirus. That's driven a lot of excitement in demand around the demand tools. Gatan K3 was the first to structure the coronavirus, getting those first images out quickly.

Nigel Coe, Analyst

Okay, so on balance, it doesn't feel like it's any worse than the average. And then maybe just a little bit context on the geo markets. If you could give us how U.S., Europe, China, etc., are performing versus... and then just on the export exposure, has that changed materially over the last several years? And I'm just curious how the U.S. dollar weakness maybe benefits you going forward?

Dave Zapico, Chairman and CEO

We’re naturally hedged at the top-line and bottom line based on currency. So the currency swing doesn't really impact our profitability. When the dollar weakens, we do get more competitive, which is beneficial because we export over $1 billion. In terms of the geographical storyline, we have broad-based weakness, and Europe and the U.S. were most challenged. Europe was down 29% on broad weakness and it also had a difficult comp due to some Middle Eastern project business for our oil and gas business. The U.S. was down about 20% but it was quite broad-based, while Asia was the best of the markets that was down mid-teens. We saw notable strength in Asia in our automation business, and China improved for us, as it was actually up 3% driven by our automation and CAMECA business.

Operator, Operator

Thank you. And our next question comes from the line of Deane Dray with RBC Capital Markets.

Deane Dray, Analyst

Thank you. Good morning, everyone. I did notice that you guys put free cash flow in your release for the first time, and we really do appreciate that.

Dave Zapico, Chairman and CEO

I'll let Kevin know that. Kevin has got a smile on his face.

Deane Dray, Analyst

I'm sure he does because I've pestered him about that for quite a while, but we really do appreciate it. Now I feel obligated to ask a free cash flow question. Here it is. Did you benefit at all from the timing of tax payments? We've seen other companies that have had upside on free cash flow. So was that a factor?

Dave Zapico, Chairman and CEO

Not a huge factor, Deane. It was probably about $18 million. So that $183 million would still be a strong number, probably in the mid-160s to 170 kind of a place.

Deane Dray, Analyst

I appreciate how you categorize the business into those three segments to provide real-time insight into the COVID impact. In the last quarter, I believe you placed defense in the better category, which can be verified. Can you provide some insight on defense? Should it remain in that category?

Dave Zapico, Chairman and CEO

Defense is in the good markets both last quarter and this quarter. Our defense business is about 5% of the company, and it's doing extremely well. It was up low-double-digits in the quarter. While the commercial market was challenged, the defense market was strong. So that's why it's in the better bucket.

Deane Dray, Analyst

Great. And then on Gatan, I really like that update there and especially on the imaging of the spore. When is the next generation due to be released? Will that be the K4?

Dave Zapico, Chairman and CEO

It is. There is a K3 Plus and the K4; we're working on both. We haven't announced when the next one will come to market.

Deane Dray, Analyst

Terrific. All right, last question on capex. You had cut $25 million out just for cash preservation. When might that come back? And just share with us a bit of your decision-making as to what you would trim and why? And when you bring back, what types of projects do you bring back on?

Bill Burke, Executive Vice President and CFO

The important point for us is our R&D spending is roughly flat with 2019. We thought that was going to be up coming into the year and we trim that back to flat, but we're really investing in R&D. The types of things we've delayed are expansions in regions of the world where we were trying to put extra capacity in place. Those types of projects got delayed. We have decentralized the entrepreneurial team, and they understand the situation, so they make natural decisions. I can see as we get later in the year, evaluating turning on some of those expansion projects we have in different geographies that we put on hold.

Operator, Operator

Thank you. And our next question comes from the line of Rob Wertheimer with Melius Research.

Rob Wertheimer, Analyst

Thanks, and good morning, everyone.

Dave Zapico, Chairman and CEO

Good morning, Rob. Congratulations on the book.

Rob Wertheimer, Analyst

Thank you so much. It's kind. So I just have two questions on the temporary side, if I can. I think last quarter you talked about delays and difficulties in getting to customer sites or whatever, pushing out a little bit of revenue. Is that still ongoing? And does that come back at any point? That's the first.

Dave Zapico, Chairman and CEO

That certainly was with us throughout all of Q2, and it's still a bit of an issue, especially now traveling in the U.S. You can travel, but you’re quarantined. That was a big issue in China. Now that's abated, but it’s a spotty issue around the world. It was a big factor in Q2, and it will be a diminishing factor in Q3.

Rob Wertheimer, Analyst

And then does that lead to a few points of revenue that come back to you in Q4 or is there a risk that it cancels or is it too small?

Dave Zapico, Chairman and CEO

No, that will come back. They’ve been rescheduled, but it will definitely come back.

Rob Wertheimer, Analyst

Perfect. And then on the cost side, if I may, can you kind of roll the temporary costs indefinitely? The way you described it, it’s obvious that commercial aerospace maybe is in trouble, oil and gas for a bit. More permanent restructuring appropriate there. But for the other markets that are just depressed during COVID and we don't know when it comes back, can you roll that indefinitely or does there come a point where costs have to come back in the system?

