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Edited Transcript of TKR earnings conference call or presentation 31-Oct-19 1:00pm GMT

Q3 2019 Timken Co Earnings Call

CANTON Nov 2, 2019 (Thomson StreetEvents) -- Edited Transcript of Timken Co earnings conference call or presentation Thursday, October 31, 2019 at 1:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Jason Hershiser

The Timken Company - Manager of IR

* Philip D. Fracassa

The Timken Company - Executive VP & CFO

* Richard G. Kyle

The Timken Company - President, CEO & Director

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Conference Call Participants

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* Christopher M. Dankert

Longbow Research LLC - Research Analyst

* David Michael Raso

Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Industrial Research Team

* Joseph O'Dea

Vertical Research Partners, LLC - Principal

* Joseph Alfred Ritchie

Goldman Sachs Group Inc., Research Division - VP & Lead Multi-Industry Analyst

* Justin Laurence Bergner

G. Research, LLC - VP

* Kenneth H. Newman

KeyBanc Capital Markets Inc., Research Division - Associate

* Stephen Edward Volkmann

Jefferies LLC, Research Division - Equity Analyst

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Presentation

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Operator [1]

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Good morning. My name is Brian, 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 Third Quarter Earnings Release Conference Call. (Operator Instructions) Mr. Hershiser, you may begin.

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Jason Hershiser, The Timken Company - Manager of IR [2]

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Thanks, Brian, and welcome, everyone, to our Third Quarter 2019 Earnings Conference Call. This is Jason Hershiser, Manager of Investor Relations for the Timken Company. We appreciate you joining us today. If after our call, you should have further questions, please feel free to contact me directly at (234) 262-7101.

Before we begin our remarks this morning, I wanted 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 will have opening comments this morning from both Rich and Phil before we open up the call for your questions. (Operator Instructions)

During today's call, you may hear forward-looking statements related to our future financial results, plans and business operations. Our actual results may differ materially from those projected or implied due to a variety of factors, which we describe in greater detail in today's press release and in our reports filed with the SEC, which are available on the timken.com website.

We have included reconciliations between non-GAAP financial information and its GAAP equivalent in the press release and presentation materials.

Today's call is copyrighted by the Timken Company. Without expressed written consent, we prohibit any use, recording or transmission of any portion of the call.

With that, I would like to thank you for your interest in the Timken company, and I will now turn the call over to Rich.

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Richard G. Kyle, The Timken Company - President, CEO & Director [3]

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Thanks, Jason. Good morning, everyone, and thank you for joining us today. We grew revenue 4% in the third quarter despite a more significant sequential decline in the top line than we anticipated as we saw softening across several markets and a continued negative impact from currency.

Organically, revenue was down 3%, with significant declines in off-highway and heavy truck as well as modest declines across industrial markets and distribution channels. Softness was exclusively in North America as OEMs and distributors became increasingly cautious and manage inventory levels down as the quarter progressed. Despite the weakness, we continue to grow in all other regions of the world as well as in wind, solar, marine and rail. Acquisitions contributed 8%, which netted to 4% top line growth for the quarter. Also worth highlighting, Process Industries revenue was higher than Mobile Industries as we continue to shift our portfolio and improve our mix both organically and inorganically.

Given the market conditions, we've performed very well on the bottom-line with earnings per share up 8% for a record third quarter of $1.14. We held EBIT margins from the second quarter at 15.5%, up 110 basis points from the prior year. This is despite production levels below sales as we continue to modestly reduce inventory levels in the quarter.

Through 3 quarters, our margins of 15.9% are up 180 basis points from last year despite tariffs, inventory reductions and sequentially declining demand. Process Industries' margins year-to-date are a strong 21.8% and continue to mix the company up, and Mobile margins are also a solid 12.4% year-to-date. Cash flow was very good in the quarter, and we continued to actively deploy capital to value-creating opportunities. We purchased about 1% of the outstanding shares in the quarter, and we expect to complete the acquisition of BEKA Lubrication today. Our balance sheet remains solid.

Let me talk briefly about recent acquisitions. First, the 2 large acquisitions that we completed in the third quarter of last year, Cone Drive and Rollon have both recently completed 1 year within the Timken portfolio. We grew revenue and EBITDA over the first 12 months of ownership and the pro forma multiples would now be below 10x for the combination. Cone Drive solar business has grown significantly, and we expect double-digit growth again next year. Rollon has and will continue to take Timken into more diverse end markets with different cyclicality and growth rates. We also purchased ABC Bearings last year, and we've quickly integrated ABC into Timken India. We're converting the operation to be capable of producing to Timken quality levels to expand our low-cost bearing capabilities. The plant is one of our many cost reduction and growth tactics that are contributing to our strong margin performance year on year, and it will contribute more next year with another year of traction.

In regards to Diamond Chain, I discussed last quarter that the acquisition got off to a much slower start than we anticipated, primarily from low plant productivity and volume. The EBITDA margins improved significantly from the second quarter to the midteens in the third quarter despite lower seasonal revenue. The improvements were driven from both improved performance and stabilization in the operations as well as cost reductions from the integration. We have implemented over $3 million of annualized cost reductions in the 7 months since the acquisition, and we will see further benefit from these actions in the fourth quarter.

