Earnings Call Transcript
REGAL REXNORD CORP (RRX)
Earnings Call Transcript - RRX Q2 2020
Operator, Operator
Good morning. Welcome to Regal Beloit’s Second Quarter 2020 Earnings Conference Call. All participants will be in listen-only mode. Please note that this event is being recorded. I would now like to turn the conference over to Robert Barry, Vice President of Investor Relations. Go ahead.
Robert Barry, Vice President of Investor Relations
Great. Thanks, Kate. Good morning, everybody. Welcome to Regal Beloit’s Second Quarter 2020 Earnings Conference Call. Joining me today are Louis Pinkham, our Chief Executive Officer; and Rob Rehard, our Chief Financial Officer. Before turning the call over to Louis, I would like to remind you that the statements made in this conference call that are not historical in nature are forward-looking statements. Forward-looking statements are not guarantees since there are inherent difficulties in predicting future results, and actual results could differ materially from those expressed or implied in forward-looking statements. For a list of factors that could cause actual results to differ materially from projected results, please refer to today’s earnings release and our SEC filings. On Slide 3, we state that we are presenting certain non-GAAP financial measures in this presentation. We believe that these are useful financial measures to provide you with additional insight into our operating performance and for helping investors understand and compare our operating results across accounting periods and in the same manner as management. Please read this slide for information regarding these non-GAAP financial measures, and please see the appendix for reconciliations of these measures to the most comparable measures in accordance with GAAP. Now let me briefly review the agenda for today’s call. Louis will be leading off with his opening comments. Then Rob Rehard, our CFO, will provide our second quarter financial results in more detail and discuss how we’re thinking about the remainder of the year. We will then move to Q&A, after which, Louis will have some closing remarks. Now I will turn the call over to Louis.
Louis Pinkham, CEO
Great. Thanks, Rob. And good morning, everyone. Thanks for joining us to discuss our second quarter earnings and get an update on our business, and thank you for your interest in Regal. To be direct, this was a challenging quarter as the impacts of this unprecedented global pandemic weighed heavily on our orders and sales, constrained some of our key manufacturing operations and supply chain and presented an array of professional and personal challenges for our associates. So before going further, I want to take a moment to thank all of my Regal colleagues around the world for their hard work, their resourcefulness, and their sense of duty as they work to serve and support our customers with essential products during this challenging time. I also want to thank them for their sense of discipline, and in some cases, I might even say sacrifice, enduring pay cuts and adhering to strict safety measures, which may be uncomfortable at times to ensure not only their own health, but also the health and safety of our entire Regal family as well as our company’s ability to be there for our customers. While the second quarter was tough, I’m also extremely proud of all that we accomplished through a relentless focus on what we can control and by delivering very strong execution. Indeed, controllable execution was our mantra in the second quarter and will remain so for the foreseeable future. And so despite having to navigate many challenges presented by COVID-19, the Regal team delivered on a wide range of targeted cost actions resulting in a 15% deleverage rate for the quarter. We also made progress on working capital, which, along with the low deleverage rate and our CapEx discipline, drove just under $80 million of free cash flow in the quarter for a cash conversion rate of 255%. And even amidst the host of top line challenges, the team managed to find pockets of opportunity to drive some share gains. Before getting further into our second quarter financial results, I’d like to update you on a few important operational items. First is safety. We run Regal guided by SQDCG. This principle is reverberating through the halls of our offices and down the lines of our production plants, and frankly, on the videoconferencing calls that continue to support so many of our daily interactions; safety, quality, on-time delivery, and cost, which will drive growth. But safety always comes first. On our last call, I shared a host of measures we implemented to help our associates stay safe from COVID-19, and I won’t repeat them all today. But what I do want to share is that we’ve continued to refine and improve these safety protocols through a regular cadence of formal best practice sharing, which have included actions such as virtual Gemba walks to get more eyes evaluating our safety measures in practice; we think many of our protocols have become best-in-class. In fact, as an example, we have on more than one occasion been approached by regional officials in the Mexican government who want to learn about and share our COVID-related safety practices. We opened our plant to them and shared all we do. And I think I speak for all of my colleagues at Regal when I say we have been proud to step up as a good corporate citizen in this way. I have to acknowledge that balancing the need to produce essential products during a pandemic while also keeping our associates safe has not always been easy. In fact, it’s been hard. But we think we’re doing it in an effective, fair and appropriate manner. That said, despite our best efforts, the pandemic has had some unavoidable negative impact on our operations. While all of our facilities around the world are currently operational, our capacity levels in Mexico and India, in particular, are not quite where we want them to be. In Mexico, for example, throughout all of the second quarter, roughly 15% of our workforce was out with full pay on a government-imposed medical decree. Clearly, a financial headwind. But the less obvious nuance is that many of those out on medical decree are generally more experienced associates who have more advanced training and skills which has an outside impact on our throughput. And as I shared with you on our last call, one of our principal operations in Mexico was closed for nearly three weeks in the quarter as we worked with local government authorities to navigate an evolving and sometimes inconsistent body of regulations to clarify the essential nature of our products. I believe, however, that it is important to acknowledge that we are still managing through a precarious period. In particular, while I’m proud of our actions to ensure the safety of our associates inside all of our facilities, we’ve increasingly been finding vulnerabilities to our operations stemming from behaviors by our employees outside of the workplace. Indeed, in a couple of cases, we have had employees contract the virus, which our tracing