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Edited Transcript of LDL earnings conference call or presentation 30-Oct-19 2:00pm GMT

Q3 2019 Lydall Inc Earnings Call

Manchester Nov 11, 2019 (Thomson StreetEvents) -- Edited Transcript of Lydall Inc earnings conference call or presentation Wednesday, October 30, 2019 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Brendan Moynihan

Lydall, Inc. - VP of Financial Planning & IR

* Dale G. Barnhart

Lydall, Inc. - President, CEO & Director

* Randall B. Gonzales

Lydall, Inc. - Executive VP & CFO

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Conference Call Participants

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* Edward James Marshall

Sidoti & Company, LLC - Senior Equity Research Analyst

* Ryan J. Levenson

Privet Fund Management, LLC - Managing Member, Principal and Portfolio Manager

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Presentation

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Operator [1]

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Good morning, and welcome. Lydall announces the third quarter 2019 financial results conference call. (Operator Instructions) Please note, this event is being recorded. I would now like to turn the conference over to Brendan Moynihan, Vice President of Investor Relations. Please go ahead.

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Brendan Moynihan, Lydall, Inc. - VP of Financial Planning & IR [2]

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Thank you Debbie. Good morning, everyone, and welcome to Lydall's Third Quarter 2019 Earnings Conference Call. Joining me on today's call are Dale Barnhart, President and Chief Executive Officer; and Randy Gonzales, Executive Vice President and Chief Financial Officer.

Dale will start the call with comments about the continued progress we are making in executing our long-term strategy, as well as provide an overview of current business conditions. Randy will follow with a review of our financial performance and discuss the key drivers by segment. At the end of our remarks, we'll open the line for questions.

Yesterday, our quarterly earnings release was issued, and our Form 10-Q was filed. So that you can follow along with today's call, please reference the Q3 2019 earnings conference call presentation, which can be found at lydall.com in the Investor Relations section.

As noted on Slide 2 of this presentation, any comments made on this conference call that may constitute forward-looking statements are made available pursuant to the safe harbor provision as defined in the securities laws. Please also refer to the cautionary note concerning forward-looking statements within Lydall's Form 10-Q for further information. In addition, we will be referring to non-GAAP financial measures during this conference call. A reconciliation to GAAP financials can be found in the appendix of the presentation I just referenced.

With that, I'll turn the call to Dale.

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [3]

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Thank you, Brendan. Good morning, everyone, and thanks for joining us. Slide 3 outlines our recently published financial results for the third quarter. Third quarter 2019 net sales of $205 million increased 3.7% or $7.4 million from the same period in 2018. Organically, sales decreased 2.2% as ongoing global trade tensions drove uncertainty in key markets and the General Motors strike impacted

automotive volumes. Sales were lower in Technical Nonwovens, particularly in China, and softer end markets in the sealing segment impacted sales in Performance Materials.

The strong dollar continued to be a headwind on foreign sales, reducing consolidated revenue by $3.1 million or 1.6 percentage points. And tooling sales were down $2.7 million or 1.4%. Acquisitions and divestitures contributed a net of $17.5 million or 8.9 points of growth with the partial quarter of interface adding $20.4 million, offset by $2.9 million of reduced sales as a result of the divestiture of the Geosol in the Technical Nonwovens business.

Adjusted EBITDA for the third quarter was $20.9 million, and the associated margin of 10.2% was down 60 basis points from the third quarter 2018. Improvements in pricing, mix and flow-through of restructuring benefits drove strong margin expansion in Technical Nonwovens. Higher operating costs in Thermal Acoustic Solutions were a headwind in the third quarter, partially offset by incremental EBITDA contribution from Performance Materials.

Adjusted earnings were $0.19 per share, down $0.35 from the third quarter 2018, including approximately $0.14 of incremental amortization associated with the Interface acquisition.

Finally, strong cash generation of $26.7 million in the quarter and $63 million year-to-date was supported by organic improvements in working capital, enabling us to pay down $13 million of debt in the quarter and continue to fund capital investments.

Turning to Slide 4. This is an overview of our long-term growth strategy, which includes 4 drivers: new product development, Lean Six Sigma, geographic expansion and M&A. Lean and Six Sigma continue to be a focal point for Lydall. Implementing these skill sets across the business is a continuous process and key to sustaining profitable growth. Leveraging existing Six Sigma resources in our Performance Materials business, we are actively deploying these tools to our Interface business and have seen positive results. In one example, a cross-functional team in Lancaster, Pennsylvania facility conducted a series of disciplined Kaizen events focused on reducing scrap rates on a specific product line. The team initially focused on gathering data on scrap rates, analyzing the data to identify root causes of scrap and prioritizing high-value, low-cost actions that can improve the results. Lean tool is employed in this and included in development and documentation of standard work, analysis of data and implementing control methods to reduce variation in the production process. The annual impact of these efforts resulted in almost $200,000 of savings, reducing production time and rework across this product line.

