Regal Beloit Corporation (NYSE:RBC) Q2 2020 Earnings Conference Call July 4, 2020 10:00 AM ET
Robert Barry – Vice President of Investor Relations
Louis Pinkham – Chief Executive Officer
Robert Rehard – Chief Financial Officer
Conference Call Participants
Julian Mitchell – Barclays
Mike Halloran – Baird
Christopher Glynn – Oppenheimer
Michael McGinn – Wells Fargo
Brian Joseph Lau – Wolfe Research
Jeff Hammond – KeyBanc Capital Markets
Chris Dankert – Longbow Research
Good morning. Welcome to Regal Beloit’s Second Quarter 2020 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] 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.
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.
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 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 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 G, 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, through all of 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 are 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 multicontinent 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 time line 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 have 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 second quarter. On the flip side, we expect a benefit to sales in 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 meaningfully 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 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 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 in a very secure balance sheet. In fact, given our strong first half cash flow generation and improving orders, we did feel 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 lots 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’d 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 second quarter as we continued to deprioritize our lowest margin account.
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 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 in at $5.2 million for 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 eke out some nice share gains in the quarter, in particular, 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 third quarter.
Thanks, Louis, and good morning, everyone. I’ll start by echoing Louis’ comments about second quarter being particularly challenging on a number of fronts, but also that our Regal associates remain focused on purposely executing what was under their control. And we’re successful in doing so, achieving a 15.5% deleverage rate, favorably below what we had referenced coming out of our first quarter earnings call, especially given the COVID cost headwinds at our facilities and $77 million of free cash flow for a cash conversion rate of 255%.
The top line story was largely about first and second derivative impacts of the coronavirus. In our first quarter, the geographic impacts of COVID were weighted to Asia and Europe, where we generate about 25% of our sales versus in the second quarter, when COVID-19 impacts weighed more heavily on the Americas, where we generate 75% of our sales. In the second quarter, we saw some recovery in Asia, but Europe remained under pressure, and North America was heavily impacted, evident in our sales being down 24.7% on an organic basis.
The good news is that as the quarter progressed, our order rates improved, with July coming in even stronger at down 7%. In our more consumer-driven business, such as resi HVAC and pool, we’ve seen a much more dramatic recovery in orders. I’ll provide more details as I walk you through our segment results.
Starting with commercial. Organic sales in the second quarter were down 23.6% from the prior year. The decline was largely volume driven, with particular headwinds in our North America general industrial and commercial HVAC markets and in our Europe air moving business. However, we did see an increase in our backlog in this business as we worked to best serve our customers, while managing challenges at our plants and in our supply chains.
We also saw more modest headwinds from our ongoing proactive pruning of low-margin accounts as we continue to execute on our 80/20 initiatives and to a lesser extent, from foreign exchange. Our pruning activities accounted for roughly 150 basis points of the organic sales decline.
Let me also update you on our pool pump business, which you may recall, was negatively impacted in first quarter by COVID-related production delays at one of our facilities in China. That facility resumed operations in April and is running normally. We also have some pool pump production in Mexico, where we’ve been experiencing scattered COVID-related operating frictions. From a demand perspective, our pool pump business saw increasingly positive momentum during the quarter.
While orders for the quarter were down 4%, June orders were up 49% versus prior year and July orders were up 30% versus prior year. With our manufacturing facility in China back up to full production levels, along with our facility in Mexico at near full production levels, we are confident in our ability to meet customer service levels throughout the pool season.
Also of note is that the commercial China market showed nice improvement in the quarter as we continue to execute on our 80/20 customer segmentation initiatives, as discussed on our last earnings call. The adjusted operating margin in the quarter for Commercial Systems was 6%, down 350 basis points compared to the prior year.
This margin was primarily down due to the volume decline and to a lesser extent, higher freight costs and increased burden from manufacturing plant inefficiencies due to COVID. We were able to partially offset the impact of these headwinds with significant cost reductions in addition to getting some benefit from favorable price/cost. Our deleverage in the quarter was 20.2%, a nice result given the headwinds in this business and far below historical deleverage rates.
