Shelly M. Chadwick - The Timken Co. Richard G. Kyle - The Timken Co. Philip D. Fracassa - The Timken Co..

Stephen Edward Volkmann - Jefferies LLC David Raso - Evercore ISI Group Samuel H. Eisner - Goldman Sachs & Co. LLC Joseph John O'Dea - Vertical Research Partners LLC Chris Dankert - Longbow Research LLC Steve Barger - KeyBanc Capital Markets, Inc. Michael Feniger - Bank of America Merrill Lynch Justin Laurence Bergner - Gabelli & Company.

Good morning my name is Paula 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. All lines have been placed on mute to prevent any background noise.

After the speakers' remarks, there will be a question-and-answer session. Thank you. Shelly Chadwick, you may begin your conference..

Thank you, Paula, and good morning, everyone. Welcome to Timken's first quarter 2018 earnings call. I am the Vice President of Finance and Chief Accounting Officer for the company. Jason Hershiser is not with us this morning because he's off enjoying some time with his new son, Dylan, who was born last week. I wanted to thank you for joining us today.

If, after our call, you should have further questions, please feel free to contact me directly at 234-262-3223. Before we begin our remarks this morning, I want to point out that we have posted on the company's website presentation materials 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'll have opening comments this morning from Rich and Phil before we open the call up for your questions.

During the Q&A, I would ask that you please limit your questions to one question and one follow up at a time to allow everyone an opportunity to participate. 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 report filed with the SEC, which are available on the timken.com website.

We've 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. Without expressed written consent, we prohibit any use, recording, or transmission of any portion of the call.

With that, I'd like to thank you for your interest in The Timken Company, and I'll now turn the call over to Rich..

Thank you, Shelly, and congratulations, Jason. Good morning, everyone. Thanks for taking the time to join us today. We reported an excellent first quarter with strong financial performance, all as a result of robust market demand, our strategic initiatives, and very good execution. Revenue was up 25% with 15% from organic and 7% from acquisitions.

While we are benefiting from strong market demand, our results also provide evidence that our outgrowth initiatives are working. We delivered $1.01 of adjusted earnings per share for an increase of 84% from the first quarter of 2017. The EPS growth reflects the benefits of growth, margin expansion, capital allocation, and tax reform.

We achieved 13.5% EBIT margins in the quarter, a 360 basis point improvement from the same quarter last year. We achieved our short-term goal of getting Mobile margins above 10% in the quarter and we still expect to be above 10% for the full year. We're very pleased to achieve greater than 20% margins in Process Industries.

The biggest driver of the margin expansion was volume. Price was also a big contributor to margins. We realized over 100 basis points of positive price in the quarter and expect to stay over 100 basis points for the full year.

Our material costs were up slightly in the quarter, and we expect material cost to continue to trend up through the year and into 2019. We remain confident in our ability to recover material costs over time. Our material costs went up last year, and we expanded margins last year.

Our material costs will be up further this year, and we expect to expand margins again this year. We've demonstrated our ability to recover material costs and expand margins in a rising cost environment, and we will continue to do so.

Margins were also helped by our ongoing operational excellence initiatives, including last year's plant closures and this year's plant ramp-ups. All of our recent acquisitions are performing well. They're all benefiting from strong industrial markets, and we are achieving synergies across the businesses.

We still expect to close the ABC Bearings acquisition in 2018. And while we have nothing new to report, we remain active on the M&A front and optimistic that we will add more inorganic revenue and earnings in 2018 and into 2019. We're excited to have a better market environment to leverage our outgrowth initiatives.

We're delivering growth across product lines, across markets, and across geographies. We're serving our customers well, and the inventory we built in the fourth quarter of last year and into this quarter has helped us to respond to the increase in global demand efficiently and effectively.

Cash flow was seasonally weak in the quarter and was compounded by the working capital build, but we are planning for our inventory build to level off in the second half of the year and to generate strong cash flow for the full year.

Turning to the outlook, we have seen demand remain strong through April and are planning for revenue seasonality in line with prior years. That would result in sequential revenue improvement in the second quarter but a modestly weaker second half than first half organically.

We had the same sales trend organically last year, and we do not see the revenue leveling off in the second half as an indication that our markets are at a peak. In total, we are planning for 17% top line growth in 2018 with 12% of that organic. We are revising our EPS guidance to $3.95 a share at the midpoint, up approximately 50% from 2017.

That implies full year margins just shy of Q1 levels and over 200 basis points up from last year. The upside to the EPS estimate are primarily stronger demand and our ability to extract greater price/mix in an expanding market. There's been a lot of activity and questions on the trade front, so I'll make a few comments on that topic.

We do not currently expect the Section 232 tariffs and the proposed exemptions to have a material impact on our business. We are concerned about the long-term impact on our U.S. customers and any trade retaliation that may take place. But at this time, we do not envision a significant impact on the horizon.

We do expect steel costs to continue to increase this year and next and have that factored into our outlook. In regards to the proposed 302 tariffs, bearing imports from China are included in the proposal. Should these tariffs go into effect, in the short-term, we would expect some positive and some negative competitive impacts to our business.

None of which we believe would result in a dramatic change in our global competitive position or financial results. We will continue to monitor the trade dynamics closely. I'll now turn it over to Phil to go into more detail on the quarter..