I'd also like to highlight a new product development initiative in our Thermal Acoustic Solutions segment, which illustrates Lydall's ability to partner with our customer and provide complete engineered solutions to address their requirements. Working with General Motors on a thermal heat shield application for the new mid-engine Corvette platform, the design team also identified an acoustical issue, which generated unwanted noise in the cabin. By adding a high-temperature thermal fabric material to the base metal heat shield, the updated design provided a single solution that addressed both thermal and acoustical requirements in one package while providing a lower-cost solution to General Motors. This collaborative interaction with our customer to provide a complete, timely and cost-effective engineered solution to address their product requirement is a key building block for long-term growth.

Turning to Slide 5. With respect to business conditions, we continue to monitor the ongoing trade discussions, which negatively affect business sentiment and create uncertainty.

On the supply side, lower cost for aluminum use in our Thermal Acoustic Solutions business provided a tailwind approximately $1 million from prior year. Average LME pricing of $0.81 per pound in the third quarter was down approximately 14% from prior year, which was partially offset by higher conversion cost domestically. We anticipate base LME index pricing of aluminum will remain in the mid to low $0.80 per pound range. In the Midwest, premium and conversion cost will remain at the levels seen through the first 3 quarters of 2019.

Polyester fiber costs in our filtration engineering materials business segments have generally been steady through the year, and we anticipate this to hold through year-end. Supply constraints and higher prices on the meta aramid fibers used in Technical Nonwovens and Performance Materials have generally stabilized.

On the demand side, through September, the domestic light vehicle seasonally adjusted production rate averaged 17 million units with gains in light truck offset by declines in cars. The full year forecast for U.S. light vehicle production is 17 million vehicles, a reduction of 1.7% from 2018. The GM labor strike in the U.S. impacted production volumes for the last 2 weeks of the third quarter and the full month of October. At this time, we don't anticipate these volumes will be recovered in the fourth quarter of 2019 or in 2020.

The full year outlook for the European auto market is down -- to be down 1%, and China is expected to be down approximately 7% following larger declines earlier in the year. We expect to slightly outpace the market on a volume basis due to our mix of application and platforms in our portfolio.

Looking to our filtration and engineering materials business, we saw weaker demand in China and mixed results in Europe and North America. In Technical Nonwovens, Industrial Filtration sales were unexpectedly softer in China as trade tensions continue, and lower in Europe as end customers are delaying filter replacement projects to help reduce expenses. As a result, we are seeing lower backlogs for Industrial Filtration in the near term.

The Advanced Materials segments saw seasonally higher demand in the third quarter driven by higher geosynthetics volumes, which will decline in the fourth quarter as colder weather restricts construction projects.

Performance Materials end market showed lackluster performance in filtration segment domestically but continued to see favorable conditions in Europe. Demand for the sealing markets saw a contraction across all geographic regions in the third quarter, and we expect the fourth quarter to be flat to down from these levels.

In response to the lower-than-expected profitability in the third quarter and in anticipation of continued softer market conditions, we have initiated targeted cost reduction actions across the business. The investment of approximately $2 million to $2.5 million, primarily for severance-related charges, will be completed in the fourth quarter and will generate run rate savings of $4 million to $5 million in 2020.

With that, I will now turn the call over to Randy.

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Randall B. Gonzales, Lydall, Inc. - Executive VP & CFO [4]

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Thank you, Dale. Turning to Slide 6. I'll briefly cover our consolidated results and then provide an overview of our operating segment results. As a reminder, we will be discussing adjusted financial metrics, including adjusted EBITDA by segment. Details and reconciliations to comparable GAAP numbers are provided in the press release and the earnings presentation.

As Dale already mentioned, consolidated sales in third quarter were $205 million, up $7.4 million or down 2.2% organically. Adjusted for lower restructuring and acquisition-related inventory step-up costs in the prior year period, adjusted gross margin was down 90 basis points.

Incremental higher gross margin sales in the Performance Materials segment from the Interface business, combined with pricing and productivity gains in Technical Nonwovens, were offset by higher production costs in the Thermal Acoustical Solutions segment.

