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Tyco International (NYSE:TYC)

Q1 2013 Earnings Call

January 29, 2013 9:00 am ET

Executives

Antonella Franzen

George R. Oliver - Chief Executive Officer and Director

Arun Nayar - Chief Financial Officer and Executive Vice President

Analysts

Ajay Kejriwal - FBR Capital Markets & Co., Research Division

Jeffrey T. Sprague - Vertical Research Partners, LLC

Scott R. Davis - Barclays Capital, Research Division

Nigel Coe - Morgan Stanley, Research Division

Julian Mitchell - Crédit Suisse AG, Research Division

Charles Stephen Tusa - JP Morgan Chase & Co, Research Division

Gautam Khanna - Cowen and Company, LLC, Research Division

Operator

Welcome to the Tyco First Quarter Earnings Conference Call. [Operator Instructions] Today's conference is being recorded. If you have any objections, please disconnect at this time. I will now turn the call over to Antonella Franzen, Vice President of Investor Relations. You may begin.

Antonella Franzen

Good morning, and thank you for joining our conference call to discuss Tyco's first quarter results for fiscal year 2013 and the press release issued earlier this morning. With me today are Tyco's Chief Executive Officer, George Oliver; and Chief Financial Officer, Arun Nayar.

I would like to remind you that during the course of today's call, we will be providing certain forward-looking information. We ask that you look at today's press release and read through the forward-looking cautionary informational statements that we've included there.

In addition, we will use certain non-GAAP measures including normalized earnings per share in our discussions, and we ask that you read through the sections of our press release that address the use of these items. The press release issued this morning and all related tables, as well as conference call slides, which contain summary financial information, can be found on the Investor Relations portion of our website, at tyco.com.

Please also note that we will be filing our first quarter SEC Form 10-Q later today. In discussing our segment operations, when we refer to changes in backlog and order activity, these figures exclude the impact of foreign currency. Additionally, references to operating margins during the call exclude special items, making them non-GAAP metrics. These non-GAAP metrics are reconciled in the schedules attached to our press release.

Now, let me quickly recap this quarter's earnings. Earnings per share from continuing operations attributable to Tyco common shareholders was $0.34 and included charges of $0.06 related to special items. These charges related primarily to separations and restructuring activities.

Earnings per share from continuing operations before special items was $0.40 compared to the prior year quarter of $0.26. As we mentioned on last earnings call, EPS this fiscal year is not comparable to the prior year, as the prior year's results include corporate and interest expense associated with supporting the ADT and Flow Control businesses.

Additionally, our 2013 results are being impacted by the synergies associated with the separation of the Commercial Security operations in North America from ADT. Normalizing last year's results for these items, the comparable prior year earnings per share before special items would have been $0.36.

Now, let me turn the call over to George.

George R. Oliver

Thanks, Antonella. Good morning, everyone. We were off to a great start as the new Tyco. During our first quarter, we made a lot of progress in bringing the teams together as an integrated Fire and Security company and executing on our growth strategy. We also continued to strengthen our competitive capabilities across our businesses. Both organically and through acquisitions, we have started to see the increased benefits from our productivity initiatives.

Overall, our first quarter results reflect a year-over-year increase of 11% in earnings per share before special items on a normalized basis, a solid beginning to fiscal 2013.

In line with our growth strategy, our Installation and Services segment benefited from increased service revenue across most geographic regions, and our product businesses continue to reap the benefits of our focused R&D spend to drive new product introductions.

Additionally, we've strengthened our service platform and augmented key vertical markets with recent acquisitions and accelerated our growth rate in high-growth markets.

Before I turn to our business results for the quarter, let me quickly touch on each of these items. First, service revenue, including recurring revenue, represented nearly 45% of total revenue in the quarter.

Given the integration of our Fire and Security businesses, we are uniquely positioned to bring differentiated solutions to our combined customer base. We expect this will allow us to accelerate the rate of service revenue growth to 5% over the next few years.

Second, we continued to fund engineering and product development with double-digit increases year-over-year. It is these types of investments which drive new or enhanced product introductions. For example, this quarter in Fire protection products, we introduced a new liquid vehicle system under our ANSUL brand, which is a new liquid agent system technology for mobile equipment, particularly suited for the mining verticals. It is a holistic approach to fire suppression, with early fire detection and fast actuation to control and suppress flames in seconds. This new technology positions us well for future growth in the mobile equipment market.

In Security Products, we developed the fastest IP camera on the market, with improvements in the speed, the camera can pan, tilt and zoom. This significantly boosts the capabilities we provide for our customers, where precision and detail can make all the difference.