Okay. Thanks, Rich, and good morning, everyone. For the financial review, I'm going to start on slide 10. Timken delivered strong performance in the first quarter and you can see a summary of our results on this slide. We posted revenue of $883 million, up just over 25% from last year.

Adjusted EBIT came in at $120 million or 13.5% of sales with margins expanding 360 basis points year-on-year. And adjusted earnings in the quarter came in at $1.01 per diluted share, up 84% from a year ago. Turning to slide 11, let's take a closer look at our first quarter sales performance.

Organically, sales were up just over 15% from the prior year, reflecting higher demand across most end market sectors led by industrial distribution and off-highway, plus the impact of positive pricing in the quarter. Acquisitions completed last year added $47 million of revenue or almost 7%. And currency translation from a weaker U.S.

dollar contributed $24 million or around 3.5% to the top line in the quarter. Sequentially, our sales were up over 13% from the fourth quarter as we saw sequential strengthening across most of our end markets. On the right, we show organic growth by region, so excluding both currency and acquisitions.

You can see that all regions were up in the quarter organically with significant growth outside North America. Let me tick through the regions briefly. In Europe and Asia, where we were up 20% and 30%, respectively, we saw broad strengthening across virtually all of the market sectors we serve.

In Latin America, we were up 29%, driven mainly by growth in rail, industrial distribution, and heavy truck. And in North America, our largest region, we were up 8% with most market sectors up led by off-highway, industrial distribution, and gears and services. Turning to slide 12.

Adjusted EBIT in the quarter was $120 million, up from $70 million last year. Adjusted EBIT was 13.5% of sales in the quarter, up 360 basis points from the year-ago period.

The increase in EBIT in the quarter was driven mainly by higher volume, favorable price/mix and manufacturing performance, and the benefit of acquisitions, offset partially by higher logistics costs and SG&A expenses. Let me comment on a few of these items. As I mentioned, price/mix was positive in the quarter.

Pricing was positive in both segments, but with more coming in Process than Mobile. Mix was also positive, driven by stronger distribution sales. Looking at price versus material costs, this, too, was a net positive in the quarter as material cost headwinds were relatively slight year-on-year.

While we do anticipate material inflation over the course of the year, we expect the positive price cost dynamic to continue for the balance of 2018 and for price cost to be positive for the full year. Turning to manufacturing. The favorable performance was driven primarily by higher production volume and cost absorption in the quarter.

The higher logistics costs were mostly volume-driven. And looking at SG&A, the increase there was driven by higher compensation expense and other spending increases to support the current sales levels. On slide 13, you'll see that we posted net income of $80 million or $1.02 per diluted share for the quarter on a GAAP basis.

On an adjusted basis, we earned $1.01 per diluted share, up 84% from the $0.55 we earned last year. In the first quarter, our GAAP tax rate was 26%. On an adjusted basis, our tax rate in the quarter was 27%, down from 30.5% last year. The tax rate was in line with our expectations and reflects the favorable impact of U.S. tax reform.

We expect our adjusted tax rate to remain 27% for the balance of 2018. Now, let's take a look at our business segment results, starting with Process Industries on slide 14. Process Industries sales for the first quarter were $395 million, up 23% from last year.

Organically, sales were up $57 million or almost 18%, reflecting increased demand across the industrial landscape with distribution, heavy and general industrial, and services all up year-on-year. We also generated higher military marine revenue and saw positive pricing in the quarter.

Currency was favorable as well, adding just over 4% to the top line, and acquisitions were slightly favorable in the quarter. Looking a bit more closely at the markets. In the distribution channel, the strength was broad-based with all regions of the world up year-on-year.

We ended the quarter with our backlog and distribution up versus last year and up sequentially. In heavy and general industrial sectors, we also saw a fairly broad growth across both end markets and regions.

The higher military marine revenue was driven by increased gearbox build activity in the quarter, and higher industrial services revenue reflects an improving market for high-speed gearbox and other reconditioning services. For the quarter, Process Industries EBIT was $82 million.

Adjusted EBIT was also $82 million or 20.7% of sales compared to $44 million or 13.8% of sales last year. The increase in earnings was driven by higher volume, favorable price/mix and manufacturing performance, offset partially by higher logistics and SG&A costs.

Process Industries adjusted EBIT margins were up 690 basis points year-on-year and up 470 basis points sequentially from the fourth quarter. Our current outlook for Process Industries is for 2018 sales to be up approximately 17%.

Organically, we're planning for sales to increase around 14% driven by broad growth across all of the market sectors we serve including distribution, general and heavy industrial, wind energy, military marine, and industrial services. And we expect acquisitions in currency to collectively add around 3% to the top line for the year.

Now, let's turn to Mobile Industries on slide 15. In the first quarter, Mobile Industries sales were $489 million, up almost 28% from last year. Acquisitions added $43 million of revenue in the quarter or over 11% and favorable currency translation added almost 3% to the top line.

Organically, sales were up $51 million or over 13%, reflecting growth in the off-highway, heavy truck and rail sectors, as well as positive pricing. Looking a bit more closely at the markets. In off-highway, the construction, mining and agriculture subsectors were all up in the quarter. In heavy truck, we saw a solid growth in all regions of the world.