Orders in commercial for the quarter were down approximately 23%, reflecting particular weakness in Europe and in our North America general industrial market, with Asia and pump as bright spots. In July, orders were down 1% with similar relative dynamics by end market that we saw in the quarter. This is a solid recovery, and we are optimistic that this rate will continue in the quarter.
In industrial, organic sales in the second quarter were down 19.8% from the prior year. The segment saw double-digit largely COVID-related declines in the general industrial, non-residential construction and oil and gas end market, in particular, in Europe. This was partially offset by stronger sales into the data center market, where our products provide standby power. The decline in sales was also impacted by our proactive approach to pruning low-margin accounts, which accounted for approximately 180 basis points of the organic sales decline.
The adjusted operating margin in the quarter for industrial was 4.3%, up 420 basis points compared to the prior year. The margin improvement was driven by 80/20, continued cost reductions, positive price/cost and favorable mix, partially offset by the impact of lower volumes. We still have a long path to raising our industrial operating margin to an acceptable level, but we were very happy to see such a meaningful improvement in the second quarter given severe COVID-related headwinds on the top line.
The industrial team has done a great job executing on what’s under its control. Orders in industrial for the quarter were down 18%, but would have been down further were it not for the strength in the data center business. The headwinds from COVID-19 quickly became more pronounced as the second quarter began, with April orders in industrial down 27%, but we started to see improvement as the quarter progressed, and orders for July were down 15%.
Turning to Climate Solutions. Organic sales in the second quarter were down 31.4% from the prior year. The decrease was primarily driven by destocking at our HVAC OEMs and in the residential HVAC channel, along with pressure on our commercial refrigeration business, which is only 8% of the segment sales, but had a sizable year-over-year decline given its exposure to the hospitality end market. As a reminder, the climate segment also had a nice volume leverage tailwind in the prior year period related to OEM prebuild activity ahead of a furnace energy efficiency regulatory change, creating a tough compare this year. Last year, we communicated that we saw roughly $9 million of FER-related pull-ahead into the first half of 2019, most of which was in the second quarter.
Overall in Q2, sales of more energy-efficient furnaces was a mix tailwind for us in the second quarter, but its impact was diminished by the end market headwinds discussed earlier. It should also be noted that weather had a fairly neutral to modestly positive impact in the second quarter, posing a headwind in April and May, but inflecting to a tailwind in June. Weather in July was particularly favorable. In addition, the decline in sales was driven by our proactive approach to pruning, which impacted sales by 300 basis points.
The adjusted operating margin in the quarter for climate was 12.4%, down 520 basis points compared to the prior year. Continued cost reductions helped to partially offset volume and mix-related pressures. Deleverage in this segment was 28.5% in the quarter, in line with the scenario planning framework we provided last quarter, but still slightly above where we wanted the segment to be.
We’d attribute the weaker deleverage to the combination of severe COVID-related top line declines and weak absorption at a couple of the segment’s principal manufacturing operations in Mexico and due primarily to the government-imposed medical restrictions and mandates in addition to FER-related mix headwinds. On a more positive note, orders in climate started to show meaningful improvement in June and July. And we are cautiously optimistic that we’ll see significant improvement to the segment’s operating margin in the back half of this year, starting in the third quarter.
Orders in the climate segment for the second quarter were down 34%, largely on the COVID-related headwinds in HVAC as well as commercial refrigeration, which makes up roughly 10% of the segment and where orders were down 40%. Orders in July were down 6% with Asia up nicely, North America down modestly and our Europe business, which makes up 7% of the segment down meaningfully. Our Europe business in climate is heavily weighted to the hospitality end market, which continue to see pressures tied to COVID-19.
Summarizing what we are seeing on the orders front within the climate segment are significant sequential improvement in order rates in both May and June and now again in July. Turning to Power Transmission Solutions, or PTS. Organic sales in the second quarter were down 21.1% from the prior year, reflecting significant pressure on the North America general industrial end market and to a lesser extent, headwinds and upstream oil and gas, lumpiness in the alternative energy market, our proactive actions to prune lower-margin business and foreign exchange. In the second quarter, our pruning actions weighed on sales by roughly 100 basis points. Partially offsetting these headwinds, we saw growth in midstream oil and gas from pre-existing project activity as well as modest growth in China and in the ag end market.