On a separate front, we are also upgrading our existing residential panels and keypads, integrating the Visonic PowerG wireless technology obtained from our recent Visonic acquisition.

And in Life Safety products, we launched the Protégé ZM, a new handheld portable gas detection device, which incorporates several technological improvements designed to extend the life of the device and improve total cost of ownership in the portable gas detection market.

Each of these new products has been very well received in their respective markets. In addition, since the separation, we closed 2 strategic bolt-on acquisitions for an aggregate purchase price of about $50 million. These acquisitions are expected to expand our Installation and Service footprint, primarily in the U.S. and the U.K., and enhance our offerings in the banking and financial services verticals.

We also signed a definitive agreement to purchase a majority ownership stake in Beijing Masters Systems Engineering, which is a leading systems integrator of building the security systems in China. We expect this acquisition will allow us to further expand our footprint and customer base, while opening up additional opportunities in the region by leveraging their grade A license, which is the highest level design in contracting license in China. The closing of this transaction is subject to customary regulatory approvals.

These types of transactions have helped us expand our position in high-growth markets, which represent 13% of our total revenue in the quarter.

Year-over-year revenue in high-growth markets increased 22%, partly driven by our prior year acquisition in fire installation and services.

Additionally, we are beginning to see the benefits of our sourcing and productivity programs earlier than anticipated, especially in North America. All of these actions are integral to our strategy and at the outset, are getting very good traction.

Before I get into the segment results for the quarter, I just wanted to spend a few minutes giving you an update on another key element of the strategy we laid out at our Investor Day, capital allocation.

As we discussed back in September, we have a deep pipeline of attractive acquisition candidates that complement our existing businesses. These potential acquisitions are consistent with our strategic priorities and provide very good long-term financial returns for shareholders. We continue to prioritize the use of free cash to execute strategic bolt-on acquisitions.

Given that the timing of acquisitions can vary, the Board approved an increase in our share repurchase authorization to $750 million. This provides us greater flexibility to be opportunistic in returning excess cash to shareholders.

Further, in support of our capital allocation strategy, we recently announced a proposed increase of our annual dividend to $0.64 per share. The proposed dividend represents about a 7% increase over the post separation annualized dividend. Our shareholders will vote on this proposal at our Annual General Meeting in March. Considering our acquisition pipeline, the $750 million share repurchase authorization and the proposed dividend increase, we continued to demonstrate our balanced approach to capital allocation.

Now let me turn to an overview of our segment results and give you a feel to the business environment in each of the segments. Then I will turn it over to Arun to provide you with more details regarding our quarterly performance.

Let me begin with our North America Installation and Services segment, which has better-than-expected operating results for the quarter. In Tyco Integrated Security, our North America Commercial Security business, we are seeing improvement in the execution of installation projects as we work through our backlog, as the discipline put in place as part of project selectivity takes hold.

As I mentioned earlier, we are seeing the benefits of sourcing and productivity initiatives earlier than expected. In SimplexGrinnell, our North America Fire business, which represents about half of the revenue in this segment, we saw accelerated organic revenue growth and continued operating margin expansion. Installation revenue grew for the first time in 5 quarters, reflective of the modest improvement we are seeing in the nonresidential construction market. We expect to see continued installation growth throughout the year.

As I mentioned last quarter, we expect to see revenue headwinds overall in our North America Installation and Services segment in 2013, as we continue to execute project selectivity in Commercial Security. I will speak a little more about that as we cover our guidance for the second quarter later in the call.

In Rest of World Installation and Services, we continue to see nice growth in Service across Europe, Asia, Latin America and South Africa. Project activity in high-growth markets continued to be more than offset by a decline in mature markets due to project selectivity and weakness in nonresidential construction markets.

Year-over-year, acquisitions added 3 percentage points of growth and have strengthened our position in high-growth markets. For example, the acquisition of Reliance, which was completed in the prior year, enhanced our Fire Systems Installation and Service position in China.

Given our Rest of World market position and backlog, coupled with a modest pickup in Installation in the second half of the year, we are well positioned for future growth and margin expansion.

In Global Products, top line growth was solid, at 16%, as organic growth of 6% was supplemented with the benefit of past acquisitions. The operating margin was short of our expectations, primarily due to a charge for an environmental reserve.

Given our R&D investments, order activity and expectations for the remainder of the year, we feel good about our ability to strengthen our global products margin sequentially each quarter to achieve a full year operating margin of about 18%.

Now let me turn the call over to Arun to discuss the operating results in more detail.