Third quarter consolidated adjusted EBITDA margin was 10.2%, including a $600,000 gain in other income related to earn-out provisions associated with sales of products from the Precision Filtration acquisition, which was completed in July 2018. Compared to third quarter 2018, adjusted EBITDA margin was down 60 basis points as margin gains in Technical Nonwovens were more than offset by margin erosion in Performance Materials and Thermal Acoustical Solutions. Adjusted EBITDA for the quarter was $20.9 million, down $500,000 from the third quarter 2018 period.

The third quarter effective tax rate of 35.1% was up from prior year, impacted by losses in jurisdictions where tax benefit is not recognized. Year-to-date, the effective tax rate adjusted for tax benefit of $10.5 million associated with the pension plan settlement, is 25.2%. We anticipate the fourth quarter tax rate to be more consistent with third quarter, and as a result, we are revising our full year consolidated ordinary tax rate outlook to be in the range of 25% to 27%.

Third quarter earnings per share were $0.17. Adjusting for restructuring costs and the completion of the pension settlement, adjusted earnings per share was $0.19. This compares to $0.54 per share in the third quarter of 2018. Note that third quarter 2019 results include incremental amortization of $3 million or approximately $0.14 per share.

Cash flows provided by operations in the third quarter were strong at $26.7 million and $63 million year-to-date. Continued focus on working capital management through the year is the primary driver of the $48.5 million improvement from last year. At the end of the third quarter of 2019, cash was $48.9 million.

Debt reduction continues to be one of our top capital allocation priorities, with $13 million paid down in the quarter and $38 million year-to-date. Total outstanding debt from the credit facility ended third quarter at $287 million for a net leverage ratio of approximately 2.8x adjusted EBITDA as defined in the credit facility.

Capital expenditures in third quarter 2019 were $6.9 million, down from second quarter on project timing and reprioritization of projects. Given the uncertainty of our end markets, we continue to reprioritize capital projects, and as a result, are lowering the full year outlook for capital spend to a range of $35 million to $40 million.

Moving to Slide 7. I'll discuss our segment results starting with our Thermal Acoustical Solutions segment. This is our global automotive business that specializes in providing innovative engineered thermal and acoustical solutions for vehicle underhood, underbody, powertrain and exhaust applications. Third quarter sales in this business were $87.9 million, up 4.2% organically. Net part sales of $80.3 million were up $2.6 million from prior year, with organic growth in all regions.

While North America sales were up modestly, sales were adversely impacted by approximately $1 million due to the GM strike, which started in mid-September and ended late last week. European sales grew slightly more than 10% net of unfavorable foreign exchange, with continued volume gains on selected platforms. While the China market continues to be down year-over-year, our part sales were up net of foreign exchange, driven on the mix of customer and platforms.

Tooling sales of $7.6 million were down $2.9 million compared to prior year, reducing sales by 310 basis points. Foreign exchange, primarily the euro, reduced segment sales growth by 140 basis points.

Profitability in the Thermal Acoustical Solutions segment was favorably impacted by $1 million or 110 basis points of favorable commodity transfer aluminum, which was offset by 90 basis points of the anticipated pricing actions, consistent with our long-term customer supply agreements.

Higher production volumes in North America and Europe resulted in $3.8 million or 420 basis points of additional operating costs compared to the prior year. In North America, we continue to see a tight labor market, resulting in higher wages, increased temporary labor and overtime, while our European operations continue to incur incremental expedite and outsourcing costs because of higher OEM delivery volumes.

In the quarter, we completed the transition of several part numbers from our French facility to our German operations, which will help mitigate some of these costs, but we continue to see higher labor and overhead costs in both operations compared to last year.

Favorability in volume absorption, product mix, including lower tooling sales, and lower SG&A spending were a benefit of 130 basis points.

Moving to Slide 8. I will cover our Performance Materials segment, which provides specialty filtration and engineered sealing solutions to a variety of end markets and industries globally.

Sales of $60 million were up $18.3 million or 43.8% compared to prior year. Recall that the Interface acquisition was completed on August 31, 2018, so third quarter results include $20.4 million of inorganic sales from Interface in the July and August periods, which contributed 48.9 percentage points to reported sales growth.

FX was a headwind of 130 basis points in the quarter, so organically, sales contracted by 3.9% or $1.6 million. This organic contraction was driven by $1.9 million reduction in sealing and advanced solutions sales in the month of September.

The third quarter segment adjusted EBITDA margin of 11.7% is down 140 basis points from the prior year, impacted by pricing pressures, lower absorption, driven by lower volumes in our sealing segment and higher labor and overhead costs. These increases were partially mitigated by lower material costs, productivity improvements and improved SG&A efficiencies. In the third quarter, Interface added $2.8 million of EBITDA compared to prior year.