Dave Zapico, Chairman and CEO

That's a good question, Rob. We think we got the balance correct. We believe those temporary costs will come back during the year, but if it gets to the point where there is a diminished long-term outlook for revenue, we can’t run with the temporary costs forever. We certainly don’t view that as a long-term situation.

Operator, Operator

Thank you. And our next question comes from the line of Christopher Glynn with Oppenheimer.

Christopher Glynn, Analyst

Thanks. Good morning, everyone. Dave, you talked about various adaptations in delivering and administering some of your aftermarket services. I'm curious if there are any businesses developing delivery models that could serve as productivity enhancements and persist post-COVID.

Dave Zapico, Chairman and CEO

That's really the case. The accelerated adoption of digital capabilities is opening our eyes. It's in digital marketing and the way we interact with our customers. Our complex systems that need to be installed and calibrated require technicians to interact with engineers. We need to find a way to get together, and there’s spontaneous productivity that comes with people getting together. We’re using the tools and managing safely and getting good progress, but it’s not ideal. But the digital tools are mitigating problems. So some of those solutions will be long-lasting.

Christopher Glynn, Analyst

Okay, thanks. And then in terms of the third quarter outlook for kind of everything getting a little better versus other than commercial aerospace, any areas you could call out where you're seeing the sharpest kind of rebounds, particularly anything getting back to normal?

Dave Zapico, Chairman and CEO

Our automation business is bringing us back. That's doing well. Our oil and gas business will recover, but that’s due to the lack of a comp as much as anything. So those are two businesses we believe will recover, and I think our defense business will be strong. We also see that in the medical space. COVID-related products like testing and breathing apparatus were strong, but elective surgeries tail off. Our med-tech customers tell us elective surgeries are going to rebound in the second half of the year.

Operator, Operator

Thank you. And our next question comes from the line of Scott Graham with Rosenblatt Securities.

Scott Graham, Analyst

Hey, good morning, Dave, Bill, Kevin. I wanted to understand a little bit more on the cost side where you talked about the third quarter your cost reductions are going to be $65 million. If my calculations here are right, you were a little bit below what the annualized number would be for structural in the quarter, and that should pick up in the second half of the year, which would suggest a pretty significant reduction in your temporary in the third quarter. Yet you're not providing full year EPS guidance.

Dave Zapico, Chairman and CEO

There are too many variables and uncertainties to give guidance with our difficult precision. I appreciate your question and understand that information typically in normal times. We withdrew our guidance and don’t feel comfortable putting it back in place yet due to COVID and the lack of visibility.

Scott Graham, Analyst

Understood. Thank you. And a couple of others, if you could. Typically, you give that by business unit stuff. Could you just call out specifically what you saw in automation, power, research specifically? And maybe if you could split for us commercial aerospace, OE versus aftermarket?

Bill Burke, Executive Vice President and CFO

Overall sales in our process business were down high-teens in the quarter. We had contributions from Gatan, offset by organic sales declines in line with AMETEK’s organic sales decline. We talked about widespread travel restrictions, project pushouts, and delays in our ability to provide services due to the global shutdown. The largest weakness in process was in our oil and gas business. Our medical businesses performed well in the quarter. The Zygo business experienced solid growth driven by some semiconductor fabrication work. While end markets remain challenged, we expect to see sequential improvements in the third quarter and fourth quarters across our process businesses, including oil and gas. The defense business was up low-double-digits in the quarter, while the commercial business was down in the high-40s. In commercial aerospace, the aftermarket was a little worse, and the OE was a little better. The expectation for our defense businesses is that they will stay strong through the third and fourth quarter. The commercial aerospace business is bouncing around at the bottom, and we're not anticipating any improvement.

Operator, Operator

Thank you. And our next question comes from the line of Ivana Delevska with Gordon Haskett.

Ivana Delevska, Analyst

Good morning, guys. I wanted to ask about the structural cost opportunities as we get into next year. I know there was some volume-related benefits that you were originally expecting to get this year that may get pushed out to next year. Could you just give us a sense of how next year is shaping up? What will be the different buckets?

Dave Zapico, Chairman and CEO

Sure. We haven't done much planning for next year at this point. But we do know we’ll probably have about $50 million to $45 million flowing into next year from the structural reductions we did in 2020. So we’ll have a good head start on whatever cost reduction plans we put together. We typically have a pretty healthy project list that we decide during our budgeting process. We haven't planned much yet, but we have a good start.

Ivana Delevska, Analyst

How much was the volume like sourcing expected to help this year that didn't materialize because of the environment?

Dave Zapico, Chairman and CEO

Sourcing was a big driver, and I can’t give you an exact number from memory. But we probably lost about $10 million to $20 million on sourcing savings because the volume isn't there, which we made up by other structural savings.

Ivana Delevska, Analyst

Perfect. Just one more question in terms of synergy realization. Could you compare next year to this year in terms of how much synergies you expect from the different deals and the timing?