We expect -- as I said, we expect to complete the acquisition of BEKA Lubrication Systems today. Automatic lubrication systems apply a lubrication to bearings and other points of industrial equipment and vehicles. This eliminates the labor cost of manual lubrication and extends the life of the equipment through a more reliable and precise application. We entered this market with the acquisition of Interlube in 2013. We then scaled our position significantly with the acquisition of Groeneveld in 2017. Combination of Groeneveld and Interlube became a world leader in off-highway equipment and on-highway trucks and buses. Together, they have been very successful in the markets, have a strong management team in place and have been performing above the corporate averages financially.

But our market position and product offering outside of off-highway and truck was small. BEKA Lubrication immediately changes that. BEKA brings a leading position in Germany and a much broader product offering with product specifically designed for wind, food and beverage, packaging and other general industrial applications. We will have one of the broadest product offerings serving diverse markets in the automatic lubrication industry.

BEKA has been family-owned and operated for 3 generations, and we're very excited to bring the company into Timken. While long term, we expect the Groeneveld-BEKA combination to mix us up at the margin level. Day 1, BEKA's margin are lower than Groeneveld's and lower than the company average, and we expect the acquisition to mix us down both this quarter and through next year. But we know that there are many synergies between these 2 entities with opportunities to reduce overhead, improve productivity and expand margins while we grow the top line. We've successfully done it with Lovejoy, Interlube and other privately owned businesses, and we will do it again with BEKA. The leadership team is ready to commence the work.

Turning to the outlook. We are taking a very cautious view on the fourth quarter, forecasting a sequential decline from the third quarter of about 4% all-in. We expect customers to continue to manage inventory, cost and cash flow tightly to end the year. We will continue to manage our cost structure and inventory levels down in the quarter to reflect the reduced demand while we invest in the business for long-term growth and success.

For the full year, we expect to deliver record earnings per share of $4.70 to $4.75 with EBIT margins over 15% on flattish organic revenue and despite another year of currency headwinds and tariffs.

Cash flow in the fourth quarter and the full year will be a strong, which will make the incremental debt from the BEKA acquisition minimal, and we will finish the year with a strong balance sheet.

While we will not get specific on 2020 yet, we do not view this sequential decline we were experiencing in the second half of this year necessarily rolling over into 2020. We believe much of the softening is normal inventory correction versus end-market demand. We have several markets that we expect to continue to grow through 2020, and we have a variety of self-help initiatives heading into next year.

We are currently planning for revenue to be up sequentially in the first quarter of next year from the fourth quarter of this year. Additionally, while we have contract still to conclude, we expect price to be modestly positive next year and price cost to also be positive. As always, we have a full pipeline of operational excellence initiatives around cost reduction and cash management that will deliver value regardless of the market conditions. And from a capital allocation standpoint, we will end 2019 with our debt levels right in the middle of our targets. We expect to generate another strong year of cash flow next year, and we will be in a position to continue to deploy that capital towards value-creating opportunities.

In summary, we continue to take a balanced approach to driving growth, margins, returns and cash flow through industrial cycles. We also continue to take a balanced approach to investing in the long-term growth and success of our business while delivering short-term results. Our pipeline of outgrowth and operational excellence initiatives remains robust and is evident in our 2019 results. We hope you will join us in New York City on December 12 as we share more on our strategy, goals and plans for the future. And with that, I will turn it over to Phil.

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Philip D. Fracassa, The Timken Company - Executive VP & CFO [4]

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Thanks, Rich, and good morning, everyone. For the financial review, I'm going to start on Slide 14 of the materials.

Timken delivered very strong operating results in the third quarter, and you can see a summary of our results on this slide. Revenue came in at $914 million, up about 4% from last year. We delivered adjusted EBIT margins of 15.5%, which was 110 basis points more than the prior year. And adjusted earnings came in at $1.14 per share, a new third quarter record for the company and up about 8% from last year despite a higher tax rate.

Turning to Slide 15. Let's take a closer look at our third quarter sales performance. Organically, sales were down about 3% in the quarter with most of the declines coming in Mobile Industries. Recent acquisitions added about 8% to the top line while currency translation continued to be a headwind, negatively impacting revenue by over 1%. On the right-hand side of this slide, we outlined organic growth by region. So excluding both currency and acquisitions. As you can see, we were down in North America but up across the rest of the world. I'll provide some additional color on regional performance as I go through the segments.

Turning to Slide 16. Adjusted EBIT was $142 million or 15.5% of sales in the quarter with margins up 110 basis points from last year. Adjusted EBITDA margins were 19.8% in the quarter, up 140 basis points from last year. Adjusted EBITDA margins were 10 basis points higher sequentially from the second quarter despite lower revenue. The increase in adjusted EBIT was driven by favorable price mix, lower material and logistics costs and the benefit of acquisitions offset partially by lower volume and related manufacturing utilization.

Let me touch on some of the drivers briefly. As I mentioned, price mix was positive in the quarter. Pricing was positive in both segments and mix was also positive. Note that material and logistics includes tariffs. We're starting to benefit from lower material costs and logistics costs were lower year-on-year as well. Tariffs were also favorable. In the quarter, we recorded a small benefit for some tariffs paid in prior periods that are now refundable as the U.S. government recently granted tariff exemptions retroactively on certain of our imports from China. With respect to manufacturing, we had strong productivity and cost performance in the quarter as we're benefiting from our more variable cost structure and implementing cost reduction actions. However, this was more than offset by lower production volumes, which produced a net negative impact from manufacturing year on year.

