Timken Co Q1 FY2020 Earnings Call

Good morning. My name is Anita, and I will be your conference operator today. As a reminder, this call is being recorded. At this time, I would like to welcome everyone to Timken's First Quarter Earnings Release Conference Call. Thank you. Mr. Frohnapple, you may begin your conference.

Thanks, Anita, and welcome, everyone, to our first quarter 2020 earnings conference call. This is Neil Frohnapple, Director of Investor Relations for the Timken Company. We appreciate you joining today. Before we begin our remarks this morning, I want to point out that we have posted presentation materials on the company's website that we will reference as part of today's review of the quarterly results. You can also access this material through the download feature on the earnings call webcast link. With me today are The Timken Company's President and CEO, Rich Kyle; and Phil Fracassa, our Chief Financial Officer. We will have opening comments this morning from both Rich and Phil before we open up the call for your questions. During today's call, you may hear forward-looking statements related to our future financial results, plans, and business operations. Our actual results may differ materially from those projected or implied due to a variety of factors, which we describe in greater detail in today's press release and in our reports filed with the SEC, which are available on the timken.com website. We have included reconciliations between non-GAAP financial information and its GAAP equivalent in the press release and presentation materials. Today's call is copyrighted by The Timken Company. And without expressed written consent, we prohibit any use, recording, or transmission of any portion of the call. With that, I would like to thank you for your interest in The Timken Company, and I will now turn the call over to Rich.