protocols determined likely resulted from non-workplace interactions. In such cases, we’ve had multi-day periods of downtime to properly clean the facilities. Beyond Mexico, our operations in India were impacted by a mandatory three-week nationwide shutdown during the quarter, followed by a gradual phased reopening based on each local state government’s guidelines. Some of our facilities were impacted for up to six weeks and also faced material supply chain challenges as certain of our vendors experienced labor shortages during the initial reopening of their facilities. In the face of these simultaneous multi-continent constraints on our operations, the Regal team responded with a sense of urgency and started to shift production elsewhere in our global network. This is a core differentiator for Regal, our global yet local supply chain. But even moving quickly, the process of adjusting our supply chains took longer due to the virus. In instances where customers needed to certify a substitute product or a product made in a different facility or both, the timeline for resuming production took longer. And because as we made these footprint adjustments, we retained strict adherence to SQDCG; safety first, then quality, then delivery. In a number of situations, we incurred expedited freight costs to bolster our service levels. And in other cases, which we believe are relatively isolated, these disruptions have had an impact on our ability to fully service our customers, although those situations have improved greatly. The other consequence of these operational challenges is ending the quarter with a sizable backlog, particularly in our commercial motors business. Shipping less of our backlog weighed on our top line performance in the second quarter. On the flip side, we expect a benefit to sales in the third quarter as we execute down our elevated backlog position. All that said, I firmly believe that by leveraging our global capabilities, executing with urgency and adhering to our 80/20 principles, our teams minimize the impact to Regal from these manufacturing disruptions. And as we’ve come through the pandemic, we see even greater value in our diverse global footprint. As of today, our operations in India are running at roughly 90% capacity with our Mexico operations slightly below this level. Our teams in China and Southeast Asia have also contributed significantly to expanding our capacity after executing with urgency to adjust supply chains and achieve requisite customer certifications. As a result, we expect to see tailwinds in the third quarter as we reduce our backlog. Also on the operational front, I’m happy to report that our absenteeism rates are at a normal level across our business. And while we saw pockets of disruptions among our supply chain in the quarter, these currently are very limited and not impacting our operations in a material way. Shifting to orders, I’d call this a bright spot. After tracking down 31% in April and down 27% in May, orders improved to down 14% in June and were down only 7% in July. Notably, we believe our bearings business in the PTS segment, a good barometer for short-cycle industrial demand, bottomed in May and has remained stable. Our pool pump and residential HVAC businesses also saw meaningful improvement in orders during the quarter, which continued in July. That brings me to guidance. Our guiding principle here is trying to provide our investors and analysts with a meaningful view on how we think the business can perform without making too many assumptions where we have limited visibility or no unique insights. For this reason, as a short-cycle business without a sizable backlog, operating against the backdrop of uncertainty tied to COVID-19, we are not providing a 2020 outlook at this time. However, we do feel comfortable sharing more detail on how we see the third quarter shaping up. Based on our recent order rates, our backlog, the current state of our manufacturing operations and supply chain, we think our third quarter adjusted net sales will decline in a range of 8% to 12%. From a margin perspective, we think we can deliver at a rate of 12% to 18%, with the midpoint of that range similar to the performance we delivered in the second quarter. Rob will provide further details on this topic in his remarks. One point I do want to emphasize in advance. We continue to have ample cash and a very secure balance sheet. In fact, given our strong first half cash flow generation and improving orders, we felt comfortable fully paying down our revolver in the second quarter after drawing it down last quarter in an abundance of caution when we were in the earliest days of COVID-19. As business conditions started to show signs of bottoming, with prospects for full recovery tenuous and a path out of this recession likely protracted, we decided to recalibrate our cost-out actions as we executed the quarter. As a result, after careful consideration, we made the difficult decision to implement a reduction in force and also to offer an early retirement program in late June, which together impacted roughly 4% of our salaried associates globally, and while we estimate will result in permanent annualized cost savings of about $7 million. On the flip side, with our fighting team now in place and a lot of hard work ahead of us on the cost and growth fronts, including executing on our backlog, we thought it made sense to end the furloughs and pay reductions we had implemented in the second quarter. As a reminder, those actions drove roughly $6 million of temporary savings in the quarter. In addition to these actions, we remain prepared to take additional measures if needed as impacts of the virus, including any second wave, continue to develop. Before turning it over to Rob, I want to share a few operational highlights. Our second quarter revenue was down 24.7% on an organic basis. We attribute the vast majority of that decline to pressures related to COVID-19, which impacted demand levels in North America and in our European businesses and also contributed to the manufacturing disruptions and backlog increases I noted earlier. To a lesser extent, our proactive 80/20 pruning efforts also created 190 basis points or $16 million headwind to sales in the second quarter as we continued to deprioritize our lowest margin accounts. Despite this revenue pressure, we executed on our 80/20 initiatives and other cost actions and posted a year-over-year adjusted gross margin improvement of 80 basis points and held our operating margin decline to 160 basis points. That translated to a 15.5% deleverage rate in the quarter, well below historic levels and below the low end of the framework we provided at Q1, owing largely to stronger execution on our cost-out actions. I remain very pleased with how our Regal team is driving 80/20, lean productivity and supply chain improvements, along with SG&A reductions to simplify our business and provide more attractive deleverage rates. Our strong controllable execution helped us deliver $0.95 of adjusted earnings per share in the second quarter. And while that’s