And in rail, our growth was driven mainly by higher shipments in Asia and Latin America. We now expect rail to be up for the full year. Mobile Industries EBIT was $51 million in the quarter. Adjusted EBIT was $52 million or 10.6% of sales compared to $37 million or 9.6% of sales last year.

The increase in earnings reflects the impact of higher volume and the benefit of acquisitions offset partially by higher logistics and SG&A costs. Mobile Industries adjusted EBIT margins were up 100 basis points year-on-year and up 90 basis points sequentially from the fourth quarter.

Our current outlook for Mobile Industries is for 2018 sales to be up approximately 17%. Organically, we're planning for sales to increase about 10%, led by global growth in the off-highway, heavy truck and rail sectors. We estimate that acquisitions will add about 5% of the top line with an additional 2% coming from currency translation.

Turning to slide 16, you'll see that operating cash flow was negative $44 million in the quarter. After CapEx spending of $18 million, our first quarter free cash flow was negative $62 million compared to positive $27 million last year.

A lower free cash flow was driven by increased working capital to support the higher sales levels we're seeing as well as the impact of incentive compensation payouts that normally occur in the first quarter and which were up year-on-year. Much of this was planned coming into the year.

And despite the increase working capital dollars, our working capital as a percentage of sales improved versus the year-ago period. We expect the first quarter to be the low point for cash flow, and we expect to generate solid free cash flow for the full year.

You can see some of the highlights in regards to capital allocation at the bottom of the slide. We spent $18 million on CapEx during the quarter, and we expect CapEx of around 3.5% of sales for the full year.

We also returned $44 million to our shareholders through the payment of our 383rd consecutive quarterly dividend and the repurchase of about 500,000 shares in the quarter.

In regards to M&A, our recent acquisitions are performing well, and we continue to make progress on the pending acquisition of ABC Bearings in India which we now expect will close before the end of the second quarter.

Finally, we ended the quarter with net debt of $946 million or 38% of capital, up slightly from the end of last year but right in the middle of our targeted range for leverage.

Our strong balance sheet continues to provide us with the ability to invest for growth both organically and through acquisitions, and to return capital to our shareholders through dividends and share buybacks. Next, let me review the outlook as shown on slide 17. We're now planning for 2018 revenue to be up approximately 17% in total versus 2017.

Organically, we expect sales to increase about 12%, driven by broad growth across most of our end markets globally as well as the impact of positive pricing. And acquisitions and currency should collectively add around 5% to the top line.

On the bottom line, we now estimate that earnings will be in the range of $3.80 to $3.90 per diluted share on a GAAP basis. Excluded anticipated special items totaling $0.10 of expense per share for the year, we expect adjusted earnings per diluted share to be in the range of $3.90 to $4.00, which at the midpoint of our guidance, is up 50% from 2017.

The midpoint of our full-year outlook implies that our adjusted EBIT margin will expand by more than 200 basis points in 2018. This would put us above the high-end of our targeted EBIT margin range for the full year, a great accomplishment.

And finally, we estimate that we'll generate free cash flow at around $250 million in 2018 or roughly 80% of adjusted net income. And with that, let me turn it back over to Rich for a final comment or two before we start the Q&A session.

Rich?.

Thanks, Phil. We're off to a great start to 2018. Our 2017 performance, followed by the first quarter of 2018 actual results as well as the full-year outlook, supports that our strategy and execution to drive market outgrowth, operational excellence and optimal capital deployment are working.

We believe our markets and the need for our products and services will continue to grow and that Timken will continue to deliver greater value to customers and shareholders. That concludes our formal remarks, and we will open the lines for questions..

Thank you. And we'll take our first question from Steve Volkmann with Jefferies..

Hi. Good morning, guys..

Morning, Steve..

Morning, Steve..

Hey, Rich, since you've kind of opened the door here, I was interested in your comment that you do not see this as sort of peak conditions, and I'm curious what made you say that.

I mean, do you feel like you have visibility into 2019 yet?.

No. I would say we have a level of optimism with our customers. So, well, let me back off 2019 first and talk about 2018. So, our normal seasonality, I think if you look back, we typically grow the top line sequentially from the first quarter to the second quarter.

And with where we sit here today in April, we believe we will do that again this year on the top line. Mobile usually has some softening in the second half versus the first half, Process, as you know, a little hard to predict on that and depends on how the year finishes there.

But basically planning for similar organic revenue to what we saw last year, although the first quarter to second quarter will certainly not be as big as it was last year because we were in the midst of a significant ramp-up last year. As you look out at 2019, obviously, we're not here to project 2019.

But I think our customers are still pretty optimistic. You look at where some of these markets have been in the past and where they went in 2015 and 2016 and where we're at today. And there's pretty good reason to believe that the momentum will carry into at least the start of 2019.

And I think that's what we're planning for the year that we would finish the year strong and roll into next year that way as well..

Okay. Fair enough.

And then I'm curious on Process, I think at least going back the last several years, we do generally see a little bit of margin improvement 2Q over 1Q, but it also sounds like maybe you had a little bit of sort of extra good price cost in the first quarter that will still be positive, but maybe not quite as good as the year progresses.

Can you just give us a sense of the cadence of margin in process?.

Yeah, on cadence, I'd say, for the corporation in total, we're looking to be slightly below the Q1 level. So as you look at Mobile, probably a little stronger first half than second half, as I talked about with the seasonality in Process.