We continue to manage SG&A costs well. Excluding the impact of acquisitions and currency, SG&A expense was roughly flat versus the year ago period as inflation and other spending was mostly offset by lower compensation expense. And finally, our recent acquisitions are contributing positively to our results, adding $11 million of EBIT in the quarter. This represents an adjusted EBIT margin of around 16% on the acquisition revenue and that's after purchase accounting amortization. As Rich mentioned, Diamond Chain continues to improve with EBIT margins above 10% this past quarter. And we're excited to be closing on the BEKA acquisition later today.

On Slide 17, you'll see that we posted net income of $64 million or $0.84 per diluted share for the quarter on a GAAP basis. Special items in the quarter totaled roughly $23 million of after-tax expense, with the largest item being pension and OPEB remeasurement charges. On an adjusted basis, we earned $1.14 per diluted share, up 8% from last year. Note that our share count is down about 2% versus a year ago due to ongoing share buybacks.

Our GAAP tax rate in the quarter was approximately 35%. Excluding discrete and other special items, our adjusted tax rate was just over 28%. This is higher than our prior estimate. As of September 30, our full year forecast calls for an adjusted tax rate of 27%, the higher tax rate in the quarter gets us to that level on a year-to-date basis. Catch-up costs us about $0.02 per share.

Now let's take a look at our business segment results starting with Process Industries on Slide 18. Process Industry sales for the third quarter were $459 million, up 10% from last year. Organically, sales were down about 1% with lower revenue in industrial services offset mostly by growth in wind energy and marine. We also benefited from positive pricing in the quarter.

Acquisitions added 12.5% to the top line, while currency translation was unfavorable by about 1.5%.

Looking a bit more closely at the markets. Industrial services revenue was down in the quarter mainly in North America and reflects softer demand for industrial gearbox and other repair services. Our growth in wind energy was seen in both Asia and Europe and reflects continued strong market growth and share gains. In Marine, we had higher revenue in the quarter from our ongoing programs with the U.S. Navy. And finally, industrial distribution was roughly flat as we saw growth in Asia and Europe mostly offset by lower demand in North America.

For the quarter, Process Industries EBIT was $96 million. Adjusted EBIT was $98 million or 21.4% of sales compared to $84 million or 20.1% of sales last year. The increase in EBIT was driven by favorable price mix, lower tariff cost and the benefit of acquisitions, offset partially by the impact of lower volume. Process Industries adjusted EBIT margins were up 130 basis points year-on-year. Our current outlook for Process Industries is for 2019 sales to be up 12% to 13% in total with acquisitions driving most of the growth. Organically, we're planning for sales to increase about 3% at the midpoint, reflecting growth in wind, solar and marine, offset partially by a decline in industrial services. We expect price cost to be positive for the year and for Process Industries adjusted EBIT margin to be around 21% for the full year or around 50 basis points higher than last year.

Now let's turn to Mobile Industries on Slide 19. In the third quarter, Mobile Industry sales were $455 million, down 2% from last year. Organically, sales were down just under 5%, reflecting lower shipments in off-highway and heavy truck, partially offset by growth in rail as well as the impact of positive pricing. Acquisitions added about 4% to the top line in the quarter while currency translation was unfavorable by around 1%. Looking a bit more closely at the markets. In off-highway, we were down in all regions and across also subsectors, including agriculture, mining and construction. This reflects lower end-user demand as well as customer destocking. Every truck was down in the quarter, driven mostly by declines in Asia and North America. Our growth in rail was in Asia and Europe while the Americas were roughly flat. Automotive was up slightly with higher shipments in the Americas driven by continued strong light truck and SUV market demand. And finally, aerospace was roughly flat in the quarter.

Mobile Industries' EBIT was $52 million, adjusted EBIT was $54 million or 11.8% of sales in the quarter compared to $53 million or 11.3% of sales last year. The increase in EBIT reflects favorable price mix, lower material and logistics costs and the benefit of acquisitions, offset partially by lower volume and related manufacturing utilization. Mobile Industries adjusted EBIT margins were up 50 basis points year on year. Our outlook for Mobile Industries is for 2019 sales to be roughly flat to down 1% in total. Organically, we're planning for sales to be down about 2.5% at the midpoint compared to 2018. This includes growth in aerospace and rail, which is expected to be more than offset by lower shipments in off-highway and heavy truck. We expect positive price cost for the year, and we expect Mobile Industries adjusted EBIT margins to be around 12% for the full year or up about 100 basis points from last year.

Turning to Slide 20. You'll see we generated strong operating cash flow of $145 million during the quarter. After CapEx spending, our third quarter free cash flow was around $101 million. Our year-to-date free cash flow of $272 million is more than double the amount from last year with the improvement driven primarily by higher earnings and improved working capital performance.

We ended the quarter with a strong balance sheet. Net debt to adjusted EBITDA was around 2x at September 30, down from the end of 2018. With the closure of BEKA expected later today, our pro forma net debt to adjusted EBITDA as of September 30 would be about 2.2x. And I would expect us to end the year below this level given the strong free cash flow we'll generate in the fourth quarter.

You could see some highlights with respect to capital allocation at the bottom of the slide, including the repurchase of 750,000 shares in the quarter, which brings our year-to-date repurchases to just under 1.3 million shares.

I'll now review our outlook with a summary on Slide 21. We've lowered our outlook for both sales and earnings to reflect our year-to-date performance and a relatively cautious view on the fourth quarter. We're now planning for 2019 revenue to be up 5% to 6% in total versus last year, with acquisitions driving the growth. Organically, we expect sales to be roughly flat at the midpoint compared to 2018 driven by growth in several sectors, including wind and solar energy, aerospace, marine and rail as well as positive pricing for the year. However, this is being offset by lower demand in off-highway, heavy truck and industrial services.