down 36% from prior year, it’s better than some of our more concerning scenarios had implied during our early days of the pandemic. Looking across our segments, both PTS and Industrial posted a meaningful year-over-year operating margin expansion, with PTS operating margins up 120 basis points and Industrial operating margins improving 420 basis points, with Industrial also achieving a nice improvement in adjusted operating profit dollars at $5.2 million for the second quarter. And all these gains were achieved while confronting severe top line headwinds, with Industrial sales down 19.8% and PTS sales down 21.1% on an organic basis. These operating margin gains are being driven primarily by very strong execution on our cost-out initiatives with some added boost for mix. We’re happy with the margin gains we’ve realized in Industrial and see a clear path to significant further upside. You remember that Regal was in the enviable position of having defined an extensive multiyear margin enhancement program at the end of 2019. So our focus during coronavirus has been keeping our heads down and executing those well thought-out plans. Our commercial and climate businesses also face significant COVID-related challenges in the quarter in addition to significant end market headwinds that weighed on these segments' top lines, including North America industrial and commercial HVAC markets in the commercial segment, along with factory disruptions and significant residential HVAC OEM destock and tough furnace prebuild comps in climate. Commercial saw an organic sales decline of 23.6%, while climate sales were down 31.4% on an organic basis. In this context, I feel the commercial team delivered very strong controllable execution, in particular on executing their cost-out initiatives, which kept the deleverage rate in the segment to 20%. Notably, June was one of the strongest performing gross margin months for our commercial business in the last 18 months, evidencing the positive margin momentum in that business. I believe our climate team also did a solid job executing on what was under its control. But candidly, the degree of top line pressure that business experienced, along with higher carrying costs due to government-imposed capacity restrictions in Mexico and India brought deleverage rates in at 28.5%. While that’s within the broader scenario framework we outlined in Q1, it’s still not quite where we want this segment to be. The good news for both commercial and climate is that we saw orders start to rebound nicely as the quarter ended in July. For example, after a challenging first quarter in our pool pump business in commercial, pool pump orders were up 49% year-over-year in June and tracked up about 30% in July. Within our climate business, HVAC orders were up 9% sequentially in May, up another 25% in June, with July orders up an additional 26% to a level that is roughly flat in dollar terms versus the prior year. In our distribution business within climate, orders were down 26% for the quarter, but up 43% sequentially in July versus June. So we’re very encouraged about what we’re seeing and feel the resilience in end-user demand that many of our customers are seeing in pool and HVAC is starting to benefit our business. As a result, based on what we see today, we are cautiously optimistic that we will see a substantial rise in our climate segment margins in the second half of this year relative to the second quarter levels. Before concluding, I would like to take a moment to highlight a couple of recent positive developments. One is that despite battling COVID-related sales and operational headwinds, some of our teams were able to achieve some nice share gains in the quarter, particularly in the data center market, in alternative energy, both wind and solar, and in the warehousing and distribution space. On the latter, our ModSort high-precision conveying system continues to see great traction in the market as warehouse operators look to advance social distancing objectives by automating what can typically be densely staffed last-mile package sorting operations. As I have said previously, Regal is no longer focused on big bang R&D investments that have varying degrees of success, but rather on more focused initiatives aimed at solving specific problems defined by the voice of the customer, which tend to drive more reliable, yet incremental growth gains. Second, I wanted to update you that we filled the last open position on my executive leadership team. Our new Head of the Regal Business System joined two weeks ago. We see opportunities to run our business better from a supply chain and manufacturing perspective, and we look forward to moving more aggressively on this front in the coming quarters and years. We’ll keep you updated as potential upside from our four walls lean and supply chain initiatives come into sharper focus. And with that, I’ll turn it over to our CFO, Rob Rehard, who will take you through the second quarter results in more detail and share our thoughts on the third quarter.
Robert Rehard, CFO
Thanks, Louis, and good morning, everyone. I want to echo Louis' comments about the second quarter being particularly challenging, but our Regal associates have remained focused on executing what they can control. We achieved a 15.5% deleverage rate, which is better than what we projected after our first quarter earnings call, especially considering the cost headwinds from COVID at our facilities and $77 million of free cash flow for a cash conversion rate of 255%. The top line was mainly affected by the coronavirus' first and second derivative impacts. In our first quarter, the geographic impact of COVID was more pronounced in Asia and Europe, where we made about 25% of our sales. However, in the second quarter, the Americas were more heavily impacted, where we generate 75% of our sales. Although we saw some recovery in Asia, Europe continued to experience pressure, and North America was notably affected, as reflected by our 24.7% organic sales decline. On a positive note, as the quarter went on, our order rates improved, with July's orders showing a 7% decline. In our consumer-driven sectors, like residential HVAC and pools, we noticed a more significant recovery in orders. I'll provide further details as I go through our segment results. In the commercial sector, organic sales in the second quarter were down 23.6% from the previous year, primarily due to volume declines, especially in our North America general industrial and commercial HVAC markets and our Europe air moving business. However, our backlog in this sector increased as we focused on serving our customers while navigating challenges at our plants and supply chains. We also faced some minor headwinds from our ongoing efforts to prune low-margin accounts as part of our 80/20 initiatives and foreign exchange. Our pruning efforts contributed roughly 150 basis points to the organic sales decline. Regarding our pool pump business, which was adversely affected in the first quarter due to COVID-related production delays in China, that facility resumed