Arun Nayar

Thank you, George, and good morning, everyone. Before I get into the details of our segment performance, let me provide an overview of our first quarter results.

Revenue in the quarter of $2.6 billion increased 5% year-over-year. Service revenue growth of 2% and products growth of 6% was partially offset by a 3% decline in Systems Installation for overall organic revenue growth of 1% in the quarter.

Our organic growth was supplemented by strategic bolt-on acquisitions, which added $76 million, or 3 percentage points, to our overall growth on a year-over-year basis.

Segment operating income before special items, was $318 million and the operating margin was 12.2%. The benefit from our productivity initiatives funded incremental investments in the businesses and absorbed the synergy costs.

Earnings per share from continuing operations before special items of $0.40 represents a $0.04 increase year-over-year on a normalized basis, of which $0.03 came from operations.

Now let me get into the details of each of the segments. Starting first with North America Installation and Services. Revenue in the quarter of $976 million increased 1% organically. Service revenue increased 1% in the quarter, while installation revenue remained flat.

Revenue growth in the first quarter was supported by the conversion of year-end backlog, which decreased 3% on a quarter sequential basis, to $2.4 billion.

As expected, overall orders in North America Installation and Services declined 9%, including service order growth of 2%.

Operating income before special items was $120 million, and the operating margin increased 110 basis points year-over-year to 12.3%. An increased mix of higher-margin service revenue, coupled with a better-than-expected retail season and accelerated sourcing and productivity savings, drove the operating margin improvement. These benefits more than offset the increased cost associated with the separation of the North America Commercial Security business from ADT.

On a full year basis, we still expect a 2% to 3% organic revenue decline in 2013 due to our project selectivity strategy. We anticipate that the benefits of restructuring, sourcing and productivity will offset the revenue decline and the $35 million of dis-synergies related to the separation, resulting in an overall operating margin similar to the prior year.

Turning to Rest of World Installation and Services, revenue was up 3% overall, mainly due to acquisitions. Organic revenue was flat year-over-year, as a 3% increase in Service revenue was offset by a 5% decline in Installation revenue.

Service orders increased 5% and Installation orders increased 8% year-over-year. In aggregate, orders increased 6%. Backlog of $2.6 billion increased 3% on a quarter sequential basis.

Operating income before special items was $121 million and the operating margin was 11.1%, relatively consistent with the prior year, as a higher mix of Service revenue was offset by incremental growth investments.

Moving to Global Products. Revenue grew 16% in the quarter, to $534 million. Organic revenue grew 6%, with positive growth across all 3 platforms, led by Security products and Life Safety. Both of these platforms had double-digit growth, as the benefits of R&D investments continue to drive new product introductions and enhancements.

Product orders increased 16% year-over-year, largely driven by acquisitions. Operating income before special items was $77 million, and the operating margin declined 390 basis points, to 14.4%.

As we discussed on our last quarter call, we expected the operating margin in the first quarter to be in the range of 16% to 16.5%, as the leverage on increased revenue would be more than offset by a 280 basis point incremental investment in R&D and sales and marketing.

In addition to making the planned investments, the quarter was also impacted by $6 million of costs associated with an environmental reserve and lower sales of higher-margin products due to the timing of shipments. We estimate that these 2 items impacted our operating income by about $11 million and our operating margin by approximately 200 basis points.

As we look ahead to the second quarter, we expect a sequential increase in the operating margin to 16.5% to 17%, keeping us on a path to an operating margin of about 18% for the year.

Now let me touch on a few other important items. First, corporate expense before special items was $58 million in the first quarter, and we expect corporate expense in the second quarter to be similar.

Next, our effective tax rate for the quarter before the impact of special items was 17.4%. This was below our annual guidance of 19% to 20% due to the timing of certain items. Although the tax rate can move around quarter-to-quarter, we continue to expect both the second quarter and the annual effective tax rate of 19% to 20%.

Lastly, our weighted average share count for the quarter was 473 million shares and includes $50 million of share repurchases during the quarter. In the second quarter, we expect the weighted average share count to be 475 million shares.

Now let me turn things back over to George to wrap up this morning's call.

George R. Oliver

Thanks, Arun. Let's turn now to our earnings guidance for the second quarter and our expectations for the second half of the year.

Based on our current order rates, backlog and the impact of project selectivity, we expect revenue in the second quarter to be in the range of $2,550,000,000 to $2,600,000,000, with organic revenue growth of 1%.

Additionally, we expect segment operating margin to be approximately 12%. From a segment perspective, starting with North America Installation and Services, we see positive growth in service revenue of about 2%, offset by a revenue decline in Systems Installation due to project selectivity.