Acquisition should add about 7.5% to the top line for the year. This includes the BEKA acquisition we expect to close on later today. We expect currency translation to be negative 2% based on September 30 exchange rates. On the bottom line, we now estimate that earnings will be in the range of $4.15 to $4.20 per diluted share on a GAAP basis. Excluding anticipated net special charges totaling $0.55 per share, we expect record adjusted earnings per share in the range of $4.70 to $4.75, which at the midpoint would be up 13% from last year. The midpoint of our 2019 outlook implies adjusted EBIT margin expansion of around 125 basis points at the corporate level. And finally, we estimate that we'll generate free cash flow of around $375 million for the year, or almost 120% of GAAP net income at the midpoint. Our cash flow guidance is up slightly from last quarter as we expect improved working capital performance to more than offset the impact of lower earnings.

Before we move to Q&A, I want to remind everyone that we are hosting an investor day in New York City on December 12. We hope to see many of you there. The event will also be streamed live over the Internet via webcast.

And with that, we'll conclude our formal remarks and will now open the line for questions. Operator?

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Questions and Answers

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Operator [1]

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(Operator Instructions) We'll take our first question from Joe Ritchie from Goldman Sachs.

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Joseph Alfred Ritchie, Goldman Sachs Group Inc., Research Division - VP & Lead Multi-Industry Analyst [2]

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Rich, maybe just starting on that 4Q guide down sequentially. I think you said 4%. When you go back into history and I think the last time we experienced something like this was I guess back in the 2014 timeframe. And so maybe provide a little bit of color on how today's environment stacks versus 2014, and then your confidence in that most of this is really inventory correction.

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Richard G. Kyle, The Timken Company - President, CEO & Director [3]

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Okay. Looking at the -- I was looking back on the '14 comp. I think -- definitely, '14 dropped off from '13. So I think we're -- there was another phenomenon happening at that time, right? The dollar was moving dramatically against the rest of the world's currency. So I think there were 2 headwinds happening at that time that carried through most of the rest of '15. I think we've got a little bit sharper sequential decline from the third quarter to the fourth quarter. And then I think the other thing that's different is we are, in this case, projecting 2 consecutive sequential declines. So when you take the third quarter and the fourth quarter together, it would be a more pronounced decline than what we saw in '14. And I think a more pronounced decline than anything we've seen probably in 5 or 6 years, so pretty significant.

And in regards to inventory versus in demand, we know there's an element of both that in some cases production levels are down in some markets and inventory's coming down more than that. But we've gotten very clear signals in data from distributors and large OEMs that a significant part of this is inventory. So I think the question is really around what happens from the fourth quarter. Well, obviously, how deep the fourth quarter decline is. And sitting here October 31, we think we've been pretty conservative on calling that, but then what happens from the fourth quarter to the first quarter. And as I said in my comments, right now, we're planning for a sequential bounce from the fourth quarter to the first quarter, largely because we believe in that inventory correction phenomenon and we -- normal seasonality would be up from the fourth quarter to the first quarter, I think the last time we weren't was '16.

So it's certainly from '15 to '16. So it does happen, but it would basically mean that market's going to be in pressure for the full year and at this point, we don't anticipate that. I think there's obviously a lot of differences in the company between then and now in regards to what we spent the last 1.5 years that, at time working on breaking up the company versus what we've been doing the last few years in building a robust pipeline of commercial activities, cost reduction activities, M&A activities. So I think the differences in the company and how the company will perform in the same or better or worse market conditions is dramatically different from what it was 5 years ago and that'll be a factor as well.

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Joseph Alfred Ritchie, Goldman Sachs Group Inc., Research Division - VP & Lead Multi-Industry Analyst [4]

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That's helpful color, Rich. And I guess maybe just following up on that last point, the margin expansion in this backdrop with organic declining in both segments. You're clearly managing the decrementals well. I guess as you think about some of the things that helped, right? Incentive comp probably helped this quarter. And I'm assuming as well price cost. How do you think about this over the next ensuing quarters if we kind of stay in a pretty weak backdrop, and your ability to manage decremental margins over the next few quarters?

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Richard G. Kyle, The Timken Company - President, CEO & Director [5]

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I think we're in a really good spot the next few quarters. You're right, incentive comp did help in the third quarter as we lowered the outlook. Incentive comp will help next year. It'll be a tailwind next year as well as we look at raising the bar over this year's performance. I said in the comments, we will start the first quarter of 2020, pricing will be up. It'll be up less than it was in '18 and '19, but it'll be up. We've got a pretty good cyclical cost dynamic I have seen, where I say the cyclical part of cost meaning material costs, scrap costs et cetera. And then we got the self-help side of costs, which I said is also robust. So I think we're in a very good position from a price-cost standpoint for the next several quarters.

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Operator [6]

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We'll now take our next question from Stephen Volkmann from Jefferies.

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Stephen Edward Volkmann, Jefferies LLC, Research Division - Equity Analyst [7]

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Maybe I'll just pull on the same thread here a little bit. I think, Phil, you mentioned that your distributor -- industrial distributor business in North America was down, offset by growth overseas. Are you willing to say how much that North America distributor business was down?