operations in April and is now fully operational. Some production in Mexico faced minor COVID-related challenges. From a demand perspective, our pool pump business showed positive momentum during the quarter. Orders for the quarter were down 4%, but by June, orders had increased by 49% compared to the previous year and July orders were up 30% year-over-year. With our manufacturing facility in China back to full production and our Mexico facility nearly at full capacity, we feel confident in our ability to meet customer service levels throughout the pool season. It’s worth noting that the commercial market in China showed significant improvement this quarter as we continued to implement our 80/20 customer segmentation initiatives discussed during our last earnings call. The adjusted operating margin for Commercial Systems in the quarter was 6%, down 350 basis points year-over-year, primarily due to the volume decline, higher freight costs, and increased inefficiencies in manufacturing due to COVID. We managed to counteract these headwinds with substantial cost reductions and some benefits from favorable price/cost dynamics. Our deleverage rate for the quarter was 20.2%, which is impressive given the challenges this business faced and significantly lower than historical deleverage rates. Orders in the commercial sector decreased roughly 23%, indicating specific weaknesses in Europe and the North American general industrial market, with Asia and our pump business standing out as strengths. In July, orders decreased by 1%, reflecting the same dynamics we observed over the quarter. This marks a solid recovery, and we remain hopeful it will persist in the upcoming quarter. In the industrial sector, organic sales dropped 19.8% year-over-year. This segment experienced double-digit declines mainly due to COVID-backed challenges in general industrial, non-residential construction, and oil and gas markets, particularly in Europe. This decline was partially offset by stronger sales in the data center market, where our products supply standby power. We also saw our proactive pruning of low-margin accounts, which accounted for about 180 basis points of the organic sales decline. The adjusted operating margin for industrial was 4.3%, increasing 420 basis points year-on-year, driven by our 80/20 initiatives, ongoing cost reductions, favorable price/cost dynamics, and a favorable mix, despite the impact of reduced volumes. While we still have a long way to go to elevate our industrial operating margin to a satisfactory level, we were pleased to see a meaningful improvement in the second quarter given the major obstacles posed by COVID. The industrial team has effectively managed what they can control. Orders in the industrial sector were down 18%, but would have declined more if not for the strength in the data center business. The impact of COVID-19 grew more pronounced at the start of the second quarter, with April industrial orders down 27%. However, we observed improvements as the quarter progressed, with July orders down 15%. Shifting to Climate Solutions, organic sales declined 31.4% compared to the previous year, mainly due to inventory destocking at our HVAC OEMs and within the residential HVAC channel, alongside pressure on our commercial refrigeration business, which represents only 8% of segment sales but faced a considerable year-over-year drop due to its ties to the hospitality market. Additionally, last year’s climate segment had a favorable volume impact due to OEM prebuild activity tied to a furnace energy efficiency regulatory change, which created a challenging comparison this year. Last year, we noted about $9 million of early pull-ahead related to the regulation, most occurring in the second quarter. Generally, our sales of energy-efficient furnaces provided a positive mix in the second quarter, but its impact was mitigated by previously mentioned end market challenges. Weather had a neutral to slightly positive impact overall in the second quarter, acting as a headwind in April and May but shifting to a tailwind in June, with particularly favorable conditions in July. The organic sales decline also resulted from our proactive pruning efforts, which affected sales by 300 basis points. The adjusted operating margin for the climate segment was 12.4%, down 520 basis points from the previous year. Continued cost reductions helped partially counterbalance the pressures from volume and mix. The deleverage in this segment was 28.5% this quarter, consistent with the scenario we presented last quarter, but still slightly above our preferred range. We attribute the weaker deleverage to significant COVID-related declines in the top line and subpar absorption at certain principal manufacturing operations in Mexico, largely due to government-imposed health measures and challenges related to product mix. On a more positive note, we’ve noticed meaningful improvements in climate segment orders throughout June and July. We are cautiously optimistic about significant improvement in the segment's operating margin in the second half of this year, beginning in the third quarter. Orders in the climate segment fell by 34%, primarily because of COVID-related challenges in HVAC and commercial refrigeration, which constitutes about 10% of the segment and saw 40% fewer orders. In July, orders decreased by 6%, with notable growth in Asia, a slight decline in North America, and a substantial decrease in Europe, which represents 7% of the segment and is significantly reliant on the hospitality market, still impacted by COVID-19. In summary, we are witnessing significant sequential improvements in order rates in both May and June, and again in July within the climate segment. Moving onto Power Transmission Solutions, organic sales were down 21.1% compared to the previous year, largely due to substantial pressure on the North America general industrial market, along with some challenges in upstream oil and gas, fluctuations in the alternative energy market, our efforts to prune lower-margin business, and foreign exchange influences. Our pruning efforts impacted sales by about 100 basis points in the second quarter. However, we did see some growth in midstream oil and gas due to existing project activity, along with modest growth in China and the agricultural sectors. Although our exposure to oil and gas is only around 5% to 7% in the PTS segment, and mainly in midstream, severe upstream declines significantly affected sales performance for the quarter in this segment. The adjusted operating profit for PTS fell by $3.6 million despite a year-over-year sales decline of $45 million, marking an 8% deleverage. The operating margin for PTS this quarter was 13.6%, an increase of 120 basis points from the previous year. Ongoing cost reductions, along with favorable mix and slight positive price/cost, more than compensated for volume-related pressures. Orders in PTS were down around 18%, influenced largely by headwinds in the general industrial and upstream oil and gas markets. In July, year-over-year orders were down 10%, still facing broad-based