Note that third quarter results include $4 million of intangible amortization for Interface, which will continue at the same level in fourth quarter 2019. This is an incremental $3.1 million from the same period in 2018. Despite softer end markets and lower sales, we continue to expect Interface to be accretive to Lydall gross margin, EBITDA margins and cash in 2019.

Slide 9 covers our Technical Nonwovens segment. This segment produces air and liquid filtration media as well as other engineered products for use in various commercial applications such as geosynthetics, automotive, industrial and medical, among others.

Sales in the third quarter of 2019 were $63.9 million, down 12.5% from prior year. Adjusting for FX translation headwinds of 180 basis points and 400 basis points for the Geosol divestiture, organic sales were down 6.8% compared to prior year.

Industrial Filtration sales were down 19.6% or $8 million, heavily impacted by lower sales in China, and to a lesser degree, softness in Europe.

Advanced Materials sales as reported are down 3.6% or $1.1 million. But adjusted for the Geosol divestiture, sales were up $1.7 million or 5.4%.

In terms of profitability, adjusted segment EBITDA margin of 16.5% was up 250 basis points from third quarter 2018 and 30 basis points sequentially. This was driven by continued pricing actions, restructuring benefits, productivity improvements, favorable mix and lower SG&A spending. As previously discussed, meta aramid fibers continued to be an area where we see material cost pressures year-over-year, but we have generally seen these stabilized compared to second quarter 2019. As a reminder, adjusted segment EBITDA accounts for restructuring expenses of 20 basis points in third quarter 2019 and 70 basis points in third quarter of 2018.

That concludes our review of third quarter results. While the third quarter opened with relatively stable expectations for sales, increasing uncertainty in the global markets drove weaker than expected volumes in our Technical Nonwovens business in China and lower sales in sealing and advanced solutions segment of Performance Materials business. We anticipate uncertainty in the market, and demand could deteriorate further in these areas in the fourth quarter. Across our business segments, we anticipate the GM strike will further dampen top line sales by approximately $3 million to $4 million.

We continue to focus on mitigating higher costs in Thermal Acoustical Solutions operations as well as the integration of the Interface acquisition into the Performance Materials portfolio. Finally, we expect continued strong cash flow generation that will allow the company to reduce its outstanding debt.

With that, I will turn the call back to Dale before we begin our question-and-answer session.

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [5]

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Before we open the call for questions, I'd like to briefly comment on recent changes in our leadership team. In early July, we announced that Joe Abbruzzi will take over as President of Thermal Acoustic Solutions segment. Joe previously led the Acoustical Solutions portion of this business and has brought automotive background and manufacturing expertise given the tools to improve performance in this segment. Replacing Joe as President of Technical Nonwovens is Robb Junker, with prior experience at Parker Hannifin and experience in China, who will lead the drive to continued profitable growth in the segment.

Finally, as we communicated earlier this month, I have announced my retirement from Lydall, and the company announced the appointment of Sara Greenstein to succeed me. I'd like to take this opportunity to thank the entire Lydall family for their contributions to our mutual success over my 12-year tender and extend my full support to Sara as we transition over the coming several months.

With that, let's open up the line for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Edward Marshall with Sidoti & Company.

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Edward James Marshall, Sidoti & Company, LLC - Senior Equity Research Analyst [2]

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So I guess we're sitting here in July, the end of July, third quarter's gone through. We've kind of looked at the outlook and talking about stability in the markets. And for the most part, sales looks relatively -- held okay. Not great, but okay. I'm kind of wondering what happened on the individual segments. And mind you, this is an outsider looking in. So maybe you can kind of walk through specific examples of, I guess, PM and TAS, where the real issues were. And just specific examples of maybe what's been happening with the fundamentals in those businesses because it just seems that it took a turn and specifically took a turn from the stability comments you talked about in July.

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [3]

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Yes. It did occur midway through the third quarter. In Performance Materials, it was continued softness in the sealing segment of that business. Across all areas of -- all regions of the world, and in particular, we saw a significant decline in backlog in orders in September of about $2 million lower than what we were anticipating when we started the quarter. So it's continued softness driven by demand for construction equipment, i.e., Caterpillar-type product, ag equipment. And several OEMs in those industries have mentioned the fact that they're seeing destocking of dealer inventory. So as that demand from the dealers declines, we're seeing less pull-through from the OEMs to our products. So that was the most significant surprise that we saw in Performance Materials in the third quarter.