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Philip D. Fracassa, The Timken Company - Executive VP & CFO [8]

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Yes. We typically don't go into that level of detail on it, Steve. But I would say it was down meaningfully and then we were up in Asia and Europe as we continue to grow in distribution in Asia as the installed base matures as we talked about before. And then we did see some incremental revenue in Europe. But it is -- the biggest, when you think of the guide down third quarter to fourth quarter, we did take the organic guide down a big piece of that was distribution. We had it sort of in the mid-single digits organically last quarter. We've got it kind of roughly flat this quarter. And the biggest move there would have been North America and it's really, as I said, reflecting lower end-user demand and then our expectations for some inventory destock in the fourth quarter.

And just -- as we sit here today, what we're hearing from our customers, what we're seeing in terms of the data we get would suggest that, that's likely to happen. So we thought we'd take a relatively cautious view and bake it in. And then, frankly, ditto on the Mobile side, in heavy truck and off-highway. We kind of took those down a bit more than they were in July. And it's, again, reflective of the demand environment we saw. But also given where we're at, we just don't see any reason customers -- anything other than probably take longer than typical shutdowns and kind of slow walk the fourth quarter and so, again, we bake that in just to take a relatively cautious view on it.

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Richard G. Kyle, The Timken Company - President, CEO & Director [9]

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I'd add a couple of comments to that, Steve, that aren't directly answers to your question but a couple of other things. North America being down 7% in the quarter. North America generally mixes us up, and it mixes the bearing industry and [general] up. So I think the fact that performing year-to-date as we have when North America is the weakest geographic market is a strong statement. And then I'd also say on the distribution side, the difference with U.S. distribution versus rest of world distribution is U.S. distribution, couple of large publicly traded companies, large private equity company, large -- one larger private held company, but they manage probably inventory a little more aggressively than the rest of the world where you get a lot of privately held businesses.

So I think, again, that dynamic that we're seeing in North America is partially that with inventory correction. And again, I think when you look at our performance despite that, it's a positive. But we also think that bodes well for the first quarter of next year. That some of that is just an inventory correction.

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Stephen Edward Volkmann, Jefferies LLC, Research Division - Equity Analyst [10]

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Okay. And then, Rich, is it your assumption that you'll be through with your own Timken inventory reductions at year-end, and that you'll be able to sort of produce to retail demands in 2020? Is that the plan?

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Richard G. Kyle, The Timken Company - President, CEO & Director [11]

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Yes. I think we are bringing inventory down in the second half, in relation to volume and assuming that we are up sequentially in the first quarter, we would expect production to step back up. We do have, as always, some inventory reduction targets and inventory improvement targets out there and things that we're working on. But on the macro level, I would say the answer to that question is yes.

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Operator [12]

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We will now take our next question from Steve Barger from KeyBanc Capital Markets.

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Kenneth H. Newman, KeyBanc Capital Markets Inc., Research Division - Associate [13]

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This is Ken Newman on for Steve. So we're hearing that some machinery product lines are planning for double-digit declines into early 2020, and we expect rail deliveries to be down year-over-year. Any more detail on what the offsets are specifically on the Mobile side or do you expect Process will offset whatever happens in Mobile?

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Richard G. Kyle, The Timken Company - President, CEO & Director [14]

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I didn't hear the first part of your question. What did you say was declining double digits?

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Kenneth H. Newman, KeyBanc Capital Markets Inc., Research Division - Associate [15]

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Yes. We're seeing some commentary that machinery product lines are planning for some double-digit declines.

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Philip D. Fracassa, The Timken Company - Executive VP & CFO [16]

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Okay. Yes. I know. I think speaking specifically to Timken for 2019. I mean I think what we're seeing is -- and I'll try and at least give some color around as much as I can around 2020. But what we're seeing relative to 2019 is there's no question. We're feeling it in off-highway, there's no question. We're starting to feel it in heavy truck. I mean both of those verticals, if you will, were down north of 10% organically in the third quarter. We're expecting continued declines both sequentially and year-on-year in the fourth quarter. There's no question we're feeling that. But on the Mobile side, we are benefiting from strong aerospace market while we were flat in the quarter, we are expecting aerospace to be up high singles, low doubles for the year. And global rail continues to be strong. So while we were flat in the Americas in the quarter, we are continuing to build that business outside the U.S., saw some really good growth in India, Eastern Europe, elsewhere in Asia and that's been really positive.

And then obviously the automotive business, while I know automotive is getting a lot of negative press these days, we think we've got a really attractive mix, and light truck and SUV demand's holding up. And I think that's mitigating a lot of what would otherwise be pretty negative, heavy truck and off-highway markets that you see on the market chart. And on Process side, wind continues to grow. It was up double digits, again, in the quarter. It's going to be up double digits, we expect year-on-year in the fourth and, again, for the full year. That's contributing significantly despite what -- you look across the rest of the vertical, the Marine's also up, which is helping.

The rest of the vertical's kind of flattish, and then the service business being down. So at least relative to Timken, you're seeing a little bit of benefit in that mix, which we've talked about for several quarters now. Heading into 2020, it's obviously tough to call. We're not giving 2020 guidance today. But I think it's fair to say a lot of the markets in 2019 that are strong still have pretty good momentum behind them when you think wind, solar, aerospace, marine, they have pretty strong fundamentals. So regardless of the equipment environment we're in next year, I mean, those markets could continue to grow for sure.