While our exposure to oil and gas is only about 5% to 7% of the PTS segment and is weighted to midstream, the severity of declines we saw in upstream had an outsized impact on sales performance in the quarter for this segment. The adjusted operating profit for PTS was down $3.6 million in the quarter despite the $45 million year-over-year decline in sales, representing deleverage of 8%. Operating margin in the quarter for PTS was 13.6%, up 120 basis points compared to the prior year. Continued cost reductions and to a lesser extent, favorable mix and slightly positive price/cost more than offset volume-related pressures. Orders in PTS for the quarter were down approximately 18%, largely on headwinds in the general industrial and upstream oil and gas end markets.
Looking at July, year-over-year orders were down 10% on diminished, but still fairly broad-based headwinds. Notably, our short-cycle industrial-focused bearings business stabilized during the second quarter. May appears to have been the bottom for this business, though we have not — though we have seen limited improvement in June and July, with customers appearing to order at demand versus showing an appetite to restock. We do believe channel inventories and bearings are relatively lean, and we would expect to see a nice tailwind in this business when end user confidence rises and restocking does start to occur.
Now I will summarize a few key financial metrics for the second quarter for total Regal. Our capital expenditures were $9.5 million in the quarter. We continue to be focused on ensuring that we deploy capital that drives returns above our weighted average cost of capital and ultimately improve shareholder value. We continue to monitor capital expenditures very closely and continue to expect full year spending of $50 million. The adjusted effective tax rate in the quarter was 22.4%. We’ve provided a table in the appendix of this presentation to reconcile the GAAP ETR to the adjusted ETR. Our full year adjusted ETR is still expected to be 21%.
Our simplification and footprint consolidation activities resulted in $10.9 million of restructuring and related costs in the quarter, and we now expect $25 million of restructuring spend for the full year. Also included on this page is a summary of the cost savings actions we have taken both in 2019 and now 2020. We expect our 2020 restructuring actions to result in approximately $45 million in annualized savings.
As a reminder, during our first quarter earnings call, we estimated that we would realize $32 million of 80/20 in restructuring-related cost savings this year. We now anticipate that we will realize $36 million of cost savings this year, an increase of $4 million from our prior estimate due to the additional actions we took during Q2. Of the $36 million in cost savings, we estimate that we realized approximately $8.5 million in Q2 and will realize an additional $23.5 million in the second half of this year. We’ve provided on this slide, the quarterly cadence of how we expect these cost savings to contribute through the remainder of this year.
In the second quarter, we also realized $6 million of savings related to temporary pay reductions and furloughs. During the quarter, we recalibrated our cost actions under the carefully considered assumptions that there will not be a V-shaped macro recovery in the U.S. or in Europe and that any recovery could be bumpy and will likely be protracted. As a result, we took the difficult decision of implementing a reduction in force and also offered a voluntary early retirement program. These two actions together impacted roughly 4% of our global workforce and are expected to generate $7 million in annualized savings, with roughly $4 million of that amount recognized in the back half of this year.
As Louis mentioned in his remarks, post our headcount actions, we believe we now have our fighting team in place. And with lots of opportunity ahead of us on the revenue, cost and cash flow front plus some positive data points on orders, we thought it was appropriate to end the pay reductions and furloughs implemented for the second quarter.
Now let’s move on to our balance sheet. Our total debt at the end of the second quarter was $1.126 billion, and our net debt was $694 million. We ended the quarter with our net debt-to-adjusted EBITDA ratio at 1.6%, the same as how we ended the first quarter and well within our comfort zone of 1.5% to 2.0%. I will also reiterate what Louis highlighted in his opening remarks in that we fully paid down our revolver during the second quarter after drawing it down out of an abundance of caution in the early days of COVID-19. Our balance sheet remains very strong with a solid cash position, along with relatively low debt.