headwinds, although our short-cycle industrial-focused bearings business started to stabilize during the second quarter. May seemed to be the lowest point for this business; however, improvements in June and July have been limited, with customers mainly ordering based on current needs rather than restocking. We believe channel inventories for bearings are quite low, and anticipate a boost in this area once end-user confidence increases and restocking begins. To summarize a few financial highlights for Regal in the second quarter, our capital expenditures totaled $9.5 million. We are focused on ensuring our capital deployment yields returns above our weighted average cost of capital and enhances shareholder value. We closely monitor these expenditures and maintain our full-year spending expectation at $50 million. The adjusted effective tax rate for the quarter was 22.4%. We provided a table in the appendix to reconcile the GAAP ETR to the adjusted ETR, with the full-year adjusted ETR still anticipated to be 21%. Our simplification and consolidation activities incurred $10.9 million in restructuring costs this quarter, and we now expect total restructuring expenses for the year to reach $25 million. Alongside this, we have summarized the cost-saving measures implemented in both 2019 and 2020, with $45 million in anticipated annualized savings from our 2020 actions. We revised our estimate for the restructuring-related savings from $32 million to $36 million, reflecting an additional $4 million in cost savings due to actions taken in Q2. Of this $36 million, we estimate around $8.5 million was realized in Q2, with an extra $23.5 million expected in the latter half of the year. The quarterly breakdown of these cost savings through the remainder of the year is provided on this slide. In the second quarter, we also achieved $6 million in savings tied to temporary pay cuts and furloughs. During the quarter, we recalibrated our cost strategy with the understanding that we do not expect a rapid recovery in the U.S. or Europe and anticipate a gradual recovery with potential bumps ahead. Consequently, we made the tough choice to reduce staff and offered a voluntary early retirement program, impacting roughly 4% of our global workforce and projected to yield $7 million in annualized savings, with about $4 million recognized in the latter half of the year. As Louis mentioned, following these workforce adjustments, we believe we have now structured a strong team to move forward. With various revenue, cost, and cash flow opportunities ahead, along with some positive order data points, we felt it was prudent to conclude the pay reductions and furloughs from Q2. Regarding our balance sheet, our total debt at the end of the second quarter was $1.126 billion, with net debt at $694 million. Our net debt-to-adjusted EBITDA ratio stood at 1.6%, consistent with our first quarter ending and well within our target range of 1.5% to 2.0%. I also want to reiterate what Louis highlighted earlier: we fully paid off our revolver during the second quarter after drawing it down out of caution early in COVID-19. Our balance sheet is robust, supported by a solid cash position and relatively low debt. In terms of free cash flow, we reached $77.4 million for the quarter, achieving a conversion rate of 255% of adjusted net income, which showcases the cash-generating capability of our business. Trade working capital contributed positively to our cash flow in the second quarter, and we expect it to continue being a source of cash throughout 2020. As mentioned during our first quarter earnings call, we decided to stop stock purchases to conserve capital in response to uncertainties boosted by COVID. For now, this program remains paused, but we are open to resuming it once there are consistent patterns in order rates. Looking ahead, similarly to last quarter, we are not issuing full-year guidance. However, unlike last quarter, where we presented various scenarios, we are at a point where our improving order rates allow us to provide a framework for the third quarter. Given our short cycle nature and continued uncertainty in the market, along with possible uncontrolled COVID impacts on our operations, we will not be offering guidance beyond the third quarter. We project sales to decline in the range of 8% to 12% compared to the same period last year, with PTS expected to be at the higher end and commercial closer to the lower end. We anticipate deleverage will range from 12% to 18%, with the midpoint consistent with the deleverage rate observed in Q2, with room for improvement. I want to remind you that we began realizing the effects of the cost actions from 2019 in Q3, which poses a tougher comparison. However, the additional cost measures we discussed earlier should help mitigate that headwind. I’d also like to reiterate our belief in the business potential when sales start to grow again, which remains unchanged from last quarter. We firmly believe that our 80/20 initiatives, supply chain moves, and restructuring efforts are shaping a business with a fundamentally different cost structure compared to previous cycles. This leads us to expect that the strong performance we’ve shown in deleverage can translate into stronger leverage rates than what we've seen historically, potentially exceeding 30%. We've included additional assumptions on this page for modeling through the rest of this year. Before I wrap up our prepared remarks, I want to extend my gratitude to all Regal associates for their hard work during these challenging times. Our Q2 results, despite facing severe pandemic-related revenue downturns and manufacturing disruptions, demonstrate impressive execution, as reflected in the low deleverage rate of 15.5% and strong free cash flow. With that, I’ll hand it back to the operator.
Operator, Operator
Our first question is from Julian Mitchell from Barclays.
Julian Mitchell, Analyst
This is Trish on for Julian. So color on residential HVAC, I was just wondering if maybe you can talk a little bit more about what you’re seeing out of the commercial HVAC market. Maybe order of magnitude there for what that business did in terms of orders and sales in the quarter? And then just kind of given what you’re seeing in resi HVAC, do you think this segment could return to growth as a whole in the second half?
Louis Pinkham, CEO
Yes. So Trish, this is Louis. I’ll take this one. So commercial HVAC, which is actually in our commercial segment, it is not in our climate segment. Commercial HVAC orders were down pretty significantly in the quarter, down 38%. Now going into July, we have seen a rebound, but still down. So overall, I would say that side of our business is not seeing the recovery that we’re seeing on the residential HVAC side. Residential HVAC, we’re getting the benefit of consumer demand, stay-at-home demand and also a warmer second quarter. April, and May was slightly weak, but certainly, June and July have seen a strong rebound. So I would say from a commercial HVAC side, will settle down high single, low double digits. Hopefully, that helps.