We're not looking for a lot of variation through the year and trying to hang right around pretty close to the number we just delivered..

Right..

Okay. Great. Thanks. I'll pass it on..

Moving on, we'll go to David Raso with Evercore ISI..

Hi. Yeah, just a pretty straightforward question.

Process, if you're looking for the margins for the year to be around 20%, it appears, can you, A, confirm that just so we're clear on the number? What are you implying then about Mobile? And what sort of changed philosophically is it maybe just price cost? Process seemed like a business that in the past, it could achieve these type margins, but it was more you were looking to grow the business now or maybe there would be more investment or whatever it may be, it wasn't going to be necessarily a high-teen margin, let alone 20%.

So I'm just curious, because, obviously, we're going to try to think about how do we extrapolate this going forward and demand for Process is strong. I mean, first quarter organic was 17%, 18%; the rest of the year you're implying 13% organic. So, the business is strong.

But can you help us, A, on the margin; and B, how to think about that margin, how you're looking to run the business in 2018 and 2019?.

Yeah. I'll start, David, on the on the guidance, and then Rich can give a little more color in terms of the strategy. So I think you're right.

If you look at the guidance we put out, the midpoint of that guidance would have consolidated margins expanding over 200 basis points, probably closer to 230 to 240 basis points in terms of expansion, and that would imply Process is about 20%, and then Mobile would be about where we landed in the first quarter..

On the outlook for Process, we've run the business for over a year before over 20%. We have targeted 17% to 20%.

We lowered that to 16% to 19% a little over a year ago, and that was, I believe, a reflection of where we're at in the markets, as well as we had mix down a little bit in particular with some wind OEM business over the years, as well as some of the acquisitions did not come in at a 18.5% EBIT margin level.

But certainly we're very comfortable striving to operate above that margin range. And for a quarter here and there, we've been below it and above it, and it does reflect, though, that we are running at a much higher utilization level than what we were before. So to your point, we would see probably some more capital investment in it as well..

Well, I just want to make sure I'm clear on that, look, obviously, Mobile has been the segment that people are wondering where the margin could go incrementally, absolute.

But, clearly, if Process can be a two-handle in 2019 it clearly takes pressure off of Mobile or Mobile getting to a – you name it, 12% whatever may be is, obviously, just further upside to earnings. So just so I'm clear, it's up to us to figure out the demand profile and think through your margins.

But if the demand is still there for Process in 2019, do we expect to purposefully invest in this business where we shouldn't think this is a 20%-plus business in 2019? Just making sure how to think about the business. Again, as you said, you had sort of backed off a little bit on your margins in that business over the last year (26:31)..

No. I would certainly not encourage you to look at it as a sub-19% or sub-20% margin business. As you look at the two segments, we are very focused on Mobile during this cycle and this good demand environment of moving up towards the high-end of that range.

So we're working to get Mobile – obviously, not this year, we're looking to get Mobile up into the range this year, but targeting the 12% for Mobile and want to get the number up to there during this cycle and certainly believe we can hold the process margins above the range..

And one near-term question, I apologize. The inventory growth sequentially about 5%, it's sort of reminiscent of late last year that it ended up being the right call. You built some inventory. You're ready to win business and do it profitably with a strong end market. This 5% increase sort of reflects to that again.

Can you help us – and this is maybe more of a second quarter question, that inventory build, which end markets is that particularly geared to make sure we get that business in 2Q, 3Q? Is it Mobile? Is it Process? Maybe some color even within that..

Yeah. Maybe I'll give you a little bit of color and then see if Rich has anything to add, David. So, I would say with the inventory build, it was across both. It was probably a little bit more in Process than Mobile.

We, obviously, took our guidance up a little bit more in Process than Mobile in terms of the organic guide from a month ago, so a little more in Process than Mobile. And I think the key point is we'll probably have a little bit of a sequential build into Q2. And then, as Rich said, probably look for the inventory to kind of stay flat.

And I think the important point is we're not planning to take inventory down in the fourth quarter. Because as Rich said, we expect 2018 to end strong and expect 2019 to start strong. And so, we're not going to look to take any inventory necessarily down in the fourth quarter.

And as we get to the end of the year, much like we did last year, we'll have to kind of see where we're at..

Okay. So, that'll shapes up your seasonality on EPS. You mentioned revenue should be up sequentially. The normal solid EPS growth we see 1Q to 2Q, nothing unique to think about that would jar that. That inventory build, as you said if anything being more Process is – and probably a positive for the mix for 2Q.

Everything I said there fair, you'd say?.

Yeah. We don't guide quarterly EPS. Don't really want to start to. If you annualize the first quarter, you come up a little less than the midpoint of the guidance. But we do expect revenue to go up sequentially in the second quarter. But again, we'd have a little bit of Mobile seasonality in the second half. So, we'll leave it at that..

I appreciate that. Thank you..

Thanks, David..

Thanks, David..

Moving on, we'll go to Sam Eisner with Goldman Sachs..

Yeah. Good morning, guys..

Good morning, Sam..

Just on the pricing changes that happened this quarter, $18 million recognized at the EBIT line, you guys have been guiding to, I think, 50 basis points; now it's about 100 basis points. Maybe you can walk through just the differences as it relates to your multi-year contract on the OE side, your annual contracts, your distribution.