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Richard G. Kyle, The Timken Company - President, CEO & Director [17]

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Ken, I would just add the -- for 2020, the market outlook, not necessarily for Timken, but the one that is -- certainly seem to be the most negative and I think it could be double-digit numbers been talking about is heavy truck and particularly heavy truck in North America. On the OEM side of that, that's an important market for us. But it's also below 5% of the company revenue from an OEM standpoint.

And then from an off-highway standpoint, I'd say that 2020 outlook has not been that negative and then flat to slightly down and depending on whether it's construction or mining. And then for us, again, what we're seeing right now is, in some cases, customers were using dealer inventory, reducing manufacturing inventory. So if that does level off and even if it's down a few percent, we could potentially be up next year when you factor that in. So I would say outside of heavy truck, we're not seeing a lot of forecasts that are down 10% next year.

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Kenneth H. Newman, KeyBanc Capital Markets Inc., Research Division - Associate [18]

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That's very helpful color. The second question here is, we appreciate the color on price cost being positive into 2020. Any help here as to whether that applies to both segments or is there one where you expect to get more price-cost spread versus the other?

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Richard G. Kyle, The Timken Company - President, CEO & Director [19]

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I would say we -- it applies to both segments first, and we have generally gotten better price-cost coverage in Process than Mobile and would expect that to be the case in 2020 as well.

I would also say Mobile -- we'll add one more comment there. Mobile gets better -- more benefit proportionally from easing material costs, which we have hit a market here in the last couple of quarters and expect that to carry over into next year.

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Operator [20]

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So we have our next question from David Raso from Evercore.

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David Michael Raso, Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Industrial Research Team [21]

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And maybe that last comment helped address part of my question. So I'm trying to understand the Mobile margins. I mean essentially, organic this quarter down 4.8% on the sales, next quarter implied it gets even worse at down 5.9%, but the margin's up year-over-year solidly in 3Q implied, again, up solidly in 4Q. So maybe that was the last comment there that the input costs relief, the price cost is particularly positive in Mobile in the second half of the year. Is that how we're seeing that positive dynamic? And obviously, if you can kind of frame a little bit. If it feels like you're trying to imply that down 5.9% for the fourth quarter in Mobile. We'll see but it might not get much worse than that. I'm just trying to see if I can extrapolate that margin performance in Mobile into my thoughts on 2020.

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Richard G. Kyle, The Timken Company - President, CEO & Director [22]

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Yes. I would say I think you have it directionally, David. Cost price positive, mix helping within there a little bit with rail being a little bit stronger, heavy truck being down. Material costs, certainly more favorable this year and more in the second half than what we had anticipated coming into the year and largely price being locked in with the exception of where we pass material surcharges through. And then I would add structural cost reductions that have been taking place and continue to take place as well as some mix impact from acquisitions.

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Philip D. Fracassa, The Timken Company - Executive VP & CFO [23]

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Yes. Maybe I'd also add, David, I mean I think the -- in the manufacturing performance, despite the inventory take out, I mean we are managing costs extremely well. So we do expect it to be a headwind at the corporate level but not anywhere near what we would've had in prior years if you will. We're flexing down as we need to across some of the softer markets. We've reduced some of our operative personnel by north of 700, 800 people so far across the world, and I think we're certainly acting quickly to keep costs in line despite lower inventory and that sort of thing.

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David Michael Raso, Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Industrial Research Team [24]

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But is it fair to say, after that performance in the second half of the year, if you do the fourth quarter, that Mobile, if the revenues are even down next year, that you would expect to hold broadly speaking from that answer, the margins from this year?

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Philip D. Fracassa, The Timken Company - Executive VP & CFO [25]

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Yes. I think it's probably -- I'd say that's probably too early to talk to. I think a lot of that depends on the environment next year. So it's probably a little premature to talk to that. I do want to comment on the fourth quarter margins, I did catch your note, and we do round the margin kind for Mobile of approximately 12 and for Process of approximately 21 is rounded. I would say, we would not expect -- we would expect margins to be up from -- flat to up from last year but not quite as much as maybe you were showing.

And then the reverse would be true, I think, on the process side.

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Operator [26]

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We'll now take our next question from Joe O'Dea from Vertical Research Partners.

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Joseph O'Dea, Vertical Research Partners, LLC - Principal [27]

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Similar line of questions, but just on the Process side. It was a good margin in the third quarter and it looks like a bigger than normal step down sequentially from 3Q to 4Q. And so trying to understand I think in the third quarter, it sounds like North America distribution was one of the pinch points I would expect that that's a continuation in the fourth quarter, but just why we might be seeing some of that larger than normal margin pressure? And then the second part of that being, what does that mean about a setup into next year? Because it would imply process margin's down if we just take the 4Q Process margin that you're indicating.

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Richard G. Kyle, The Timken Company - President, CEO & Director [28]

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I'd say, first there's an element of seasonality there that the fourth quarter company-wide margins are generally a little bit lower and production is a little bit lower. There's an inventory take out element in there, revenue decline in process sequentially. So I don't think it bodes at all for 2020. So I would say it's not -- I wouldn't read much more into it than seasonality inventory reduction and a sequential decline. Obviously, if you're forecasting sequential declines for next year, then there could be some other things but we're not anticipating as we're sitting here today for Process.