Julian Mitchell, Analyst
Yes. And then just maybe 1 follow-up on the cost savings. How should we be thinking about that by segment? And then it seems like it’s been weighted more towards industrial given the incremental actions. Are there any changes to how we should be thinking about incremental margins on the upturn? And maybe, can industrial do 30%, 35% incremental margins, do you think?
Robert Rehard, CFO
Trish, this is Rob. I’ll take that one. First, regarding the split by segments, all segments are benefiting from cost savings. The industrial segment, as we've mentioned before, has a significant share of those savings in their projections. Most of the improvement plan in the industrial sector is related to cost savings rather than top-line growth. This is an important perspective to consider. With regard to industrial's progress towards higher margins, we have outlined a plan to achieve industrial margins above our weighted cost of capital over time, as shown in our Investor Day presentation. That’s the framework for thinking about it. If industrial can achieve about 35%, I believe it might be around 30%, possibly just below that, which is how you might want to view it.
Operator, Operator
Our next question is from Mike Halloran from Baird. Go ahead.
Mike Halloran, Analyst
So first on the climate side, could you help put a lot of those moving pieces into context for us? We’re certainly hearing about some strong residential trends in June and July, indicating some sequential improvement. There are other factors at play, including some FER comparisons and other constraints, but could you discuss that trend a bit more? How do you perceive the end markets right now? Any insights on current inventory throughout the channel would help us understand the comparative performance between your outlook and what the industry sell-out looks like.
Louis Pinkham, CEO
Yes, Mike, this is Louis. I'm glad to share. We included a lot of information in our prepared remarks and provided numerous figures to enhance transparency and detail. To give you our view on HVAC in our climate segment, we certainly experienced weak demand in April and May. Customers and channels significantly reduced their inventories in the early parts of the second quarter, continuing through early June. Additionally, about 10% of our sales come from commercial refrigeration targeting the hospitality market, where orders were down significantly this quarter and have not shown signs of recovery. Also, the difficult comparison with FER likely had about a 3-point impact in the second quarter. Regarding your question on how this compares to some of the OEMs that have reported results already, we are positioned upstream of those OEMs. They have reduced their inventory levels in the second quarter, but we are beginning to see them restock, which supports some of the upsides we’re observing. In April, orders in that segment dropped over 40% year-over-year. We saw improvements of 9% in May, 25% in June, and another 26% in July. Overall, for July, it’s been largely flat compared to the previous year. I am optimistic about what’s happening in this segment. I'm also very encouraged by our relationships with our OEMs and our collaborative efforts. We’re in the midst of negotiating a couple of long-term agreements that are progressing positively. Ultimately, our role as a supplier in this segment is to deliver good product technology, excellent service, and remain cost-competitive, and I believe we are succeeding in all areas while partnering with our OEMs to support their future success with new products and technology. Overall, while Q2 was challenging with tough orders in April and May, we are seeing a definite rebound, and we feel positive about the third quarter and beyond. This is also why we mentioned in our prepared remarks that we expect our operating margin to improve due to the anticipated sales increases in the second half. I hope this addresses your question.
Mike Halloran, Analyst
Yes. No, that does. And so what I’m hearing is pretty stable on the share side. And it’s just a question of timing on the inventory side from where we sit here today?
Louis Pinkham, CEO
That’s exactly right. That’s exactly right.
Mike Halloran, Analyst
Okay. And then the second question is then, just when you think about the back half of the year and the framework that you put up for the third quarter, excluding the commentary we just had on the residential climate side and probably the pool side as well, are you embedding pretty normal sequential trends from what you saw in the kind of June, July time period from here? Or is there a different thought process internally for some of those core industrial and commercial markets?
Louis Pinkham, CEO
Yes. Overall, Regal’s orders in July decreased by 7% compared to last year. We expect our sales to be down about 8% to 12%. However, our backlog did increase in the second quarter. We don't anticipate significant improvements in consecutive order rates; if anything, July may have shown a slight increase. At this time, we do not expect August and September to be any stronger.
Operator, Operator
Our next question is from Christopher Glynn from Oppenheimer.
Christopher Glynn, Analyst
So nice milestone on the traction with the industrial margin. The time is kind of interesting now. Is it just really a lot of the traction hitting in this quarter that you’ve been working on for the past year, two years? Or were there any timing factors that helped the margin rate? Or do you expect to continue to build off the 2Q level for industrial margin?
Louis Pinkham, CEO
Yes, really, Chris, no one-timers in the quarter. A slight impact because of the furloughs and pay reductions. But this is the outcome of the hard work that the industrial team has been putting into driving the performance of the business. This is all of our cost-out initiatives. This is, as we’ve talked on previous calls, all about coming out with a new global TerraMAX industrial motor solution that’s had a much better cost position. And we’re actually, I’d say, in the early days of reaping the benefits of that, as well as taking significant cost out of our alternator and generator business so we can be more cost competitive. So I’d say very limited one-time impacts, which should allow us to continue to improve on the operating margins in this segment as we proceed through the year.
Christopher Glynn, Analyst
And then just wanted to visit the pruning initiatives, just a brief overview of the state of play there, types of accounts. And in particular, at climate, where it’s a little bit higher.