Kind of where is the pricing ultimately is coming from?.

Yes, let me take price and take it a little bit broader than that even and hopefully answer your questions as we go through it. So very specifically, it is more coming in in Process than in Mobile, and it's more coming in the ability to move it in the shorter term than the longer term. And some of that goes with Process and Mobile.

As you hit – two things I'd want to say about price start. As you hit, we have a lot of different pricing mechanisms between material surcharges, distribution list prices, multi-year, short-term, et cetera, et cetera. And then we have thousands of customers and hundreds of thousands of parts, and we sell in a lot currency.

So when you take the permutations across those four, there's a lot of complexity in that. Second point on pricing, we are only four quarters, five quarters into a good pricing environment. We entered 2017 after some weak markets and a very strong dollar.

So now that we're a few quarters in coming into the year, our guidance was to be up for the company, 100 basis points. We were more than 100 basis points in the first quarter. That $18 million you referenced I think it was on slide 12, that $18 million is price and mix. So the price was more than 100 basis points but mix was also positive.

So the combination yielded the $18 million..

And to the point about you're able to – you have material passes and things of that nature.

Is this more related to the raw material move or is this actually a function of you guys seeing tightness in the market in those particular channels that you're able to actually push price at this point in time?.

It is more a combination of us moving base prices, list prices, contractual prices than it is the material surcharge, but they're both positive..

All right. That's helpful. And then, as it relates to kind of the industrial distribution portion of the Process Industries segment, you guys walked around the world. You've historically done this as it relates to that distribution exposure. So maybe you can just do that again, in particular focusing on restocking.

Obviously, a big question, just curious kind of where inventory level stand as it relates to some of your industrial distribution customers on a kind of geographic basis..

Not sure if I understood the first part of the question..

Yeah. I'll (32:26)....

I guess – yeah....

You're talking channel – kind of our view on distribution and channel inventory, Sam?.

Correct..

Okay. Yeah, sure. So, I think as we talked about industrial distribution really led the way for process. We were up in all regions of the world. As we look at channel inventory, where we have visibility, which should be North America and maybe some limited areas outside North America.

I think we'd say that channel inventory is still pretty light relative to the sales levels we're seeing. So I would say maybe inventory was up a little bit from the end of last year among our distributors where we have visibility but still relatively light compared to the level of sales activity we're seeing.

And again outside the U.S., it's – and particularly in the emerging markets, it's very difficult for us to stay, but looks to be relatively stable there as well..

Sorry.

Just going back to pricing, one last question, when you look at where index pricing is relative to 2014 or 2015 levels, where do we stand? I guess how much do we fall? Ultimately, how much are we off the bottom? Just any kind of sense of where that pricing curve stands relative to the last few years?.

Yeah. I don't know that I'd be able to index it, but we were down about 50 bps, and then a year before that, I think, we were down about 100 bps. So, looking to get back a little more than last year and start carving into the prior year, but probably still a little bit down over the last few years..

Got it. Thanks so much..

Thanks, Sam..

Moving on, we'll go to Joe O'Dea with Vertical Research Partners..

Hi. Good morning..

Hey, Joe..

Morning, Joe..

In the revised guide, does that contemplate additional price actions moving forward? And are those things that have been announced to customers? I'm just trying to get a sense of what still might need to be achieved on the pricing side vis-à-vis the higher guide..

I would say it does, but the vast majority of it is done and is negotiated or out into the market. But there would certainly be some further pricing actions through the balance of the year, but they would be smaller than what happened in the fourth quarter and the first quarter..

Okay. Thanks.

And then when you talk about material costs going up as the year progresses similar to what we're hearing from other companies, but can you put any context around when you look at the – your bucket materials on logistics as a $9 million headwind in the quarter? But can you give us any sense for what that progression is like in terms of the headwinds that you face? And then when you talk about that extending into 2019 at all, just how you think about that framework with base prices going up, and then how much 4Q cost pressure actually incrementally gets even more significant as you go into 2019?.

Let me – I'll let Phil answer that, but let me start that with, going back to my point on that, historically and recently, we are able to recover material costs in the – while we fight very hard to keep our material costs down, the cyclical nature of our input and material cost generally means that the capital equipment cycle is good and from mining ore to making steel to building cars and railcars, our end markets are strong.

So the supply-demand of that winds up well with us. So, again, with our belief that our markets are relatively early into a growing run here, we believe that steel cost will continue to come up. And again, we haven't seen anything that's been enormous. It's been a gradual upturn now for five quarters. I believe that will continue.

And if, at the end, this year higher then, obviously, it rolls into next year higher to your point. I'll let Phil add any color on the granularity of the timing..

Sure. So, Joe, I think you're right. So on the slide where you saw the negative $9 million, I think that was – the majority of that would have been logistics in the quarter. Price – or material was up. It was up slightly in the quarter. As Rich said, we do expect an increase as we move through the year. But I would say relatively modest.

If you think about inflation as a whole, I would say – we get a lot of questions on material, of course, but we get questions on fuel, energy, wages, et cetera. And I would tell you that across the company, the inflation we're seeing is relatively modest, relatively normal, I would say. Maybe – and then material, I would put material in that category.