With relation to TAS, as we said, we had organic growth in revenue and part sales in the third quarter. The challenge there was from erosion and expense -- and increasing expense, specifically in Europe, specifically in our facility in France, where we saw demand far in excess of what the OEMs had forecasted on some of the new platforms that we won. That resulted in significant over time, expedited freight and outsourcing in the third quarter. Randy mentioned some of the corrective action we've taken to mitigate that as we go forward is we've moved several parts now from the French facility to our German facility, which had available capacity to reduce the outsourcing expense and expedited freight. So those were the 2 principal areas that drove, one, unexpected cost increases in TAS given the fact that we did see organic growth; and then the underperformance of Performance Materials as it relates to the sealing market. And again, as we started the third quarter, our backlogs were such that we were comfortable that the demand would be stable in Performance Materials. Unfortunately, that didn't turn out to be the case.

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Randall B. Gonzales, Lydall, Inc. - Executive VP & CFO [4]

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Yes, the other thing I'll mention, Ed, is that the TNW business, where all these segments dropped sequentially from Q2 to Q3, over $15 million, so about 7%. The TAS business typically sees a reduction from Q2 to Q3 because of seasonality. In July in North America, you typically have plant shutdowns at automotive OEMs. So we expected a little bit of decline there. Of course, the surprise there was the GM strike, which impacted Q2 to Q3 by the $1 million that we referenced on top line. But TNW was a big surprise in terms of the reduction, and that reduction quarter-to-quarter was over $5 million. And big drop in China, that was unexpected, and that kind of reared its ugly head in the second half of the quarter.

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Edward James Marshall, Sidoti & Company, LLC - Senior Equity Research Analyst [5]

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Right, right. So going to TAS for a second, you talked about the transitions and the transition in Europe from one facility to the other, and this has been going on for a while. So maybe I can ask, how long is it going to take? I mean how long does it take to kind of resource to Germany? How long does it take to kind of move those parts from France to Germany so that these costs kind of get water under the bridge, so to speak?

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [6]

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There were a total of 5 parts that we're moving and they'll all be completed by the end of the fourth quarter. And I believe 3 of them have already been transferred.

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Edward James Marshall, Sidoti & Company, LLC - Senior Equity Research Analyst [7]

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Okay, then. But this has been going on now for, what, 4, 5 quarters. I mean does it just take time to get sort of in that kind of respect?

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [8]

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No. It was -- the outsourcing and expedited freight were in the second and third quarter in France.

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Edward James Marshall, Sidoti & Company, LLC - Senior Equity Research Analyst [9]

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So there are other issues that were underlying TAS for the most of the balance of '18 and into 2019?

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [10]

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Yes. It was the North American outsourcing that we were experiencing in expedited freight due to all the new product launches in '18.

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Edward James Marshall, Sidoti & Company, LLC - Senior Equity Research Analyst [11]

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Got it. So what's the mix in PM from OEM to aftermarkets as it relates to Interface?

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [12]

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About 30% of the Interface volume is aftermarket. So that would be about 17% of Performance Materials.

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Edward James Marshall, Sidoti & Company, LLC - Senior Equity Research Analyst [13]

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Got it. So I'm assuming that the aftermarket component of Interface held up okay and OEM has been where you've been seeing the declines?

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [14]

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No, we've seen declines in both. I mean the aftermarket again, think about it, if construction projects are slowing down, if mining projects are slowing down and they're not using the vehicles as much, they're not going to have the need for the replacement product. And plus, I think we're also seeing destocking of the wholesalers that sell those gaskets to the end users.

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Edward James Marshall, Sidoti & Company, LLC - Senior Equity Research Analyst [15]

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So the question then is how dilutive to EPS was Interface in Q3? And maybe year-to-date if you'd provide that number.

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Randall B. Gonzales, Lydall, Inc. - Executive VP & CFO [16]

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Yes, I don't think we're -- I mean I think it's -- from a cash perspective, it's accretive. But I don't think, on EPS, we're disclosing what the dilutive impact is...

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [17]

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Yes, Ed, we've got -- the op income is disclosed in the 10-Q. If you adjust that for amortization, it's not too hard to get to EBITDA, which Randy mentioned in his comment was $2.8 million in the quarter versus prior year.

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Edward James Marshall, Sidoti & Company, LLC - Senior Equity Research Analyst [18]

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Got it. You've mentioned there was a CapEx revision for 2019. If I were to step forward and look into 2020, what would be the assumption for capital outlays in 2020?