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Philip D. Fracassa, The Timken Company - Executive VP & CFO [29]

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Yes. And maybe just -- and maybe a couple of things I would add to that, Joe, I think Rich has got it. The only things I would add would be I think mix, as I talked about the -- with the services business being a bit softer and then our expectations relative to distribution, I think that would be negative for Process from a mix standpoint. I think it's definitely impacting there as well. And then, probably the last point, Rich mentioned it, we're really excited about BEKA in terms of what we can do with it, but it will come in below the corporate average from a margin standpoint, meaning, it would be a lot -- significantly below the Process average if you think about it that way. So while only about 30% of it's going to go into Process, I mean that will be a little bit of a headwind as well temporarily, until we drive those synergies and get those margins back up.

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Richard G. Kyle, The Timken Company - President, CEO & Director [30]

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Particularly in the fourth quarter because we're hitting it for November and December, which would typically be 2 of, if not the 2 weakest months of the year for all of our business units.

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Joseph O'Dea, Vertical Research Partners, LLC - Principal [31]

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Understood. On the distribution in what you're seeing with destock and given that I think you have better visibility into some of your large North American distribution partners. Any insight on where you think months of inventory will stand at the end of the year just to kind of appreciate what kind of a step down we're seeing here in the back half of the year?

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Richard G. Kyle, The Timken Company - President, CEO & Director [32]

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Yes. I wouldn't say months or days of inventory but I think our distributors get better every year at managing inventory. And it's been a trend for well over a decade. So they leverage their inventory better in the '17, '18 and first half of '19 upturn, and what they did in the past. As we've talked before, we didn't really see inventory levels ever. In fact, the inventory turns improved during that time. So I think some of what we're seeing is a level of caution there, some of it is just bringing it down with the realities of where their market demand is. But we're going to end the year relatively low in the U.S. as a percentage of sales -- or as a percentage of cost of goods sold is generally the way we look at it.

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Joseph O'Dea, Vertical Research Partners, LLC - Principal [33]

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And then just one more on wind. And any perspective on demand patterns there, how to think about current demand levels, bigger picture just in terms of where this is trending sustainability of demand here because that's been a nice source of strength for you.

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Richard G. Kyle, The Timken Company - President, CEO & Director [34]

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Certainly expect 2020 to be very strong, and I think that also has ripple effects for some of our confidence on the pricing side because a large of the large [board] bearings go into off-highway and other markets. And so the demand, while some of those markets may be off their peak, the demand in total is strong in, what I'll call, large industrial bearings. So it's good for the pricing side. So we expect a very strong year in 2020 for wind. That's one of our longer lead time areas as well. And not looking to call 2021 but if you look out over the next 5 years, we are certainly believers in growth of renewable energies globally and continue to grow our position there, both in wind and in solar. And I'll just toss in part of the interest in the acquisition of BEKA is that they bring a product line and a market position in wind lubrication systems, which we're excited about.

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Operator [35]

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We'll now take our next question from Chris Dankert from Longbow Research.

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Christopher M. Dankert, Longbow Research LLC - Research Analyst [36]

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On the SG&A, flattish on an organic basis. You did highlight some structural cost out. Just can you give go into a little bit of detail on what's going on there? We're talking about just kind of pulling down headcount a bit? We looking at the footprint kind of what's bigger picture and kind of can we expect additional cost out actions going forward here?

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Philip D. Fracassa, The Timken Company - Executive VP & CFO [37]

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Yes. Chris, I'll take that. Let me just talk -- I'll talk to the SG&A first, and then maybe we'll talk a little more even costs of sales. But on SG&A, yes, we we're roughly flat year-on-year despite the lower organic revenue, if you will. While we are working on cost-reduction initiatives across our administrative functions and did capture a lot of benefits there, we are also adding some costs. We're building out some of our capabilities outside the U.S., we're adding salespeople in Africa, for example, to serve that market and other parts of the world. So I mean that continues. But I think net net, we kept it under pretty good control. And then we did benefit from lower compensation expense in the quarter, which was primarily incentive compensation as we adjusted the outlook. So that kind of altogether kind of kept us flat.

My comment around headcount was really more around operatives, obviously as markets soften particularly in off-highway and heavy truck, we have had to slow down some of our production. And we do a pretty good job and a very swift job of flexing down, and we've been able to take out or reduce headcount quite a bit to match demand. I think that'll continue, and we'll continue to flex with demand. And it's really helped from a manufacturing standpoint, we show negative $5 million year-on-year. But given the reduction in inventory, it certainly would've been higher than that, were it not for the cost reduction actions and the more variablized cost structure that we have.

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Richard G. Kyle, The Timken Company - President, CEO & Director [38]

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I would just add is, by design, we are trying really to mix into what would generally be higher SG&A markets and businesses for us. Process runs a higher SG&A level than Mobile and as you go beneath that, lubrication systems runs a higher SG&A model than bearings et cetera. So we really look over the last few years, SG&A has been I think a bigger contributor to the margin improvement than just what the pure math would show. Because we've improved the mix, which would've just naturally about the SG&A up. We've driven a lot of productivity improvements, we've driven acquisition synergy improvements and it has been a significant contributor to margins.

And as you look forward, I already talked about we're -- we've done a lot of Diamond drives integration already. Really most of that just in the last quarter, so we'll see the benefits of that this quarter. It'll take us a couple of quarters, but there will be significant integration between Groeneveld and BEKA over the course of next year. We've got a lot of things happening in other parts of the business. We've taken out another ERP system just this quarter, which not only simplifies the business and improves our IT cost structure but allows us to pursue order cost reductions as well. So it's a integral part of our strategy and our operating performance, and it's been a significant contributor to our acquisition results as well as the performance of the business.