Thanks, Neil. Good morning, everyone, and thanks for joining us today. I'll start with some very brief comments about the first quarter and then spend most of my time discussing the impact that the COVID-19 pandemic is having on our business and the actions that we are taking in response. We had a good first quarter, particularly in light of the impact from the coronavirus in China in February and then the bigger impact it had across the globe in March. Our end markets were largely in line with our projections for the first 2 months of the year, then in early March, we began to experience various adverse impacts from the virus. Our execution was good, both in regards to our results as well as our quick response to the impact from the virus. For the quarter, organic revenue was up 3% from the fourth quarter and down 9% from the first quarter of 2019. The acquisitions of BEKA and Diamond added 5% to our revenue and currency was just under negative 2% for a net of negative 6% from last year. We delivered $1.11 of earnings per share and 19.2% EBITDA margins despite the weak finish to the quarter. EBITDA margins were up almost 300 basis points from the fourth quarter. Also worth highlighting, the BEKA acquisition performed much better in the first quarter with EBITDA margins in the mid-teens. The business will not be immune to the short-term COVID-19 issues we are facing, but after 6 months of ownership, we remain very optimistic about the potential of this acquisition and the synergies with Groeneveld. Again, it was a good quarter. But as you all know, our markets have changed significantly since February, and I will expand on the impact that we have seen from the coronavirus. Our first experience with the coronavirus was in China in late January and early February. We were shut down in China for one full week due to government mandate, and then we lost about the equivalent of another week due to ramp issues that impacted us and our customers. By the end of the first quarter, our China customers and our China operations were back to normal levels. We grew year-on-year in March and again in April. After China, our next business impact was in Italy. We have 3 manufacturing facilities in Italy that serve local as well as export markets. From there, the virus and government mandates spread through Europe, to the U.S., and other parts of the world. In the beginning of March, we were experiencing a modest revenue and production impact in Italy. And by the last week of March, our revenue in Europe was down by over 50%. The global automotive and truck industries were essentially shut down. India had mandated a shutdown of all industrial manufacturing and the impact was starting to hit industrial markets in the U.S. and the rest of the world. In the last 2 weeks of March, we had temporarily idled over 30% of our production, primarily due to weak customer demand. And all of those issues are included in our $1.11 of earnings per share and our 19.2% EBITDA margins. So again, we performed very well given the environment in the first quarter. Let me now jump to April. From a supply perspective, Timken operations have largely been deemed essential around the world, and we have been able to meet customer demand. We've had some supply challenges and inefficiencies, primarily in Italy and India, but supply has not been a major contributor to our revenue decline, and we are filling the needs of our customers. Our expectation is that this coming Monday, restrictions in India and Italy will be lifted, at which point we will be able to operate all Timken global facilities to the degree that we need to. We expect April revenue to be down slightly more than 30% from prior year. Some more color on that number. Europe has been the hardest-hit geography for Timken. Our revenue in Europe bottomed for about 3 weeks starting in late March. It bounced up meaningfully off that bottom in mid-April. And we believe we have more customer demand coming back in the next couple of weeks as customers restart or step up operations. U.S. has been about 3 to 4 weeks behind Europe in regards to impact, and we've been hovering around what appears to be a bottom for the last 3 weeks or so in the U.S. Our automotive business in the U.S. has been down over 80% in April. And while we do not have definitive restart dates, we do expect more automotive revenue in May and June than April. China, as I said earlier, was up year-on-year in April, partly driven by renewable energy. And India was close to 0 revenue for the entire month of April. We expect India customers to restart demand beginning next week but starting at modest levels. Our other smaller geographies are all experiencing various, and in most cases, significant declines in demand and have not yet shown signs of a rebound. In regards to the outlook for the rest of the second quarter of the year, the situation remains dynamic, and our visibility is limited. We are in close contact with customers. We're managing our supply chains tightly, and we plan to remain flexible through the second quarter. There are a lot of variables and possibilities for the second quarter, and we will continue to be responsive to changes in demand. As we look out, there are positive signs as well as negative signs. I'll start with some of the positives. I'll say the spread of the virus appears to be much better than the worst-case scenarios that we were contemplating in late March and early April. The world, in general, appears to be headed to reopen and work through the pandemic in the coming weeks. And Timken and other manufacturers are quickly implementing new work practices to aid in safely working through the pandemic. Our customers have not made structural reductions in capacity. They have furloughed employees and temporarily shut down plants, but they have not closed plants, permanently reduced staffing levels, or reduced inventory. They are planning and prepared for a rebound. A significant number of customers are telling us that they intend to ramp up production through May and June, and that they expect the third quarter to be better than the second. Timken should see improvement