Moving to free cash flow. We achieved $77.4 million of free cash flow in the quarter. Our second quarter free cash flow resulted in a conversion rate of 255% of adjusted net income and speaks to the cash generating capability of the business. Trade working capital was a source of cash in the second quarter, and we continue to expect trade working capital to be a source of cash throughout 2020. As we discussed during our first quarter earnings call, we decided to pause on stock purchases to preserve capital in response to COVID-related uncertainties. For now, our program remains paused, but we are open to reinstating this program when we see sustained order rate patterns.
Moving on to the outlook. Similar to last quarter, we’re not providing guidance for the full year. But unlike last quarter, when we provided scenarios, we’re now at a point where our order rates are improving, giving us more confidence to provide a framework for the third quarter. However, given we’re a short-cycle business and there’s still uncertainty in the market and potential uncontrolled COVID impacts on our operations, we’re not providing an outlook beyond the third quarter. We expect sales to decline in the range of 8% to 12% versus the third quarter of last year, with PTS at the higher end of the range and commercial near the lower end.
We expect deleverage to be in the range of 12% to 18%, which at the midpoint is consistent with the deleverage rate we saw in Q2, with room to improve. I’ll remind you that we started realizing the cost actions implemented last year in Q3 of 2019, which provides a bit tougher comp. However, the additional cost actions discussed earlier should help offset that year-over-year comp headwind.
Next, I thought it made sense to remind you of comments we made last quarter about how we believe the business can perform when our sales start to grow again. Our thoughts here are unchanged. We feel very strongly that through our 80/20 initiatives, our supply chain move and our other restructuring actions, we are building a business that has a fundamentally different cost structure versus recent cycles. That means we expect the strong performance we’ve been executing on deleverage will also translate into stronger leverage rates versus history, which we think can be above 30%. At the bottom of this page, we’ve included some additional assumptions that can be used when modeling the remainder of this year.
Before I conclude our prepared remarks, I want to once again thank all of our Regal associates for everything they are doing to navigate these difficult times. Our results in Q2, despite severe pandemic-related revenue headwinds and manufacturing disruptions showed very strong execution, as demonstrated by a low 15.5% deleverage rate and strong free cash flow. And with that, I’ll turn it back over to the operator. Operator, we are now ready to take questions.
[Operator Instructions] Our first question is from Julian Mitchell from Barclays.
This is Trish on for Julian. So [indiscernible] 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?
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, May was slightly weak, but June — 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 digit. Hopefully that helps.
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?
Trish, this is Rob. I’ll take that one. So first of all, on the split by segments, all segments have their share of the cost savings. And of course, the industrial segment, as we’ve communicated previously, does have a good percentage of those cost savings in their expectations. Certainly, we’ve communicated how in industrial most of the improvement plan is cost savings related as opposed to growth related on the top line.
So that’s really the way to think about it. In terms of industrial coming out of this and working towards higher margins, we have a — as we showed in our Investor Day, we have a plan to get industrial margins above our weighted cost of capital over the term, as we pointed out in that presentation. So that’s really the way to be thinking about it. Should industrial lever up 35% or so? I think just maybe around 30%, maybe slightly just south of that, that’s kind of the way to think about it.
Our next question is from Mike Halloran from Baird. Go ahead.
So first on the climate side, could you help put a lot of those moving pieces into context for us? We’re certainly hearing of some pretty robust residential trends in that June, July time period, you’re certainly talking about some sequential improvement, you’ve got other pieces in there, some FER comps and other — and some other pieces that are constraining that, but maybe talk a little bit about that trend, if you’re keeping up with what you think the end markets are looking like right now.
Any commentary on what inventory looks like through the channel to help understand the comparative performance between what you’re looking like and maybe what the sell-out from the industry is looking like?