Louis Pinkham, CEO
Yes, this encapsulates our core focus. It's about understanding our customers, recognizing the value they see in our offerings, and delivering optimal solutions. If we cannot remain competitive or achieve suitable margins, we'll have to make difficult choices. Historically, Regal may not have approached this with the analytical depth we are applying today, which highlights the need for adjustments. Our strategy revolves around the 80/20 principle, allowing us to concentrate on our most valued customers and grow alongside them. We categorize these customers as those who appreciate our value as well. Additionally, this approach helps us prioritize what we now identify as our ideal prospective customers and market segments—those who recognize the worth of our technology and differentiation and are prepared to pay accordingly. I've mentioned a few segments and regions gaining good traction lately, including our commercial motors division in China, which is seeing strong momentum, along with our hermetic segment. We're directing our teams toward areas that will yield the best returns. Regarding pruning, as previously stated, we anticipated it to be between 1% to 2% for Regal, and it ended up being 1.9% this quarter, slightly higher in climate, but I’m comfortable with that, as we are focusing on the right areas and setting the business up for long-term success. I hope this provides clarity.
Operator, Operator
Our next question is from Michael McGinn from Wells Fargo.
Michael McGinn, Analyst
Congrats, Mr. Barry, on the new seat.
Robert Barry, Vice President of Investor Relations
Thank you.
Michael McGinn, Analyst
So if I could just jump into the incremental margin discussion. It seems like you got some really good trends here within climate heading into July. It’s a large segment for you, highly profitable. So are there any considerations that would push that deleveraging to the high end of the range? It seems like maybe a little conservative? I mean is there a currency or FX piece in that? Any color would be greatly appreciated.
Robert Rehard, CFO
Yes. I think that the deleverage rates that we’ve highlighted on our third quarter here are pretty consistent with what we would expect. There’s nothing that we see as kind of an outlier from that perspective. Our climate business does tend to delever around that 25% range, where we certainly see them delevering better than that as we go through this next quarter, aligned with the framework that we’ve provided. So no, there really isn’t anything that stands out as a big headwind to offset that impact.
Michael McGinn, Analyst
Okay. You mentioned some repo considerations for the latter half of this year. Shares have performed very well and are trading above pre-COVID levels. Can you discuss the balance between market considerations and your own return on capital metrics? How do you envision this evolving in the second half of the year?
Robert Rehard, CFO
We are still suspending the share repurchase program. However, if we see continued stabilization in our order rates, that could lead us to reopen and reinstate the program. We observed a positive sequential increase in our orders, which we discussed during the call, and maintaining that growth will be a significant factor in our decision. Additionally, as the market stabilizes, it will play a role in our confidence to potentially reinstate the repurchase program.
Michael McGinn, Analyst
Okay. Very helpful. If I could ask one more question about the PTS, I haven’t heard much about it yet. Some other OEMs have mentioned strength in the center of the aisle and grocery sectors. I know you have some involvement in conveying, parcels, and food there. Could you share your thoughts on the long-term market drivers that you anticipate as we navigate through these uncertain times?
Louis Pinkham, CEO
Yes. Our PTS business and conveying business are primarily focused on beverage and material unit handling. We are very optimistic about material unit handling. This enthusiasm predates COVID, as the current driver is social distancing, while previously it was about safety and automating the last mile of package distribution. We have robust technology that ensures high accuracy in the sorting process, which adds to our confidence. In 2019, the beverage sector experienced a slowdown due to uncertainties in the marketplace regarding plastic packaging alternatives, and this issue remains unresolved amid COVID. Currently, we are observing a positive aftermarket business. However, once we move past COVID and have a clearer path for packaging, I'm confident that the beverage sector will perform well too. Our primary focus right now, however, is on material unit handling.
Operator, Operator
Our next question is from Nigel Coe from Wolfe Research.
Brian Joseph Lau, Analyst
This is Brian on for Nigel. Maybe just to start off. Could you just maybe recap some of those supply chain moves that you mentioned in your prepared remarks as far as moving some of that capacity to, I think, Southeast Asia?
Louis Pinkham, CEO
Yes, I'm happy to. As I mentioned earlier, our global supply chain is a key strength for Regal. We can manufacture in various facilities, and it's primarily about collaborating with the customer to secure their approvals and certifications from the manufacturing site. We have successfully shifted a significant portion of our production capacity to our facilities in China and Southeast Asia to meet market demand and maintain service levels, especially since we experienced some challenges in Mexico during Q2. This capability sets Regal apart and enhances our position in the market.
Brian Joseph Lau, Analyst
Great. And then maybe just any changes on how you look at the portfolio or any different pieces of it going forward. Obviously, really strong performance from industrial this quarter? Just any changes there?
Louis Pinkham, CEO
Not really. We have a path with every one of our businesses to drive continuous improvement and performance improvements. And so we have, I’d say, compelling stories to bring shareholder value creation in each of our segments. So nothing changes for us at this time.
Operator, Operator
Our next question is from Jeff Hammond from KeyBanc Capital Markets.
Jeff Hammond, Analyst
So the guidance is a decline of 8% to 12%. You mentioned that the better end is related to PT, while commercial is at the lower end. Should we assume that the other two businesses are in the middle? Also, why would commercial be at the lower end considering the order rates and the backlog build?
Robert Rehard, CFO
Yes. I believe that is why they would be at the lower end, as on the deleverage standpoint, we would expect them to see a slight improvement in deleverage as we progress through the third quarter.
Jeff Hammond, Analyst
No, I’m asking...