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Christopher M. Dankert, Longbow Research LLC - Research Analyst [39]

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Yes. Absolutely. And then just kind of follow up here. When we look at Europe and Asia, and I apologize if I missed this, but growth certainly well ahead of IP. I know you called out rail as one of the markets that kind of helped lead there. But just any additional color on it? Was it cross-selling, was it program exposure? What's kind of driving the outgrowth in Asia and Europe?

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Philip D. Fracassa, The Timken Company - Executive VP & CFO [40]

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Yes. I would say it really is driven a lot by our mix, Chris, as we talked about. So wind was clearly a contributor. Rail in Europe and Asia has -- continues to grow as we said we were up in distribution. And I think it's really more market-driven. We tend to be more industrial -- tilted toward industrial markets in Europe and Asia like we are as a company. And I think just those markets in particular have held up really well and continue to grow, and have enabled us to more than offset the declines we're seeing. Heavy truck and off-highway declines are global to a great degree and -- but yes, we've been able to offset that with I would say, the wind, the rail and distribution probably are the biggest ones that would come to mind.

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Operator [41]

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(Operator Instructions) We'll now take our next question from Justin Bergner.

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Justin Laurence Bergner, G. Research, LLC - VP [42]

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To start off, and I got on the call a little bit late, so I apologize if anything is redundant. But to start off, I guess, on the first quarter, you suggested you see a sequential revenue bounce driven by seasonality. Are you expecting that to just be sort of in line with normal seasonality or actually stronger than normal seasonality?

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Richard G. Kyle, The Timken Company - President, CEO & Director [43]

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I would say we're planning for normal, which in the last few years have been mid- to high single digits up from the fourth quarter. We are double digits in one of those years and mid-single digits in the other couple of years. And I'd say we're planning for the lower end of that.

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Justin Laurence Bergner, G. Research, LLC - VP [44]

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Okay. That's helpful. Secondly, just the GAAP EPS guide came down a lot more than the adjusted EPS guide. I'm not sure if you've bridged that at all. Is that higher restructuring expenses, tax rate or what's behind that?

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Philip D. Fracassa, The Timken Company - Executive VP & CFO [45]

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Yes. I would say it's probably -- the 3 main things I'd point to, Justin, would be the pension remeasurement charges that we took in the third quarter will then -- would obviously be in a full year guide that wasn't in last quarter because we didn't have the number calculated. The BEKA acquisition will come in with acquisition related charges that we wouldn't have anticipated or baked into the guidance last quarter. So that would typically be like inventory step up, acquisition fees et cetera that would hit. And then the last point would be the tax that. We do have some discrete tax items we're recording during the current year for some prior year reserves that we're setting up, that are larger than what we would've factored in last quarter.

Those would be, I would say, the 3 main items, with the biggest one being the remeasurement charges. And I would point out, at the end of the year, we always have to do a remeasurement of all of our pension and OPEB plans it's required. We don't know, as we sit here today, we don't know what that amount would be, so we don't bake in anything for that. So that could be another number -- another amount coming in. It will be another amount coming in, I'm not sure which way it's going to go at this point. But that will come in, in the fourth quarter, and we will not have included that. Does that make sense?

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Justin Laurence Bergner, G. Research, LLC - VP [46]

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Yes. That makes sense. It doesn't seem like there's anything too unusual there. And then the price mix was I guess a $15 million benefit year-on-year in the third quarter versus $7 million year-on-year in the second quarter. Was that mainly mix or are you still getting better pricing through the third quarter?

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Richard G. Kyle, The Timken Company - President, CEO & Director [47]

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I would say pricing in the third quarter was similar to the second quarter. So the improvement from Q2 to Q3 in that column would've been more mix related, but pricing is largely held since the first quarter of the year. Maybe a little bit more has come in through the year, but that's also been offset by material easing and as material input cost on some of our contracts, we passed some of that through. So that's largely washed out any midyear price increases we would've realized.

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Justin Laurence Bergner, G. Research, LLC - VP [48]

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Okay. Maybe one last one on big picture. Has your acquisition appetite slowed now? I mean I realize BEKA was a really good opportunity, even if the industrial backdrop is decelerating. But looking forward are you focused on sort of integration deleveraging, or are you still open to material M&A?

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Richard G. Kyle, The Timken Company - President, CEO & Director [49]

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It depends on how far you're looking out. I would say, we're certainly not expecting to do anything else in 2019 or probably early in 2020. As I mentioned in my comments, we feel very good about the 3 acquisitions we completed last year that -- they're performing well, we know what we have, integration has been good, management team's stable et cetera. So -- and then, we got off to a rough start with Diamond. We feel a lot better about that than we did 3 or 4 months ago. Definitely, the short-term focus is absorb BEKA.

Our cash flow, as we said, we're going to end of the year with our -- right about in the middle of our targeted debt levels. Our cash flow tends to be second-half weighted, and generally as we look at next year would anticipate putting that cash to things other than debt reduction and probably ending our next year at the middle of our targeted range as well. And obviously, M&A could be a part of that as well as share buyback could be a part of that as well.

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Operator [50]

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At this time there appears to be no further questions. I would like to turn the conference back to you for any additional or closing remarks.

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Jason Hershiser, The Timken Company - Manager of IR [51]

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Thanks, Brian, and thank you, everyone, for joining us today. If you have further questions after today's call, please contact me. Again, my name is Jason Hershiser and my number is (234) 262-7101. Thank you and this concludes our call.

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Operator [52]

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Thank you for your participation. You may now disconnect.