off of April revenue levels for automotive, commercial truck in India, which have all been at extremely low levels as well as several other markets where revenue has also been low in March and April. And also positive, the diversity of our revenue by end market, customer, and geography has put us in a good position to weather the storm. As an example of that, our demand in China, wind, solar, aerospace, defense, marine, logistics, and several niche markets has remained strong through the pandemic. On the negative and uncertain side, we do not know how the pandemic will play out, including if there is a resurgence in the virus as the world lifts restrictions and returns to work. And while as I said, our customers generally remain optimistic on ramping production back up in May and June in the third quarter, they also do not know how this plays out. They don't know how the virus plays out, and they don't know how their own customer demand will develop in the coming months. And while we have several markets and customers that appear to have bottomed, we also have several that are likely to weaken or take more time to recover. Commercial aerospace, oil, and longer-cycle markets like our industrial services are all likely to be lower in the coming months. There's also the risk of channel destocking. As I said, our customers have largely responded to this with temporary actions. But if demand remains down, we could experience inventory destocking impacts. And while China and several of our other markets remain strong, there's no guarantee that they will be immune to the economic spillover from the other markets. Based on all these factors, we are planning for a very challenging second quarter, but also for the second quarter to be the bottom and to see sequential revenue improvement off the second quarter and the third quarter. But again, there are a lot of variables in play. The situation remains dynamic, and we are preparing for a wide range of revenue possibilities. The Timken management team has responded quickly and decisively to the pandemic. We've taken significant actions to retain our employees while keeping them healthy, to serve customer demand, reduce costs, and assure liquidity and financial strength through the crisis. Let me expand on each of those. Safety has always been at the top of Timken's priorities and remains at the top through the pandemic. We've been very proactive across our global operations in assuring safe workplaces and safe practices for our associates. We were early adopters of preventative measures that included work from home and restricted travel, PPE, social distancing within our facilities and more, and we will continue to lead in our safe operating practices. As I said, we are prepared for a wide range of demand possibilities. While we hope the worst doesn't happen, we will be prepared if it does, and we believe we can stay profitable and positive quarterly cash flow through a significant and sustained decline in demand. We've taken short-term steps to increase our liquidity, which Phil will go into in a moment. We hope this will prove to have been unnecessary. But again, we are prepared for a wide range of demand scenarios. We've increased our focus on cash generation and are confident that we will generate strong cash flow in a contracting or expanding market in 2020. And again, Phil will elaborate on this in a moment. We will be more conservative on capital allocation until the virus in our demand stabilizes, including the suspension of share buyback and the deployment of free cash flow after dividends to the reduction of debt. We have quickly reduced production in line with reduced demand. We do not expect to reduce inventory levels significantly until we get better clarity on the outlook, but we will manage working capital in line with demand levels as the year progresses. In a down market scenario, working capital will be a significant generator of cash for us. We slowed capital spending in the second quarter and expect the full year to be more than 20% below our prior guide of $160 million. We could go further, but that will depend on better visibility in the second half as we continue to believe in the long-term attractiveness of investing in our markets and the value creation of our capital projects. But we will slow further if the recovery is slower. We came into the year with a good pipeline of cost reduction activities, the partial results of which were evident in our first quarter margins. We will continue to execute these initiatives through the year to drive structural cost improvements. Through April, we have retained our global workforce and their benefits. However, we have all taken various forms of temporary reductions in our compensation. I appreciate our employee sacrifices and support of these measures. We've taken an aggressive approach to temporary cost reductions in the second quarter that include reductions in spending, furloughs, and compensation reductions. We expect compensation costs to be down more than 25% in the second quarter. However, these are temporary measures. During May and June, we will prepare to make structural cost reductions in the second half of the year if they are deemed necessary as visibility demand improves. We remain closely connected with our customers, their production plans, their new product plans, and we remain focused on our long-term objectives to outgrow our markets. In summary, the Timken Company is well positioned to perform through this crisis. Our strategy is to diversify the revenue of the company by product, by end market, and by geography, and that diversity will serve us well. Our products are critical elements of our customers' equipment and supply chains. We have been solid generators of cash and will continue to be, in shrinking or growing market conditions. We have been disciplined allocators of capital and entered the downturn with a good balance sheet. And we have a management team that has significant experience in managing through challenging cycles, and a dedicated and talented workforce that is committed to our success. I'll now turn it over to Phil.