Yes, Mike, this is Louis. I’m happy to share. We provided a lot of information in our prepared remarks and a lot of numbers. And hopefully, not to confuse, but to provide as much transparency in detail. But to give you our perspective on HVAC in our climate segment, in particular, certainly, weak demand in April and May. We saw significant destocking by our customers as well as in the channel in early parts of second quarter, certainly through early June. In addition, when you look at the mix of that business, roughly 10% of the sales are our commercial refrigeration that served the hospitality end market, and those orders were down significantly in the quarter, and we’re not seeing them rebound.
And then to your point, there was the tough compare of FER, which we believe has probably about a 3-point impact in second quarter. Now you — when you asked the question of how do you compare that maybe to some of the OEMs that have provided results already, clearly, we’re upstream of those OEMs. Those OEMS were — we would say, have taken their inventory levels down in second quarter. But we are starting to see them restock. And so that justifies some of the upsides we’re seeing. Now sales in — excuse me, orders in April were down 40-plus percent in that segment year-over-year. And then we saw a consecutive improvement of 9 in May and 25 in June and July, another 26.
And so overall, we’re seeing for the month of July, pretty much flat from year-over-year perspective. I’m bullish, actually, of what’s going on in this segment. I’m also very positive about the relationships we have with our OEMs and the partnering that we have going on. We’re in the middle of a couple of long-term agreement negotiations that I would tell you are going positively. In the end, our responsibility as a supplier to this segment is to provide good product technology, great service, which we do and be cost competitive, and I believe we’re doing all of that well and partnering with our OEMs to help them be successful in the future with new products and technology.
So overall, a tough Q2, no question, orders in April, May, tough. Definitely rebounding, and we feel good about third quarter and beyond. This is why also in our prepared remarks we made the comment that we feel our operating margin should improve because of this — the sales increases we expect in the second half. So hopefully, that answers your question.
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?
That’s exactly right. That’s exactly right.
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?
Yes. So a couple of comments there. Overall, Regal’s orders in July were down 7% year-over-year. And we believe our sales will be down roughly 8% to 12%. I will comment that our backlog did grow in second quarter. And so from a consecutive orders rates, we’re not looking for a great improvement, if anything, maybe even July was a little bit of a bump. August — we’re not expecting August and September to be anything stronger at this point.
Our next question is from Christopher Glynn from Oppenheimer.
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?
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 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 onetime impacts, which should allow us to continue to improve on the operating margins in this segment as we proceed through the year.
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.
Yes. I mean this is our 80/20. This is who we are. This is understanding our customers, understanding the value they place in our offering, and providing the best solution. Now if we can’t do that competitively and we can’t make appropriate margins, then we’ll make those tough decisions. I would say historically, as I’ve commented on other calls, that perhaps Regal hasn’t done this in the level of analytical detail that we are doing today, which is raising this need to do pruning.
Where our focus is, is around having 80/20 drive us so we can focus on our highly valued customers and grow with them. And we’ll define those highly valued customers as those that value us as well. In addition, it allows us to focus on what we define now as our perfect prospect customers and segments. Those customers, again, that value our technology and our differentiation and are willing to pay for that appropriately. And so I’ve talked about a couple of our segments and regions that are gaining some nice momentum here.
Our commercial motors business in China has gained some fantastic momentum. Our hermetic business is gaining some momentum. Because we’re focusing our teams on where we’re going to get the best returns. And so I’m not surprised by — we had said before that we thought pruning would be between 1% to 2% for Regal. It was 1.9% in the quarter, a little bit higher in climate, but again, I’m okay with it. And because it’s — we’re putting our focus on the right places and where we need to go with the business long term. Hopefully, that helps.
Our next question is from Michael McGinn from Wells Fargo.
Congrats, Mr. Barry on the new seat.
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.
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.
Okay. And then I think you mentioned some repo considerations, maybe the back half of this year. Shares have had a good, a really good run here. I think you’re trading above pre-COVID levels. So can you just talk about what you’re baking into — what is more market considerations versus your own return on capital metrics? How do you see that playing out through the back half of this year?