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Randall B. Gonzales, Lydall, Inc. - Executive VP & CFO [19]

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Think the assumption should be very similar to our outlook for 2019. We're -- because of where we are in the cycle, we'll continue to fund the organic growth programs that are already in flight. But beyond that, it's the carryover CapEx, plus maintenance CapEx for next year. So what I would be comfortable with in terms of guiding would be around the $30 million range for 2020.

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Edward James Marshall, Sidoti & Company, LLC - Senior Equity Research Analyst [20]

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Okay. And then the final question for me, the severance, $2.2 million to $2.5 million this year. How much of that, and then the subsequent cost savings, is associated with the CEO transition?

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Randall B. Gonzales, Lydall, Inc. - Executive VP & CFO [21]

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None. Yes, Ed, we'll base it -- though we announced it today, the $2 million to $2.5 million is strictly severance that -- the actions have not been completed, so we won't go into details, but that is across the operating segments, and that's where we'll see the benefits flowing next year. Clearly, this year, as per our prior discussion, we will be looking to adjust out on a onetime basis the CEO transition cost, which will primarily be the sign-on bonus for Sara, consistent with her employment agreement, as well as the final agreement for Dale as he exits in terms of his compensation. So round numbers, that's going to about $2 million that will be impacted in the quarter. But we will look to adjust out for external reporting.

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Edward James Marshall, Sidoti & Company, LLC - Senior Equity Research Analyst [22]

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And does any of that $2 million to $2.5 million have anything to do with the transition in Andrew's in Europe, or has that been completed already and on the preplanned movement from Andrew's.

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Randall B. Gonzales, Lydall, Inc. - Executive VP & CFO [23]

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Yes. The Andrew's restructuring is largely completed. We got a very small amount yet to go here in Q4. But it's, to address your question, completely separate.

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Operator [24]

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(Operator Instructions) The next question comes from Ryan Levenson with Privet.

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Ryan J. Levenson, Privet Fund Management, LLC - Managing Member, Principal and Portfolio Manager [25]

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I have really just follow-ups to a lot of the data that I think came out of both the last year's questions. And I'm just having a tough time footing some of the numbers here. So did you say on PM that is was a $2 million revenue miss that was a sudden decline in the quarter? Was that the delta that you saw from Europe?

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [26]

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That was in the sealing product category, where we saw a significant drop-off in the third.

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Randall B. Gonzales, Lydall, Inc. - Executive VP & CFO [27]

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Yes. That was organic sales decline in the sealing segment, which was about $1.8 million.

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Ryan J. Levenson, Privet Fund Management, LLC - Managing Member, Principal and Portfolio Manager [28]

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Okay. And so does that not -- is there -- was there another chunk of the miss and -- from those prior expectations in Performance Materials? Or is that the whole miss?

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Randall B. Gonzales, Lydall, Inc. - Executive VP & CFO [29]

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So the organic sales decline from Q3 '18 to Q3 '19 is all attributable to the September performance in the sealing business.

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Ryan J. Levenson, Privet Fund Management, LLC - Managing Member, Principal and Portfolio Manager [30]

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Okay. All right. And so then, can you talk about -- I mean was it $2 million that accounted, it just flowed straight down to the operating profit line? It looks like there's -- just from an absorption standpoint on a margin basis, it looks like there was no -- nothing to offset that decline in sales. Am I interpreting that correctly?

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [31]

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So one thing to keep in mind that we do have mixed periods year. So from a reported viewpoint, you have the, what I would call, the legacy Performance Materials business for July, August and September of last year and 1 month of Interface, the month of September from this year. This year, you have a full 3 months with both businesses. But to address your question, in terms of the profitability, certainly, while we saw some issues on filtration in terms of mix, the vast majority of it was the drop in volume that we saw on the sealing and advanced solutions, which is the Interface business. Year-over-year, the volume was down, and the absorption and margin impacts of that flowed through to the bottom line on what is a relatively healthy contribution margin.

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Ryan J. Levenson, Privet Fund Management, LLC - Managing Member, Principal and Portfolio Manager [32]

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Okay. And so then, is the next thing that we can extrapolate from that is that -- will be able to -- have you been able to right-size and offset and reposition so that you can get your absorption back to prior levels?

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Randall B. Gonzales, Lydall, Inc. - Executive VP & CFO [33]

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That'll be part of the reduction in force that we just announced.