Okay. Thanks, Rich, and good morning, everyone. For the financial review, I'm going to start on Slide 11. Timken delivered solid results for the first quarter despite the growing impact of COVID-19, and you can see a summary of our results for the quarter on this slide. Revenue for the first quarter was $923 million, down just under 6% from last year. We delivered an adjusted EBITDA margin of 19.2% and adjusted earnings came in at $1.11 per share. Keep in mind that last year was a difficult comp, as both adjusted EBITDA and earnings per share were records for the company, and the current year was impacted by market conditions, COVID-19, and currency headwinds. I want to point out that our performance did improve meaningfully from the fourth quarter as we guided, with revenue up 3% and adjusted EBITDA margins expanding by almost 300 basis points sequentially. Turning to Slide 12. Let's take a closer look at our first quarter sales performance. Organically, sales were down about 9% in the quarter, with both Mobile and Process Industries down versus the year-ago period. As Rich mentioned, revenue was largely in line with our initial expectations in the months of January and February. Sales were adversely impacted beginning in March due to the broadening impact of COVID-19 across the globe. Acquisitions added nearly 5% to the top line in the quarter as we benefited from the BEKA and Diamond Chain acquisitions completed last year, while currency was a sizable headwind, negatively impacting revenue by around 1.5%. On the right-hand side of the slide, we outlined organic growth by region, so excluding both currency and acquisitions. Let me briefly comment on a few regions. In Asia, we were up 6%. Our operations in China have recovered nicely from the COVID-19 shutdown in early February, and we saw solid growth in renewable energy in the quarter. In North America and Europe, we were down 13% and 12% respectively, as most sectors were down across those 2 regions in the quarter. Our operations in North America and Europe were both impacted by COVID-19 in March, and this had a meaningful impact on end market demand in automotive, heavy truck, and other industrial sectors. Turning to Slide 13. Adjusted EBITDA was $177 million or 19.2% of sales in the first quarter, compared to $202 million or 20.7% of sales last year. The decline in adjusted EBITDA reflects the impact of lower volume and related manufacturing utilization, driven in part by COVID-19. Currency also had a negative impact on EBITDA in the quarter. On the positive side, we had favorable price/mix, lower material and logistics costs, and lower SG&A expenses. In addition, recent acquisitions contributed $8 million to EBITDA in the quarter or around 16% of revenue, a nice step-up from the fourth quarter. BEKA performance improved significantly as our team continues to integrate this acquisition and drive cost synergies. Let me comment a little further on manufacturing and SG&A. On the manufacturing line, we delivered good operating performance in the quarter, considering the lower production volume. Our teams around the world acted quickly to flex down labor and variable costs in response to COVID-19. Unabsorbed fixed costs drove most of the negative variance in the quarter. And SG&A was favorable compared to last year, driven mainly by lower incentive compensation expense. On Slide 14, you'll see that we posted net income of $81 million or $1.06 per diluted share for the quarter on a GAAP basis. This includes $0.05 of net special charges related to restructuring and other items. On an adjusted basis, we earned $1.11 per diluted share in the quarter, down 18% from the record earnings per share we posted last year. While it's hard to quantify exactly, we would estimate that COVID-19 was easily a $0.10 headwind in the quarter. Note that the $1.11 we earned in the first quarter was a significant step-up from our fourth quarter adjusted earnings per share of $0.84, as we saw a normalization of the higher expenses we called out last quarter. We also had the benefit of higher volume and better mix as well as a nice improvement in BEKA profitability. Our adjusted tax rate was 27% in the quarter, reflecting our geographic mix of earnings and in line with our prior expectations. Right now, we expect the tax rate to remain in this range as we move through the year. Now let's take a look at our business segment results, starting with Process Industries on Slide 15. For the first quarter, Process Industries sales were $457 million, down 4.8% from last year. Organically, sales were down 7.5%, driven by declines in global industrial distribution and the general and heavy industrial sectors partially offset by strong growth in renewable energy and positive pricing. Marine demand, which is mainly defense-related for Timken, also remained strong. Currency translation was unfavorable by 1.7%, while acquisitions added 4.4% to the top line in the quarter. For the quarter, Process Industries adjusted EBITDA was $112 million or 24.4% of sales compared to $131 million or 27.4% of sales last year. The decrease in adjusted EBITDA was driven by the impact of lower volume and related manufacturing utilization and unfavorable currency, offset partially by lower SG&A expenses and the benefit of acquisitions. Now let's turn to Mobile Industries on Slide 16. In the first quarter, Mobile Industries sales were $467 million, down 6.7% from last year. Organically, sales were down 10.4%, reflecting lower shipments in off-highway, automotive, and heavy truck partially offset by growth in aerospace, which was mostly defense-related, and positive pricing. Acquisitions added 5.3% to the top line in the quarter, while currency translation was unfavorable by 1.6%. Mobile Industries adjusted EBITDA was $76 million or 16.3% of sales compared to $84 million or 16.8% of sales last year. The decrease in adjusted EBITDA reflects the impact of lower volume and related manufacturing utilization and unfavorable currency partially offset by favorable price/mix, lower material and logistics costs, and the benefit of acquisitions. This represents a decremental margin of around 18% on an organic basis. So very good operating performance for Mobile Industries in the quarter despite a double-digit organic sales decline and a challenging environment. Turning to Slide 17. You'll see we generated operating cash flow of $56 million in the quarter, up slightly compared to last year as improved working capital performance more than offset the impact of lower earnings. We generated free cash flow of $24 million, which was down from last year as we had higher CapEx spending in the quarter to support long-term growth and operational excellence initiatives. In the first quarter, we also paid our 391st consecutive quarterly dividend and repurchased 1 million shares of company stock. Keep in mind that cash flow was seasonally low in the first quarter of the year as our incentive compensation payouts occur in March and we normally see some working capital increase from December. Over the rest of 2020, we expect to generate significant free cash flow, which will reflect favorable working capital performance and the impact of costs and other spending reduction initiatives. And we plan to deploy our free cash flow after dividends to reduce debt. You'll note that we have suspended our share repurchase program while we navigate through this period of uncertainty. I want to reiterate that we're confident in our ability to generate strong cash flow in 2020 under almost any scenario. When revenue drops, we typically reduce working capital, and we also have the ability to reduce CapEx. This serves to mitigate the impact of lower earnings on our cash flow when markets contract and vice versa. I'd also like to comment briefly on our pension situation. From a cash standpoint, we expect pension and OPEB contributions in the range of $14 million to $18 million for 2020, essentially unchanged from our prior outlook. And despite all the stock market and interest rate volatility, our estimated funded status has moved only modestly since the end of 2019. We took steps several years ago to derisk our pension exposure by investing in liability matching assets. This is helping protect our funded status in this environment. Let's take a closer look at our capital structure with a summary on Slide 18. We ended the quarter with a strong investment-grade balance sheet and $388 million of cash on hand. Our net debt to adjusted EBITDA was around 2.2x as of March 31. We included a long-term debt maturity schedule on the top right, where you can see that we don't have any significant long-term debt maturities before 2023. Note that we drew $350 million on our revolving credit facility on April 3 as a precautionary measure to enhance our financial flexibility during this period of uncertainty. This increased our cash on hand to well over $700 million as of that date. We currently expect net interest expense in the range of $65 million to $70 million for the full year. So to summarize, our balance sheet, liquidity, and expected strong cash flow put us in a great position to successfully navigate this period of uncertainty. We're taking aggressive actions in response to COVID-19 to conserve cash, and we're shifting our short-term capital allocation priorities to direct our free cash flow after dividends toward debt reduction. And finally, I want to remind you that we previously withdrew our sales and earnings guidance due to a significant uncertainty caused by COVID-19. And while we are not providing sales and earnings guidance today, we do intend to reinstate guidance at some point in the future. In closing, we'd like to commend our more than 18,000 Timken employees for delivering solid first-quarter results. It is their hard work and dedication that drives our confidence that Timken will emerge from this environment well positioned to continue to advance as a global industrial leader. And with that, we'll end the formal remarks and open the line for questions.