We negotiated base prices for 2018 with the bulk of our domestic suppliers and, obviously, subject to surcharge movements both inside the U.S. and quarterly adjustments outside the U.S. So do expect some inflation from increased scrap steel prices which really drives it, but expect it to sort of be a steady increase as we move through the year.

But again, expect markets to remain strong, expect pricing and mix to improve, expect productivity to improve as we move through the year. We're only in the fifth quarter of a ramp, so productivity continues to improve.

So as we look at it on balance, still expect price cost to be positive for the year, and really expect to more or less hold margins near the first quarter levels despite some modest material inflation for the rest of the year..

That's great. I appreciate the details, and maybe just a clarification.

When we think about the balance between the base price and the surcharges, if we think about 4Q this year with a base price that would have been negotiated in 4Q of the prior year, and then surcharges that flow through, how representative of kind of a 2019 cost structure, when we think about just materials, will 4Q be? And you think, so maybe base prices go up, but surcharges go away.

Just trying to think, is there a meaningful step-up that you would anticipate into 2019 material costs at this point, or will 4Q be pretty representative of that?.

Well, a couple things. One, I'd say the surcharge mechanism versus base is much more of a U.S. discussion than it is global. So more of our global steel was purchased on an all-in price and is generally purchased shorter term. So there's some moving dynamics there and roughly half of the business outside the U.S. half-in.

As you look to the fourth quarter of this year, I would say it would not necessarily be indicative of 2019 but we would have a good feel for what 2019 would likely be. So I think that's probably the best way to answer that at this time..

Yeah. And I think the other thing to keep in mind, Joe, is between distribution, as Rich talked about, which is about, call it, half the portfolio and the OE which is a blend of annual contracts and multi-year agreements, we do have the ability to – we have the opportunity anyway to reprice a majority of the portfolio on an annual basis.

So we do have the ability. While we don't know what 2019 is going to look like as we sit here today from a cost standpoint, we do have that pricing ability. And as Rich said, would expect to, over time, offset any impact we might see from material cost increases..

Got it. That's really helpful. Thank you..

And next, we'll hear from Chris Dankert with Longbow Research..

Hey. Morning, guys. Thanks for taking my questions..

Good morning, Chris..

And congrats on a great quarter here..

Thanks..

I guess first off, could we dig in a little bit more on rail? Just to get a bit of an update domestic versus global and services versus OEMs, just kind of what's driving the more optimistic outlook there?.

Yeah, sure. I'm happy to do that, Chris. So we were up in Q1. As I said, that was driven mostly outside the U.S., Asia, and Latin America. And I'd say in Asia, it was pretty broad ASEAN, India, Australia and then Latin America, probably mostly Brazil, but some Mexico.

So up in those two regions of the world, I'd say North America and Europe were relatively flat in the first quarter. But I would say we are starting to see an improvement in North American freight car build rates which should bode well for rail over the rest of the year and over the coming quarters.

And I would say – and obviously, the service business with miles hauled and the rail traffic we're seeing has actually held up really well. So, as we look at an improving freight car market and improving environment outside the U.S. really took us from starting the year we thought rail would be relatively stable.

Now, we think we can actually grow and its market is coming back. But it's also Timken continuing to penetrate new markets like Eastern Europe, Russia, and also in other parts of the world as well..

Got it. That's really helpful. And then I guess you did highlight a little bit of incremental investment for growth in the quarter here.

Just could you comment around that? Is it head count, automation, digital just kind of break that out a little bit?.

Yeah. I mean, I think as Rich referenced, when we do our CapEx – so we had $18 million of CapEx in the quarter, we're guiding to 3.5% for the year, and there's always a good chunk of that earmarked for growth or margin expansion initiatives. So, call it, 1% for maintenance and the rest is targeted for growth and margin expansion.

So, as we sort of plan our CapEx, we're thinking through, hey, let's make sure we have the capacity we need to support growth.

And as we sit here today, don't see anything that would inhibit our ability to grow through this year and through next year, but always looking to identify those potential bottlenecks down the road and look to alleviate those.

And I'd say it's been a little more on new capacity but also investing certainly in higher-cost countries, making some incremental investments in automation and other initiatives that would help improve the overall productivity and profit profile of some of our higher cost plans..

Got it. Thanks for the color. And then just one last clarification, if I could. The news of Ford kind of winding down sedans in North America and really focusing on their core higher margin stuff, I assume if anything that's really good news for you guys because, again, the F-150 just comes more to the fore yet again.

Is that the right way to think about that?.

I'd say yes. I think the more Americans like their pickup trucks and larger cars and premium cars, the better it is for our position and our mix. We are generally not on, in any meaningful way, smaller vehicles in the United States..

Got it. Thanks so much again, guys..

Thanks, Chris..

And next, we'll go to Steve Barger with KeyBanc Capital Markets..

Hey, good morning, guys..

Good morning..

Hi, Steve..

Thinking about your comments on strong volume through distribution, can you talk about what's happening in terms of your legacy products versus trends in some of the newer non-bearing product lines? And I'm really just trying to get a sense for whether there's further upside from channel penetration or if you're well-covered from a partner standpoint and this is just benefiting from a better cycle?.