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Ryan J. Levenson, Privet Fund Management, LLC - Managing Member, Principal and Portfolio Manager [34]

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Got it. Okay. So that attaches to that. That was, really, my ultimate question there. And then on TAS, can you quantify what the overtime and nonlabor spend was in the quarter? I mean it looks like -- it seems like there was -- if I'm understanding what you said correctly, that the issue with TAS was sort of surprised demand that your current labor force was not necessarily best positioned to absorb and have set out good incremental margins instead. We had to allocate more labor and nonlabor spend in order to service that customer. And that weighed on merchants, if I'm understanding that correctly. I guess the first question, am I understanding that correctly? But the second question is, I mean, is that -- if we were to hold the margins the same, you're talking about, I think, about a $4 million cost item in the quarter. Is that all attributable to overtime and nonlabor spend?

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [35]

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Yes. So we did mention -- Randy mentioned in his remarks, approximately $3.8 million. So your math is pretty much spot-on. That is inclusive of incremental labor in terms of not only the tighter labor market domestically here in the North Carolina area, but also over time and temporary support to meet demand in the U.S. as well as the discussion that we had about the European facilities, particularly the pickup in demand that we saw in our French facility that started in Q2 and persisted here into Q3. Those charges, although there are certainly some labor associated with it, also include expedites and outsourcing costs that impacted the total cost stack.

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Ryan J. Levenson, Privet Fund Management, LLC - Managing Member, Principal and Portfolio Manager [36]

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Okay. And so that I'm sorry, I missed that in Randy's prepared remarks. But is that -- is it fair for us to think of that as transient? Or is this kind of a permanent condition that as long as we're having to service this elevated level of demand, we really haven't done anything to reposition the business so that we can recapture that margin or even get better absorption?

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [37]

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No. Our focus -- and Mr. Abbruzzi's focus as taking over the TAS operation is to eliminate those premium charges that we're having by improving the productivity through all of our sites. And we're starting to already see some improvement in the French facility by resourcing those 5 parts from France to Germany. So no, we should not plan on having those excessive costs as part of our business going forward. It will take some time. It won't happen immediately, but that's clearly their focus as they go into 2020 is to improve the efficiency in all their operations to eliminate those excessive labor cost.

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Ryan J. Levenson, Privet Fund Management, LLC - Managing Member, Principal and Portfolio Manager [38]

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Okay. I mean I guess there's a difference between a little bit of a demand shock that something that can be digested and cycled through in one quarter versus a new kind of cost takeout initiative that's going to take kind of 12 months to implement. So I mean the $3.8 million, I mean, how would you characterize that $3.8 million? Is it more the former or the latter?

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [39]

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Well, I think it's not 100% either. I mean some of it, we're already addressing and taking out, and I can't quantify the exact percentage of that as we are. But the other part is this business -- we've invested heavily, if you've been following us over the last several years, in automated equipment in the TAS business to produce these metal shields. And it's a matter of getting the productivity we should have out of those, which we're not seeing right now. That's the one that'll take a little longer. And I'm not in a position to divide up that $3.8 million between those 2.

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Ryan J. Levenson, Privet Fund Management, LLC - Managing Member, Principal and Portfolio Manager [40]

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Yes. Not so much dividing up the $3.8 million, it's more of -- and I don't mean to get bogged down in that. It's more of a higher-level question, just trying to figure out what the -- really, just trying to figure out if the -- if there was kind of permanent structure impairment to the margin profile of the TAS business. And I think what I'm hearing is that, mostly no, and that we're going to transition through that, but then there are some certain things that are initiatives that have been loaded in to either maintain or to increase margin that have not necessarily permeated the whole system yet.

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [41]

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That's correct.

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Ryan J. Levenson, Privet Fund Management, LLC - Managing Member, Principal and Portfolio Manager [42]

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Okay. Then the last thing is just on your investments. CapEx guidance of $30 million. How much of that is a carryover CapEx of the new programs versus maintenance?

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Randall B. Gonzales, Lydall, Inc. - Executive VP & CFO [43]

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Carryover is probably in the range of $15 million to $20 million.

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Ryan J. Levenson, Privet Fund Management, LLC - Managing Member, Principal and Portfolio Manager [44]

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Okay. And so going forward, I mean, is this like recurring kind of new initiative CapEx that we’re going to always have? Or are we going to be able to eventually start squeezing a little bit more free cash flow, not having it to freight by, say, $30 million to $40 million of CapEx?

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [45]

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I think going forward, planning on around $30 million is a good balance for the size of the business we have, for both maintenance and growth capital that we would have across all the businesses.

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Ryan J. Levenson, Privet Fund Management, LLC - Managing Member, Principal and Portfolio Manager [46]

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Okay. And can -- so on the growth capital, I mean, is it evenly split among the 3 businesses? Or is there a...