We'll take our first question from Rob Wertheimer from Melius Research.

So thanks for all the detail in April. I think anything that helps to clarify this uncertainty. And in your case, anyway, it was...

Rob, are you there?

I believe that is likely connected to your efforts in the mix and the significant hard work you've put in over the years. So, I have a question about something that was not clear.

Rob, I didn't catch what you said for about 15 seconds. Could you please repeat that?

So anyway, I guess what I was saying is that the color on April is very, very helpful. It just reduces uncertainty, and that's great for everybody. Down 30% is also way better than we had feared at least as inventories swing up and down and you sell into people who thought it could have been worse. So that's great. And I think it reflects some of the very positive mix improvements you've done in the years. I wondered if you can just look at either '09 or just what pockets of business you have that have been strong. Does that really feel like the bottom in April? Or could we have a major destock that's big enough to drag us down a little bit more? Just really a sense of whether that really does feel like a bottom and whether the remaining pockets that could trend down are big enough to pull us off that or not?

Yes, I believe there are several markets that are close to reaching their lowest point. In sectors like automotive, heavy trucks, and in countries such as India and Italy, we are seeing declines of 0% to 10% to 15%, which I don't think can be sustained. Therefore, I anticipate an increase in revenue in the near future from these markets compared to March and April. Additionally, we are on a trend towards improvement. If over the next couple of months we hear news about automotive companies resuming operations and the virus situation improving, it suggests that we are indeed at the bottom. However, there might still be some smaller areas of our business that could decline, but these would not significantly impact the overall positive outlook. That said, we've encountered unexpected challenges recently; for example, just last night we were optimistic about India, only to wake up to news about a government shutdown affecting our customers for three weeks. We're still navigating this uncertainty, but generally, if current trends continue, Europe seems to be recovering from its lows, and the U.S. also appears to be on an upward trajectory.

That's very helpful. I just want to clarify something. You mentioned that commercial aerospace is highly uncertain and may trend downwards. In your aerospace business, is the commercial segment a minor part compared to rotorcraft or others? Is it a significant area, or just one that you pointed out could be unpredictable?

No. We're disproportionately weighted towards defense. So last year, of our 8% aerospace, over 50% of that would have been defense. So say, 3-ish percent would be commercial. But that 3% has done pretty well through April. But I would also say that's living off backlog, and we'll likely see some pressure in the coming quarters, as an example.

And now we take our next question from Michael Feniger from Bank of America.

Great color so far on what you're seeing on the ground. When you say customers are not stocking right now, that they're waiting to see what the recovery could look like, I'm just curious, is the inventory levels that the customers are holding, is that you feel like contingent on demand getting back to a pre COVID-type level?

Yes. I believe that our markets have already been in a cyclical contraction for about three to four quarters. We indicated that we would see a year-on-year decline in the first half of the year. Currently, inventory levels align with a single-digit decline in year-on-year revenue. If we were to see a reduction in the range of 5% to 9%, that includes inventory destocking for us. However, if the decline is more significant, around 15% to 20%, we could experience additional challenges related to inventory destocking. Does that answer your question?

Yes, that is helpful. Do you have an idea about the distributors? Are you seeing any trends there? For example, have your auto customers or distributors already adjusted their inventories based on a lower demand expectation?

Auto and truck OEMs represent about 13% to 15% of our business, and they are likely the exception where there is minimal inventory between us and those customers. While they had inventory that affected them, our delivery is very fast and responsive. Beyond those two markets, my comments also apply to distribution. We engaged in significant destocking in the latter half of last year in our highway markets, for instance. Our off-highway sales in the first quarter aligned more closely with our customer sales rather than falling below them. Overall, I believe this applies to nearly all our markets, with a few exceptions where inventory levels are quite tight between us and our customers.

Fair enough. You mentioned that Europe significantly bounced back in April from the lows of March, which is encouraging. Can you share how much of what you observed in April in Europe is down compared to last year? Also, you discussed businesses like commercial aerospace relying on the backlog. Do you believe this is why parts of your portfolio have performed well in areas such as marine or renewable energy, or do you think it is more about some long-term shifts and gaining market share, resulting in those markets performing much better?

Yes. There are likely several different answers to that. That was around seven or eight questions, but I'll address a few. I do believe that in some of those markets, we have gained share over multiple years in wind, solar, and marine. Those markets have not been significantly negatively impacted, aside from some production issues we experienced in China, which did have an adverse effect. However, our order backlog remains strong and extends well into the future. This reflects a combination of market dynamics and our sustained share in Timken over the years. Regarding the situation in Europe, about three weeks ago, from mid to late March to early to mid-April, our numbers were almost double what they were during that period. Many of our customers reduced production by one to three weeks, and the automotive and truck sectors in Europe largely shut down, but some of that has since resumed. We have witnessed a notable increase in demand in Europe as a result. Looking ahead over the next month, we anticipate both positive and negative factors, but overall, demand is significantly up. We have not yet seen the same increase in the U.S., but for certain markets that are currently at extremely low levels, we expect to see some recovery in the coming weeks from those lows.

Yes. I think it's safe to say, Mike, that the Europe, while as Rich said, we bounced back up, we're still down year-over-year.

Yes. Lastly, could you remind us of your exposure to the oil and gas market? Please quantify it and specify where it is. It's clearly small.

Our exposure is quite small. It used to be higher maybe 10 years ago. We've grown other parts of the portfolio. In a good market, it's less than 2% direct. There are some indirect impacts in other markets like metals and transportation, but directly, it has a minimal influence in the power transmission market.

And now we take our next question from Chris Dankert from Longbow Research.

Sorry if I missed it, Rich. Did you comment at all, and then I'd understand if you'd prefer not to, but any comments on kind of April and kind of what the initial orders have been? What sales have been kind of through that month? Just any short-term data there.

Yes, I think as Rich mentioned in his opening remarks, we expect April sales to decline by more than 30%. While we have started to see some recovery in regions like Europe and anticipate that North America will reach its lowest point soon, India may have already reached its bottom. We still expect sales to be down over 30%.