Right. So as I talked to during the call, we are still suspending the share repurchase program. However, the things that will cause us to actually open that back up and reinstate the program would be things like, hey, the continued stabilization of our order rates, for example. As we go through the year, we saw a really nice uptick sequentially in our orders, as we commented on the call. And so that continuation will certainly be one of the factors that we’re looking to in order to reinstate that program. The other would be market as you said. The demand side — as the market starting to stabilize more going forward and is that our expectation. It’s that sort of confidence that would trigger our decision to potentially open back up and reinstate the repurchase program.
Okay. Very helpful. And if I could just sneak 1 more in on the PTS because I don’t think it’s gotten a lot of color thus far. Some other OEMs noting strength in the center of the aisle, grocery. I know you have some conveying, parcel, food exposure there. Any comment on the long-term end market drivers that maybe you see as we get through these — this choppy waters here?
Yes. So if you look at our PTS business and our conveying business, it’s a bit more focused on beverage and then material unit handling. We are incredibly bullish on material unit handling. This is even pre-COVID, which the driver now is around social distancing. But pre-COVID, it was around safety and automating that last mile of package distribution, and we have a great technology. It’s differentiated with solid accuracy in the sorting process. And so very, very bullish there.
On the beverage side, we tell you we’re — during 2019, there was a bit of a lull, and it was really what’s going on in the marketplace around plastics and what’s going to be the replacement packaging for plastic bottling, et cetera. That hasn’t been worked out, and we’re in the middle of COVID. So right now, we are seeing some nice aftermarket business. But I would say, once we get through COVID and there’s a clarity on the path forward for packaging, I believe bev is going to be strong as well. But our — where we’re putting our 80/20 focus is material unit handling.
Our next question is from Nigel Coe from Wolfe Research.
Brian Joseph Lau
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?
Yes. No, happy to. Again, as I emphasized in those remarks, this is a core capability of Regal, is our global supply chain. And so we have the ability to manufacture in multiple facilities, and it really just comes down to working with the customer to get their approvals and certifications from the manufacturing site. And so we’ve actually transferred quite a bit of our production capacity into our China and Southeast Asia facilities to be able to support the demand in the marketplace and the service levels as we were — through Q2 did have challenges in Mexico in our supply chain. And so again, I think it’s a core differentiator for Regal and makes us as strong as we are in the market.
Brian Joseph Lau
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?
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.
Our next question is from Jeff Hammond from KeyBanc Capital Markets.
Just back on — so the guidance is 8% to 12% down. I think you said PT at the better end, commercial at the lower end. Should we assume that the other 2 businesses are kind of square in the middle and why would climb — or why would commercial be at the lower end given kind of order rates and the backlog build?
Yes. Well, I think that’s the reason they would be at the lower end because on the — they do have — on the deleverage standpoint, we would expect them to have a little bit of — a little bit of an uptick in terms of — or improved deleverage as we move through the third quarter.
No, I’m asking…
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.
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?
They’re in that, yes, within that range, yes, they’re within the middle.
Okay. So then just moving back to climate because I’m still confused. So I think you said July orders down 6% overall. And resi HVAC, which I think is 40% to 45% of the segment is up 26%. Can you just go through the piece — because I understand refrigeration is weak, you said that, but that’s only 10%. Can you go through these other pieces like general industry, combustion, aftermarket? Like it just seems like that other 60% is just really, really bad still.
Yes. So just to be clear, from a segment perspective, we are combining our HVAC in combustion, and that’s overall roughly 55% to 60% of the segment, so not the 40% that you referenced, Jeff. So it’s a larger part of the segment. Now distribution. Distribution is also roughly about 10% to 15% in the segment.
The rest of the segment, I remind you that we do have a small India business, and India orders were weak in second quarter. And then general industrial and commercial refrigeration are the other two. Commercial refrigeration absolutely down. And so to that point, we saw orders down 40-plus percent in second quarter. And then general industrial down as well, but in the mid-20s from a Nordic perspective. So that 40% is — actually, it’s more like 30% are definitely down.
It just doesn’t seem to add up to down 6% for July given that mix you talked about, but I can follow-up offline. So just — just on — so I think clearly, the OEMs destocked, and then they saw rapid demand. So it seems like channel inventories are very, very lean and demand is very, very high. I mean are you — is there any indication that there’s not only some catch-up in demand, but a view that inventory levels need to catch up as well and you continue to see kind of this sharp restock and recovery kind of continue into 4Q or at least continue through the third quarter?