Yeah. So, I think that's a really good question and, as I said in my comments on – we're excited to be in a good market environment with our outgrowth initiatives. I think that applies to what we've done organically over the last five-plus years where we've developed products, and inorganically where we brought products into the portfolio.

It has not been a great environment to try to capture market share with your new and improved spherical roller bearing line up until the last four or five quarters.

So, I would say, in general, as I said, all product lines are essentially growing, but our growth is better in nontraditional Timken products than it is in the traditional Timken products..

Okay.

Well, and obviously with the environment for price increases improving, are you seeing distributors raise prices beyond the increases that you're communicating to them? And any difference in terms of product lines in terms of how they're approaching the market that you can see?.

Yeah. I don't think I'm the best person to comment on their pricing, but I would say they are taking the pricing, working with their suppliers and their customers. There's cases where they have one-year agreements as well. So they look to, in some cases, absorb that; in other cases work with.

So I think they are supporting pricing, and that would be a statement generally around the world..

Okay.

And if I can sneak one more in, is there any change within the distributor channel or your communications with them around product R&D and new product design as they try to increase value-added services? Just thinking about ways that you potentially win more share of wallet with some of these distributors that may be getting more aggressive in what they're providing?.

Certainly not to the point of vertical integration of R&D manufacturing, but certainly on the services side. So where we do bearing reconditioning, gear drive reconditioning. We have some bumping into our customers with that. But that's something that we're accustomed to.

We buy product in a lot of cases from customers that they buy from us and compete against them. So it's something that we've been dealing with for a long time, and I would not say we've seen any significant moves on our part or on their part in that overlap in recent years. It's relatively small..

Got it. Okay. Thank you..

Next, we'll hear from Michael Feniger with Bank of America..

Hey, guys. I know you touched on this....

Hey, Mike..

Hey, guys. I know you touched on this with David's question. Just trying to flesh it out a little bit more. So Process margin, very impressive in the first quarter and it's above your long term range. You mentioned how revenues are kind of still below peak.

So, is the target to kind of hold this margin even in 2019 at the strong levels and really grow that top line since the margin targets now kind of out of date? Or is it – should we just expect really in 2019 the revenues will grow a certain rate and we should assume a similar type of incremental margin with margin expansion on top of that? Just how do we kind of think about that with now you guys kind of really outperforming your range right now?.

Yeah, sure, Mike. So kind of, as Rich said, we set the range of 16% to 19%. At the time, distribution was down, we've made some acquisitions, we sort of had the mix where we felt like 16% to 19% was a good range and, obviously, running above that now.

I think a lot of it depends on maybe the M&A that we do and how that comes in over the next several quarters, the next couple of years.

I would say with the mix we have today, if markets remain strong, I think there is opportunity for us to certainly hold the margins at the 2018 levels and, if not, even expand them a bit in the 2019 with the right kind of environment..

Okay. That's helpful. And I may have missed this. I know you guys were talking about your business and how a certain portion of it is clearly locked-in, the long-term contracts on pricing.

Does it work the same way on the costs like how much of your business for SBQ price is kind of locked into a year or multi-year contracts that kind of basically helps you as these prices rise – as prices continue to rise?.

Yes. So, I want to just clarify on Phil's comments around multi-year versus annual versus spot. Half of it is purchase order, purchase order was priced, et cetera, so can move pretty quickly. And then of the other half – probably less than half is multiyear. So, we're down to quarter multi-year.

Very rare to have anything – multiyear is often two years and sometimes three. So, you're not locked into a large part of the portfolio for an extended time.

And where we have multi-year, we generally have at least some material recovery mechanism and/or if it's an – if we have a significant currency exposure, we have some sort of currency protection as well. So, not a significant – not a huge part of the business locked in for multi-years.

On the raw materials side, it would be rare for us to have anything out over a 12-month period. And on steel specifically, probably typically half of it on a year and half of it on less. So, you can experience that a little quicker than the surcharge part of it. It can flow through in the U.S. quicker. That can flow through quarterly..

Okay. No, that's helpful. I mean, thanks for clarifying that. And just lastly on the free cash flow, I think you guys are expecting it to be 80% net income. Obviously, you guys are building a stronger environment.

Just, is there any change on how you guys are kind of managing or guiding that free cash flow through the cycle?.

No. I mean, I think we're, by and large, managing it the same way. I mean, we are – we have become a very consistent, strong free cash flow generator. We don't have as much cash anywhere near the kind of cash we had going into pensions and other legacy benefit plans and things of that nature.

So, we do feel like we will continue to generate strong free cash flow. But as we've said, the organic swings are really the biggest variable to the free cash flow generation. So, when we're moving up cycle, we are going to need the working capital and we – it was a bit of a drag – it was a bit of a drag last year relative to free cash flow.

And I think, this year, we expect to – we are building a little bit of inventory through the first half then expect that to level off. So, feel like $250 million was a good number, assuming that we hold inventory relatively stable in the back half of the year.

But again, I think our bias has been – and rightly so, in my opinion, has been to err on the side of having the inventory capturing the share, succeeding in the marketplace, keeping our customer service levels high versus being overly focused on hitting a specific cash flow number. So we do – 80% is the guide we put out there.

We're very comfortable with that guide. But we'll continue to look to grow share, expand our business, and grow profitably..