Got it. Okay. That's what I thought I heard. So I guess it's extremely difficult to kind of get hands around cost because sales can move so wildly here. But if we assume full-year sales are down in mid-teens ish, should we expect a decremental margin near 30%? Or just kind of how should we think about the cost structure of the business in this down cycle versus last?

Well, in the second quarter, we've taken a lot of temporary cost actions to align with what we expect to be, together, a very challenging quarter. So the traditional decrementals I'm not sure will hold in a market where we could be down 30% in quick order, where we wouldn't have had time to make structural changes, et cetera. As you look out the third quarter, if we were to conclude that we expected to be down significantly in the second half, we would start taking more structural actions to try to get back to whatever historical type of decrementals would be, which would typically be in the 25% to 35% range, depending on mix and so on. I do think the speed at which this came at us without temporary actions, our decrementals probably would have been worse, the speed and the depth. But again, we've taken some pretty significant actions here in the second quarter.

Yes. I would just add, Chris. Tough for us to guide the decrementals, obviously. But we're working really hard to manage the decrementals. We're a better business today than we were in prior cycles. I expect to perform, relatively speaking, better. And as Rich said, we're moving quickly to reduce costs in the second quarter, which we think will be the bottom from a revenue standpoint. We also expect price cost to remain positive. We're going to benefit from lower incentive compensation as we would in this kind of an environment as well as the ongoing cost reduction initiatives, not just the second quarter actions, but we had actions coming into the year. All of which, I would say, will help us protect margins and help decrementals as we move through the year. But until we get better clarity on, as Rich said, steepness, length, et cetera, it's tough for us to guide to a specific number.

Yes. Yes, absolutely. Appreciate the difficulty there. But just one last one for me, if I could sneak in here, I guess. Just any commentary on what your internal working capital targets are? How should we be thinking about cash flow into the back half of the year, kind of maybe excepting 2Q? Any thoughts there would be great.

Certainly, on receivables, as revenue declines, we expect to liquidate, if you will, a significant amount of cash from receivables, and we're managing that tightly. From an inventory standpoint, this significant of a decline in demand, it takes some time to turn the inbounds spigot off. We have turned the spigot of production off proportionate with demand. We haven't taken it significantly below demand to get inventory out. And that, again, is strategically what we're choosing to do, at least through the first 60 days here in reaction to our customers' plans and intentions to the levels we're at in March and April we will not stay at. And as you look out in the second half, we would expect to rightsize our inventory with where we think the demand levels out at, which, again, we're not ready to call as we sit here today.

And now we take our next question from Joe O'Dea from Vertical Research.

You commented on significant free cash flow this year and obviously, a whole host of scenarios, but just your confidence in that. Can you talk about those ranges at all and give us some perspective around confidence and significant free cash flow?

No, I think the challenge with ranges is valid. You have to begin with the revenue number, then move to an EBITDA number, and then proceed from there. We're not quite ready to make that determination, but we are confident in our conversion. Generally, we believe our conversion percentage could improve under lower revenue and EBITDA scenarios. So, in the short term, there's a natural hedge over the next two to three quarters. If EBITDA faces more pressure, we believe our cash conversion will improve. Conversely, if EBITDA performs better, we will benefit more from our starting point. Therefore, our focus will remain on conversion and staying flexible. We will adjust working capital, capital expenditures, and costs in proportion to the demand we anticipate in the second half.

Okay. And then on distribution, I guess, primarily in North America, where I think you have really good visibility among large distributors on sell-in and sell-through. And curious as you're taking some of the temporary actions but pockets of the economy continue to work, and demand for aftermarket could still be there. Whether or not you're actually seeing the sell-in lag, the sell-through in certain pockets of that, is there a period of time where there's actually, just given the circumstances, some destock in distribution? Or is it really about your production aligned to that distributor sell-through at this point?

In North America, inventory remained largely unchanged. However, it’s important to note that North American distributors did not experience much of the COVID-19 impact initially. In early March, they started to feel some effects, which intensified by the end of April. Currently, they are focused on maintaining inventory to support their customers and the industries they serve. However, if their outlook for the second half of the year is lower than what they expected back in February, they may reduce inventory, which would lead to some impact. As of now, that reduction has not occurred through April.

And talking about the timing there and some of the mid-April crunch that they would have felt as you're able to monitor those trends, North America distributors specifically. Is that something that sitting here today, based on what you're able to see, it does look like some stabilization of those declines?

No, I would not say that we have clear visibility on this because it's been later. Additionally, there are a lot of critical industries like food and beverage, logistics, and material handling that may be impacted positively in some cases. Therefore, the revenue decline for us would be significantly less than the 30% that the company as a whole is experiencing. As we started the month, it would even be less than that. It's too early to predict which way that goes.

And now we take our next question from Steve Barger from KeyBanc Capital Markets.