Dave Zapico, Chairman and CEO

We’re on track with all of our deals. I mentioned Gatan; it's the biggest deal we did last year, and we just did a review of that business. We're slightly ahead of our acquisition model. When we combine that business with our EDAX business, it drives synergy as they have the same customer base. All of our acquisitions are progressing, and we need to focus on synergy. It’s tough to quantify that right now for 2021, but we’ll typically report that in the beginning of 2021.

Operator, Operator

Thank you. And our next question comes from the line of Andrew Obin with Bank of America.

Andrew Obin, Analyst

Hi guys, good morning. One of the companies that I covered today took a stab at when they thought revenues were going to turn flat year-over-year. Would you guys care to guess if and when that happens?

Dave Zapico, Chairman and CEO

I’m not going to guess that.

Andrew Obin, Analyst

Okay. You guys highlighted automation doing well. Are you seeing any of your customers moving their supply chains around the globe? What are the sources outside of China of automation doing well?

Dave Zapico, Chairman and CEO

We are seeing supply chains regionalizing. There was overdependence on China in the past, but many companies are reconfiguring their supply chains. Those seeds are just beginning now, but this will be a good long-term driver for us. Manufacturing inefficiencies due to reshoring are already beginning to take root.

Andrew Obin, Analyst

What industries are you seeing this reshoring in, particularly in North America?

Dave Zapico, Chairman and CEO

It’s just the beginnings; companies want more durable regionalized supply chains, and retailers will be looking for production and intake volume increases in places like the U.S. and Europe.

Andrew Obin, Analyst

On the M&A front, you highlighted that you're engaged in some due diligence. How do you look at your firepower in terms of how much you can spend on M&A over the next couple of years? How big a deal can you guys get to?

Dave Zapico, Chairman and CEO

We can certainly look at our free cash flow, which is over $1 billion year type thing. Our liquidity of about $2.1 billion means we can support several deals of a couple of billion dollars.

Bill Burke, Executive Vice President and CFO

Dave, you mentioned the $2 billion; we could do more than that and still remain below our covenants. This is not a capital constraint strategy; it’s about finding the right businesses to drive returns. But the strength of the balance sheet supports several deals.

Andrew Obin, Analyst

More appetite for larger deals going forward?

Dave Zapico, Chairman and CEO

We’re looking at larger deals as well. Gatan was close to $1 billion, and we have some businesses in our pipeline right now at that size.

Operator, Operator

Thank you. Your next question comes from the line of Andrew Buscaglia with Berenberg.

Andrew Buscaglia, Analyst

Good morning, guys. Can you comment on the price versus cost in the quarter?

Dave Zapico, Chairman and CEO

We achieved about a point and a half of price across the entire business. Total inflation and the impact of tariffs were a little less than 1%. We see a positive spread added to margins, which helped margin performance in the quarter.

Andrew Buscaglia, Analyst

Okay. And David, can you update us on what you're seeing, what you're hearing from customers about aerospace outlook over the next couple of years?

Dave Zapico, Chairman and CEO

It's going to take several years to get passengers back to the same volume in 2019. Our base model for aerospace assumes that there’s a medical solution to the virus. People have to be comfortable flying again, which will take time. We’re balancing our aerospace, military business is doing extremely well. We have a high-quality set of businesses and are strategizing to focus on a diverse set of markets. We think we are well-positioned.

Operator, Operator

Thank you. Your next question comes from the line of Richard Eastman with R.W. Baird.

Richard Eastman, Analyst

Yes. Thanks for the questions. Dave, just to expand on your last answer, could you just recalibrate us on the percentage of the business in AMETEK that is aerospace? And also how the four businesses will perform for '20?

Dave Zapico, Chairman and CEO

Aerospace comprises 15% of sales; 5% of that is military, and 10% is commercial. In commercial aerospace, we’re not seeing a clear recovery path moving forward and call it maybe down 45% for the balance of the year. For our other businesses, we believe there will be sequential improvements in the third and fourth quarters across the board.

Operator, Operator

Thank you. And our next question comes from the line of Joe Giordano with Cowen.

Joe Giordano, Analyst

Hey guys. Good morning. Could you just comment on organic performance in EIG versus EMG in the last quarter? I’m curious how that flipped during the quarter?

Dave Zapico, Chairman and CEO

We didn’t signal that EIG would be better than EMG. We did talk about the automation business getting stronger. We talked about the military business and commercial aerospace. We anticipated weakness there, and oil and gas was weak, and those are predominantly in EIG.

Joe Giordano, Analyst

On R&D side can you talk about how R&D is critical? What has changed to allow R&D to progress in this environment?

Dave Zapico, Chairman and CEO

I’m pleasantly surprised at the quality and effectiveness we’re maintaining. But it’s not ideal; technicians need to interact with engineers to find a way to get together. Spontaneous productivity that comes with people getting together is missing. We're using digital tools to mitigate issues. We’re making good progress, and some of those solutions will be long-lasting.

Operator, Operator

Thank you. Ladies and gentlemen, this concludes today’s conference call. Thank you for participating. You may now disconnect.