Makes sense. And just lastly, you guys mentioned how – you guys always are exploring inorganic ways to add revenue, you said it in 2018 and even in 2019.

Any changes in terms of – if that's more mobile process or any type of evolution in your thinking about capital allocation, maybe leaning more towards share buybacks if certain valuations are stretched?.

Well, certainly, we – to the first part of your question, we target – put more energy into Process acquisitions than Mobile and cultivating them.

However, you look back over the last two years, they have been more Mobile than Process and certainly we're not opposed to Mobile and look to have the same value creation in Mobile, but we are looking to mix up and generally find that there's better opportunities in the bearings and power transmission space within Process to do so.

On your question then on buyback versus M&A, as Phil just covered, we are expecting to generate strong free cash flow for the year. We don't see any reason to de-lever as we go through the year. So, certainly, we would look to deploy our cash flow to either M&A or potentially buyback, and we'll see as that goes through the year.

As we sit here in May, whichever we do there will have a bigger impact on 2019 at this point than it will on 2018..

Got it. Thank you..

Thanks, Mike..

And next we'll go to Justin Bergner with Gabelli & Company..

Good morning, Rich. Good morning, Phil..

Good morning..

Hey, Justin..

First question just relates to sort of the, I guess, operating profit bridge.

I mean, should we expect the operating profit bridge, I guess, that you guys laid out on slide 12 in terms of sort of the combined effect of price/mix, material logistics, manufacturing, and SG&A, other – I mean, I guess that sort of came out pretty close to even in the first quarter.

I mean, should we expect a similar bridge in subsequent quarters and for the year, or were any of those components meaningfully changed on a net basis?.

On the volume side, the comps get significantly harder, starting in the second quarter because our first quarter was really an inflection point last year. Price and mix were negative through last year. So I think the answer to that would be, yes, and maybe even some upside there as the year goes on, and probably similar for the material.

On the manufacturing side, as Phil said, we would have some negative impact from – negative compared to the plus $9 million, not negative necessarily compared to prior year on the inventory. Assuming we do stay with our current plan to level off inventory in the second half, we'd have some negativity there.

And then, obviously, the current acquisitions we have fall off by the end of this quarter, the end of the second quarter..

Yeah. And if I could maybe just complement that a little bit, Justin. So, if you think about it from an incremental standpoint – I know we've got a lot of questions on incrementals – the first quarter, we would have – the incrementals were around 28%.

I think if you look at the full-year guide and do the math, the year-on-year incrementals would be in that, call it, 27%, 28% range, so very, very close to the first quarter levels.

And frankly, the slight fall-off from the ever-so-slight fall-off from the first quarter is really tougher comps as the first quarter of last year was the lowest margin of the year for the company. So, we'd still expect despite kind of the puts and takes to still generate really strong incremental margin year-on-year as we move through the year..

Okay. Great.

And that $16 million of negative SG&A and other, should that persist at or near the levels of the first quarter?.

Yeah. And I would say sometimes the first quarter can be a little bit elevated SG&A with certain resets of employment taxes and things of that nature. So, I think we probably would expect a little bit more fixed – more cost leverage on the SG&A line as we move through the year and probably not see it quite as negative in the coming quarters..

Okay. Great. That's helpful. And then on the tariff side, you mentioned that you don't expect the impact of steel tariffs to be material.

Could you maybe define sort of how you think about the threshold for materiality in terms of steel tariffs and their impact?.

Well, I'm not sure I'll probably be that precise. But certainly, we already have factored into our outlook steel costs continuing to trend up through this year globally and up year-on-year and they were up year-on-year last year as well. So we already have an inflationary environment in our outlook.

On the tariffs themselves, we don't buy a lot of foreign steel for our U.S. operation. So the day one impact is – I'm not sure if you could say – it'd be very, very small. The bigger issue, obviously, is the ripple impact of where does capacity go? Do – can customers that buy your U.S.

product and then export it, do they continue to produce that product in the U.S., et cetera, et cetera, et cetera? But the bottom line is, it would – all that will move over time and we will adjust to that. I think the short-term, when it first came out and it was all steel producers, that was certainly more concerning.

But as Brazil, South Korea, other places have been opened up, we believe there's enough capacity there that there will not be an artificially high U.S. price over the rest of the world which that's where the concern would really be for us to be competitive in the U.S., and for our customers to be competitive in the U.S.

is we need competitive steel prices, and I believe with what we're seeing right now, we will have that when it all settles down..

Okay. That's very helpful. And then lastly, wind, I guess, now is in the positive category for 2018 end markets.

What shifted there?.

Yeah. I think great question. So I think wind is something that deserves a little bit of discussion. So we did start the year thinking it would be down, and margin I think we thought we'd be flat, we now expect to be up.

I think the market is still pretty soft, call it, flat to down but we continue to win business, continue to gain share in Europe and other parts of the world. So the first quarter, we were relatively flat. We do expect that to inflect and – not huge growth in 2018, but, call it, mid – mid-singles, mid to high-singles in wind in 2018.

So, really more share gains and probably a slightly better market environment than we thought coming into the year..

Great. Thanks for taking all my questions..

Thanks, Justin..

Thanks, Justin..

Okay. Thank you for joining us today. This concludes our call. If you have further questions, please call me, Shelly Chadwick, at 234-262-3223. Thanks again..