I know there's less inventory in other truck and truck, but for other industries, how will it structurally work in terms of turning things back on? Does the OEM warn the supply chain that it's going to restart on some dates so suppliers produce in front of that? Or does the OEM restart with inventory on hand and then the supply chain follows?

In the automotive and truck sectors, operations tend to be aligned. We plan to restart on the dates of May 4, May 11, and May 18, and we want you to join us for that. Other industries typically take a week here or there off and may delay orders by a week. However, they usually aren't as coordinated. The markets we serve are quite fragmented, and the complexity arises from having thousands of different part numbers. Thus, the situation isn't straightforward, and there will typically be an inventory buffer in most supply chains.

Got it. So we'll see the OEMs turn on before they start pulling from you probably?

Yes. Although in most cases, I would say they have continued to pull, just at lower levels. Outside of the auto and truck sectors, we have not experienced shutdowns lasting 2, 3, or 4 weeks in countries like India and Italy. Instead, we see adjustments such as taking a week off or deciding to produce less of certain items. Generally, there have been pulls.

Okay. How much time are you spending with the team talking about share gain opportunities or getting incremental content from customers? Or is this more about managing service levels for current programs?

I would say that in the long term, our collaboration with engineering functions to secure the next design platforms is still robust and active. We are all working from home and interacting with customers via video rather than in person, but customers have not slowed down their efforts, and that work is ongoing. There is always a chance for gaining market share through product availability and distribution, and I believe we are well positioned to capitalize on any such opportunities. However, I don’t see any significant supply and demand imbalances, especially with the current weak demand. I believe we are well positioned and would not expect to miss out; rather, we expect to come out ahead. I’m not sure if it will be significant enough to highlight specifically.

Okay. And then last, just more of a philosophical question about we've had the combination of tariffs and now the virus. Do you think this changes supply chain? Do you expect more reshoring or localization of supply? And second, do you think you or your customers will shift more towards automation or robotics? And would that be meaningful to your power and motion control product lines?

Regarding the second part of your question, I see ongoing trends indicating that the situation will serve as an accelerant. While this applies to some of our customers, it's important to note that they typically have global operations and are accustomed to sourcing from various places. Economic factors will always influence these decisions, and we're already witnessing an increased focus on local sourcing. Recent volatility from tariffs and the pandemic has certainly prompted companies to reconsider their supply chains and reduce reliance on a single source. While this shift was already underway to some extent, I believe our customers generally maintain a certain level of diversity in their sourcing strategies. Therefore, the short answer is yes; I expect the trend to accelerate, but it will evolve gradually over time.

And now we take our next question from Courtney Yakanovis from Morgan Stanley.

This is Courtney Yakanovis from Morgan Stanley. I was curious if you could discuss the sales trends in the Asia Pacific region for the quarter. The 6% increase was somewhat unexpected. Could you explain where revenues declined during the quarter and how strong the exit rate was in March?

Yes, regarding Asia, we're seeing a 6.25% increase, and we had year-on-year growth in China. We did take an additional two weeks off compared to a typical Chinese New Year holiday, but we've bounced back well and recovered nicely in China. It's important to note that a significant portion of our renewable energy business is in China, and it saw strong growth in the double digits year-on-year, primarily driven by the Asian market and mainly China. In India, we experienced a decline, as we started feeling the impacts of COVID-19 towards the end of the quarter. It faced economic challenges last year and saw another decline this quarter, especially with almost complete shutdowns through April. While China remains robust, India is gradually emerging from the COVID-19 shutdown, and the rest of Asia is relatively flat or slightly down this quarter. Overall, Asia's performance is primarily influenced by China and India, and the positive story comes from China's recovery alongside the strong growth in renewable energy.

Okay. Got it. That's helpful. And then maybe switching over to decrementals. I know you kind of highlighted some moving pieces there, and I understand that there's a lot of fluidity in the situation. But I guess, in the quarter on the Process, they were still a little bit higher than your historical performance in that business. So I guess looking through the trends in 2Q, how much of that decremental affected performance in the quarter is still related to BEKA and Diamond Chain? And I guess, to what extent can you sell-through some utilization next quarter?

Yes. So I think it's a great question. So on incrementals and decrementals, I mean, the first thing to keep in mind is the acquisitions and currency can skew it a bit. So in the quarter, the organic decremental for the company was 29%. Mobile was very good at 18%. Process was around 55%. So it was a little higher than what we normally would run. And then a few things to keep in mind there. The gross margins are generally higher, so Process will run higher. Volume declines can have a bigger impact. We had a difficult comp last year with the mix. Mix was a headwind this year. With the growth in renewable energy, well, it's a great market for Timken, great long-term opportunity there. When renewable energy is up and the industrial distribution is down like we saw in this past quarter, that can really negatively impact the mix. So those are probably the main items. But I would tell you, when you look at the mix we were running in the environment we were in, 24.4% was pretty strong considering everything we were dealing with in the quarter.