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [47]

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Disproportion amount have gone to TAS, and that's where we've had a lot of it. But in this year and in 2020, there has been higher-than-normal growth capital in Performance Materials and in Technical Nonwovens, and that's an encouraging thing because the teams feel they have some good growth opportunities to pursue.

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Ryan J. Levenson, Privet Fund Management, LLC - Managing Member, Principal and Portfolio Manager [48]

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Okay. And so is that -- just looking, is that going to start to materialize into actual growth? I'm looking at 2 businesses that have both declined, not just on a year-over-year, quarterly.

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [49]

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Sure. We should start seeing the impacts of the investments by the second half of 2020 as far as incremental growth over whatever the market is doing.

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Ryan J. Levenson, Privet Fund Management, LLC - Managing Member, Principal and Portfolio Manager [50]

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In theory, you could really kind of curtail TAS CapEx get down some more of the maintenance CapEx level of the $10 million to $15 million. And we could have fairly sizable growth and free cash generation over the course of 2020 where we do not kind of -- and this is what was forecasted within theory if we were not to initiate new growth programs as well.

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [51]

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Well, the good news with TAS is all the capital that's required over now and 2020 is to support new business we've already won. So in the auto space, we will pick up awards that don't go into production for 2 to 3 years after the actual award. So the investments we're making in 2020 is to support business we've already won. There's a carryover and a little bit of new that's going into 2020 based on platforms of products we've won, that won't go into production until 2021. So there's a little bit of stagger there. But you were right in that as over time, as these high-volume assets get running efficiently, we should start seeing improvement in our operating performance because we're fully utilizing all the new capital that we've put in place in TAS. And then in Performance Materials and Technical Nonwovens, again, a little bit incremental in 2020. But the real growth from the investments that are put in place in 2020 will be seen in '21.

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Brendan Moynihan, Lydall, Inc. - VP of Financial Planning & IR [52]

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Ryan, this is Brendan. If you're at the end of yours, let's continue otherwise to give others a chance and, certainly, we can follow up off-line.

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Operator [53]

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Next, we have a follow-up call from -- question, rather, from Edward Marshall with Sidoti & Company.

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Edward James Marshall, Sidoti & Company, LLC - Senior Equity Research Analyst [54]

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Two more for me. So TAS investments, it's going towards automation. I presume, or maybe I shouldn't but that you have a smaller labor force. I'm kind of curious, what -- quantify maybe if you could maybe the wage inflation you're seeing both domestically and internationally.

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Randall B. Gonzales, Lydall, Inc. - Executive VP & CFO [55]

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Yes. I mean, generally, what we're seeing domestically is, as I alluded to previously, Ed, the labor market here is tight. And as a result, for not only the direct labor positions, but some of the indirect labor positions in the factory, there have been onetime adjustments to keep up with the local market. So those year-over-year compares will continue into Q4. I'm not necessarily going to quantify what they are, but they're significant. In Europe, the labor issues, while there is some amount of escalation year-over-year, it's primarily the freight and expedited freight and the outsourcing that are the big drivers there.

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Edward James Marshall, Sidoti & Company, LLC - Senior Equity Research Analyst [56]

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And is your labor force -- I'm sorry, go ahead.

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Randall B. Gonzales, Lydall, Inc. - Executive VP & CFO [57]

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I was going to say, the other thing to keep in mind is that on the high-speed automated lines typically takes a degree of higher-skilled labor. And so that's one reason that we do have wage escalation is because it requires more technical skills for the operators, and thus, an increase in the overall wage structure.

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Edward James Marshall, Sidoti & Company, LLC - Senior Equity Research Analyst [58]

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Yes. But I assume those -- that was kind of present valued in the decision to spend that capital, correct?

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [59]

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Yes it was.

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Randall B. Gonzales, Lydall, Inc. - Executive VP & CFO [60]

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It is.

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Edward James Marshall, Sidoti & Company, LLC - Senior Equity Research Analyst [61]

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The $4 million to $5 million you said that you're saving next year, it sounds like some of that comes midway through 2020. Can you give an annualized number for that cost savings? So I'm assuming there's additional that would carryover on an annual basis.

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [62]

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So just the nature of the activity is almost exclusively severance based, it's headcount based. Those actions will be completed in Q4. And so we expect the full $4 million to $5 million to flow through in 2020.

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Operator [63]

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This concludes our question-and-answer session and our conference. Please -- thank you for attending today's presentation. You may now disconnect.