Robert Rehard, CFO
Just on revenues. Yes. So the low end for commercial is because we have that backlog sitting there along with the improved order rate. So the backlog that we said we’ve built within the second quarter was largely in commercial. So it provides that level of protection. And that’s why you’ve got maybe a lower sales decline for commercial.
Jeff Hammond, Analyst
Okay. So commercial is at the better end of the decline and PT is at the worse end of the decline? And the other two are in the middle?
Robert Rehard, CFO
They’re in that, yes, within that range, yes, they’re within the middle.
Jeff Hammond, Analyst
Okay. So moving back to climate because I'm still confused. I think you mentioned that July orders are down 6% overall. However, residential HVAC, which makes up 40% to 45% of the segment, is up 26%. Could you explain the details? I understand refrigeration is weak, as you mentioned, but that only accounts for 10%. Can you clarify the other segments like general industry, combustion, and aftermarket? It seems like the remaining 60% is still performing really poorly.
Louis Pinkham, CEO
Yes. To clarify, we are combining our HVAC and combustion segments, which make up roughly 55% to 60% of the overall segment, not the 40% you mentioned, Jeff. Distribution accounts for about 10% to 15% of the segment. Additionally, we have a small business in India, and orders there were weak in the second quarter. General industrial and commercial refrigeration make up the rest. Commercial refrigeration has seen a significant decline with orders down over 40% this quarter. General industrial is also down, but around the mid-20s from a Nordic perspective. So the decline is actually more like 30% for those segments.
Jeff Hammond, Analyst
It doesn't seem to make sense that we're down 6% for July given the mix you mentioned, but I can follow up later. Clearly, the OEMs reduced their inventory and then experienced a surge in demand. Channel inventories appear to be very low, while demand is extremely high. Is there any sign that not only is there a need to catch up on demand, but also that inventory levels should be replenished? Do you expect this trend of sharp restocking and recovery to continue into the fourth quarter or at least through the third quarter?
Louis Pinkham, CEO
Yes, we definitely expect restocking to continue as inventories have been reduced. From our perspective, the underlying consumer demand remains down at a high single-digit to 10% rate, indicating that a full rebound has not yet occurred. On the positive side, restocking is happening, but we also note that about 30% of the segment is related to commercial refrigeration and general industrial, which may offset some gains. Our data shows that orders were down 5.5% in July. We anticipate a better third quarter but are preparing for a decline in the range of 5% to 8%.
Operator, Operator
Our next question is from Chris Dankert from Longbow Research.
Chris Dankert, Analyst
I guess, if we can update, and my apologies if I missed it, there was a lot of data out this morning. Did you guys specify were there any actual plant closures in the quarter kind of driving those permanent savings? And then maybe just in the past, we’ve talked a lot about automation driving some of these savings. Just any update on where we are with the pace of automation in the business would be great, too.
Robert Rehard, CFO
Thanks, Chris. This is Rob. I’ll begin, and then Louis can also provide input on the automation aspect. Regarding the additional savings we mentioned during the call, they primarily stem from the staff reduction and the voluntary retirement program we implemented at the end of Q2. This amounts to $7 million on an annual basis, with about $4 million expected in the latter half of this year. This is not related to plant actions. The plant-related restructuring efforts we undertook were already reflected in the previously discussed figures of $38 million or $32 million for the year.
Louis Pinkham, CEO
I’ll add to that. Rob is correct. I want to emphasize, as we discussed at our Investor Day, that we have a clear plan for consolidating our footprint. We're sticking to our communicated plan, which includes a 23% reduction in square footage over the next three years. We did close a couple of facilities in the second quarter, but to Rob’s point, that is not part of the additional $6 million in savings; it was already included in our prior communications. We are optimistic about our ability to implement the 80/20 strategy at Regal and streamline our operations. With the 23% reduction in footprint, we're also working on a 42% reduction in product rationalization. We're significantly improving our sourcing from the best value countries during this time. All of these efforts align with our goal of achieving a 3 basis point improvement over the next three years. Regarding automation, you may remember from previous earnings calls that we adjusted our approach. Regal had been pursuing large automation projects, but we have since shifted our strategy. Instead, we are focusing on implementing solutions that offer quicker returns, like cobots, which require lower investments. We've already implemented these solutions in many of our facilities and will continue to do so. As Rob mentioned in his remarks, investments like these will pay back in less than a year and are being rolled out across multiple facilities. Our emphasis is not on large-scale automation, but rather on tailored solutions in our manufacturing processes that enhance safety, quality, and cost-efficiency. I hope that answers your question, Chris.
Operator, Operator
This concludes our question-and-answer session. I would now like to turn the conference back over to Louis Pinkham for closing remarks.
Louis Pinkham, CEO
Thank you, operator. To summarize, the second quarter was tough as we expected it would be, confronting the unique challenges posed by COVID-19 across our business. And as I mentioned in my opening remarks, the virus also impacted our associates personally in many ways. But when it comes to factors under our control, I’m pleased with how our Regal team executed in the quarter, achieving 15% deleverage, very strong cash flow and even a few bright spots on the share gain front. I thank them again for all of their efforts. With the challenges of the second quarter now hopefully largely behind us and some encouraging signs that our business is inflecting towards the positive, the Regal team will continue executing on our near, mid- and long-term goals, guided by the priorities of SQDCG; safety, quality, on-time delivery and cost, which will achieve profitable growth for our associates, for our customers, and for our shareholders. Thank you for joining our call, and please stay safe.
Operator, Operator
The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.