Okay, I understand. I have one last question to ask. Regarding your exposure to the aerospace sector, as partially addressed in Rob's question, I’m curious if the market's situation has altered your perspective about pursuing M&A in that area moving forward, or do you still see it as a favorable focus for the future?

So our aerospace business said that last year, about 8% of sales, over 50% of that weighted towards defense. And it has not been a significant part of our acquisition strategy. That has been a significant part of our organic growth and outgrowth strategy. The commercial side of that is no doubt going to be challenged for probably quite some time. The defense side, though, on the flip side is going to be very strong and remains an opportunity for us. So I think, net, it's still certainly long-term an attractive marketplace for us. But definitely, the commercial side of it is going to be under pressure for the foreseeable future.

And now take our next question from David Raso from Evercore ISI.

I was curious, now that we're a month into the quarter, you are starting to see a little bit better trend sequentially. I know they're tenuous but still all set with the cost actions. Do you feel the company at a net income level will be profitable in the second quarter?

I would say that we need to select a revenue number, which we are not prepared to do yet. If we maintain the trend lines we've discussed and if April was the lowest point, then the answer would be yes. However, we could definitely face worse conditions moving forward. So I would say we could potentially be profitable across a broad range of scenarios, but certainly not in all cases. We have customers who have experienced no revenue for six weeks at a time, and if a situation like that were to occur for Timken, it would pose a challenge. But if the trend lines remain positive, then yes.

And now we'll take our next question from Justin Bergner from G.research.

Two questions on my end. Most others have been answered. You mentioned the change in the compensation, I think, expense second quarter versus first quarter that you're expecting given the temporary actions. Could you repeat that? And is that for all salary, all both salaried and hourly folks or just salaried individuals?

We anticipate that overall compensation will decrease by 25% across the company in the second quarter, which includes both salary and operational expenses. This estimate assumes that a considerable portion of our production remains idle in May and June. If the situation improves, we could see a recovery in these numbers. However, we still expect both salaried and SG&A expenses to be down 25% year-over-year in the quarter, regardless of how demand develops moving forward.

Okay. The other question was regards to price cost. Looking at the adjusted EBITDA bridge in the first quarter, it looks like there was a $12 million benefit from price/mix. Could you break out the price versus mix? And then where does material deflation, to the extent that played a role, fit into that adjusted EBITDA bridge slide?

Yes, that's a great question. We typically don't disclose pricing and mix separately, but both were positive. Pricing contributed positively, as did mix. We discussed pricing during the last call and had indicated an expectation of around 50 basis points, possibly a bit better. We still anticipate positive pricing for the year, which is one definite point I can share. In the first quarter, we performed slightly above our annual forecast, with positive pricing in both Mobile and Process. That's a strong narrative for the company. That pricing includes material pass-through, which we recognize with a lag, so it’s reflected in those figures. We also noticed favorable material costs during the quarter, and there's a significant logistics component shown on that slide. Both material and logistics were beneficial, but material likely had a greater impact on the quarter than logistics. Overall, it's a positive situation for Timken. As we progress through the year, we expect material costs to stay low. While there may be some necessary pass-through, it shouldn't be substantial and will likely be more than balanced out by the advantages we gain in material costs.

Just to add a little bit to what Rich said, overall, yes, we've seen favorable price each quarter. And we would expect that to continue through the full year, given our pricing and our market position.

And also, we would expect that commodity prices stay relatively low certainly through the second quarter. And all that should help on the overall margin side as well.

And now we take our next question from Michael Feniger from Bank of America.

I just have a quick question. You mentioned that if we experience a decrease in demand, you would consider more structural cost-saving measures in the second half. You've already made significant progress on cost savings over the years. Could you remind us of the structural costs you removed in 2018 and 2019? If further cuts are necessary, is there still easy-to-address opportunities available, or are you reaching a point where it becomes more difficult?

Yes, I would say we've been aiming for a 1% net increase per year and have largely achieved that, mainly due to our manufacturing footprint. We started this year with several significant projects, including the acquisition of Diamond Chain and restructuring within our manufacturing operations and bearing divisions, which have contributed significantly. We intend to pursue this approach regardless of market conditions, with the goal of accelerating our efforts. Our digital platform has played a key role in improving efficiency; we consolidated several systems onto our primary digital platform last year. We have identified material savings, some of which are structural and some cyclical, with the cyclical aspect looking quite promising at the moment. Additionally, we are benefiting from acquisition synergies; for example, we have made notable progress in consolidating regional structures for Groeneveld and BEKA, leading to cost savings. Therefore, our target remains the 1% increase for this year. In response to your question about making cuts, our long-term focus is on growing the business. We aim to avoid cutting core functions and prefer to implement strategies that enhance our capabilities during downturns and strengthen our position as we recover.

Thanks, everyone, for joining us today. If you have further questions after today's call, please contact me. Again, my name is Neil Frohnapple, and my number is 234-262-2310. Thank you, and this concludes our call.

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