Yes. I mean, definitely, we expect restocking to go on, inventories were brought down. I’ll remind you, our perspective, the underlying demand, the underlying consumer demand, and we at least believe we heard this in the OEM’s earnings call, are still down that high single-digit 10% rate. So it’s not a full rebound there yet. But — so you add that to the positive of some restocking, but then the negative of roughly 30% of the segment being in commercial refrigeration and general industrial. And I do think it comes up well because our numbers came out at 5.5% orders down in July. We certainly expect a better third quarter, but we are planning for that roughly 5% to 8% down.
Okay. Yes. Because — I mean the distributors and the distributor data, which would represent sell-through indicates June and July were like closer to plus 20, so where is the negative underlying consumer demand coming from?
Yes. Well, April and May were significantly lower. So if you look at April and May results for distribution, it was quite a bit lower than that. So down 47% in April, down 29% in May for us. This is for us, Jeff, down 29% in May, down 3% in June, up 24% in July. So from a second quarter perspective, orders were quite weak, down 26% overall in second quarter, but absolutely rebounding in July.
Our next question is from Chris Dankert from Longbow Research.
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.
Thanks, Chris. This is Rob. I’ll start and then Louis can also add on, on the automation side. But when it comes to the additional savings that we highlighted during the call, those are really more around the reduction in force and the voluntary retirement program that we laid out — implemented at the end of Q2. So that’s the $7 million annualized with roughly $4 million of that coming in the back half of this year. So that wasn’t really plant related. The plant-related restructuring actions that we’ve taken were already embedded in the $38 million or the $32 million in the year that we talked about last quarter.
Yes. So I’ll add on to that as well. Rob’s right on. I’ll reemphasize, though, as we talked about at our Investor Day that we have a clear path for footprint consolidation. And we’re on our plan that we communicated, which was going to be a 23% reduction in our square footage over the next 3 years. And so we did close a couple of facilities in second quarter, specific to that question. But to Rob’s comment, that’s not part of the incremental $6 million of savings. It was already embedded in what we’ve communicated in the past. But we feel really bullish about the opportunities to drive 80/20 at Regal and to simplify our business. So a 23% reduction in footprint, we’re driving a 42% reduction in product rationalization. So SKU count, we’re improving our best value country sourcing significantly over this period. All of these things are with our path of 3 basis points of improvement in three years.
Now specific to your question on automation, and you may recall in earnings call — three or four earnings calls ago, we changed our direction a bit here. Regal was going down the path of large automation implementations. And we’ve pulled that back and we said, where it makes sense and we can put a solution in that results, like a cobot, lesser cost investment but a faster return, we’re going to do that.
And we’ve done that at many of our facilities, and we continue to do that in many of our facilities. And so Rob made the comment in his prepared remarks around our capital investment. An investment like that is going to pay back in less than a year and we’re driving it in many of our facilities. And so that’s where our focus is, not on a big bang automation solution, but on tailored, customized solutions in our manufacturing lines that drive safety, quality and then cost. Hopefully, that helps, Chris.
No, that’s very helpful. And then just to follow-up. Again, we’ve heard from a lot of companies so far. With the downturn in volumes kind of revisiting the go-to-market commercial excellence, just given the kind of air pocket here, any thoughts from you guys in terms of shifting direct versus indirect growth strategy? Just any comments more broadly on go-to-market would be great.
Yes. So no changes in our approach to go-to-market other than 80/20, and it’s all about servicing our highly valued customers and providing them better service solutions and then leveraging our digital customer experience, which we’ve invested significantly in over the years, that I’ve reinforced investment in since I’ve been CEO, to make it easier to do business with Regal. So beyond that, no changes in our go-to-market plans.
This concludes our question-and-answer session. I would now like to turn the conference back over to Louis Pinkham for closing remarks.
Thank you, operator. To summarize, 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 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.
The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.