Overall, organic revenue is expected to decline 1% year-over-year, with an operating margin of approximately 10.5%, which represents an 80-basis-point improvement year-over-year.

On a quarter sequential basis, the decline in operating margin is due to normal seasonality we see in the business, particularly in retail, which typically yields a higher revenue and operating income in the first quarter.

Looking to Rest of World Installation and Services, we expect organic revenue to increase about 1%, with an operating margin similar to the prior year.

Moving to Global Products, we expect to see organic revenue growth in the mid-single digits, with acquisitions adding about 3 percentage points of growth year-over-year.

As Arun mentioned, we expect the operating margin to increase, on a sequential basis, to 16.5% to 17%, as the additional income from higher volume will more than offset incremental R&D and sales and marketing expenses.

Taking all of these assumptions into account, along with the below-the-line items Arun mentioned earlier, we expect earnings per share, before special items, in the second quarter, to be in the range of $0.37 to $0.39.

This compared to a normalized earnings per share of $0.35 in the prior year. At the mid-point, this represents a $0.04 increase in operations year-over-year, offset by $0.01 of share dilution.

Within the new Tyco, we typically generate 40% of earnings in the first half of the year, with 60% achieved in the second half. Our first quarter results and guidance for the second quarter puts us in line with our normal EPS spacing.

Based on our first quarter performance and expectations for the second quarter and balance of the year, we continue to see our full year earnings per share, before special items, to be in the range of $1.75 to $1.85.

Thanks for joining us on the conference call this morning. And with that, operator, please open the line for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question today is from Ajay Kejriwal with FBR Capital Markets.

Ajay Kejriwal - FBR Capital Markets & Co., Research Division

So is there a way to kind of look at the North America Installed business on a normalized basis? So I know you're doing all this selectivity and the Security orders are down, but that's kind of expected. So if you x that, I mean, is there a way to look at the run rate as to what the rest of the business is doing?

Arun Nayar

Yes, I think, if you, Ajay, if you look at our 2012 numbers and our 2013, embedded in the 2013 numbers is roughly, on an annualized basis, about $35 million of dis-synergies. So if you take those $35 million of dis-synergies and, on a quarterly basis, it's about $9 million a quarter, that adds about -- roughly about 30, 35 basis points. Overall segment margins are about 90 to 100 basis points to the quarterly segment margins.

Antonella Franzen

So when you take a look at Q1 '12 normalized, Ajay, North America was, like, at a 10.3% operating margin, which compares to our reported number of 12.3%. So on a normalized basis, we've actually improved the operating margin 200 basis points year-over-year.

Ajay Kejriwal - FBR Capital Markets & Co., Research Division

Got it. And could you give some color on the top line as well? So the orders declined 19%. But obviously, due to the selectivity, I mean, if we x this at work you are doing kind of moving away from this lower margin business, and what is the underlying growth rate?

George R. Oliver

So, Ajay, George here. When you look at the overall orders, we're up about 2%, 2.5%. And that was driven by Products up 16%, Service up a little over 3%, with Installation down 6%. And the Installation is really driven by North America. The project selectivity that we've been driving is part of the strategy for the Commercial Security business. And so when you look at North America, North America is down about 8.5%, Rest of World is up 5% and Product is up 16%. So this is very much in line with the strategy that we deployed as we took the Commercial Security businesses and begin to integrate those with the Fire businesses that I had responsibility for. Now when you look at the execution on margins, I think it is an output of the -- we're integrating the businesses, we're driving accelerated sourcing benefits, we're looking at, really, synergizing the back offices. So we knew that we had the $35 million of dis-synergies this year, and they'll be recurring. But our task was to how do we now accelerate our productivity to try to offset that in the first year of operations here as a standalone. And so it's very much in line. The back -- as we get the question on the back -- the margins in backlog, given the project selectivity that we’ve deployed, is progressing very nicely. And with that backlog, we're up over 100 basis points in backlog, which projects that we're going to be able to continue to improve margins through the course of the year.

Arun Nayar

And just to add to that, George, like we have said at the Investor Day, as well, in the long run, if you look at what we have done to the Fire business over the last couple of years, the Fire business, it's -- we did the project selectivity for the Fire business a couple of years ago when, George, you were running it at the time. And now the businesses are stabilized and it's growing at GDP plus rates, right? So once we get over the project selectivity phase on the Security business, we should see the same algorithm for the Security business as we have for the Fire business.

Antonella Franzen

And Ajay, the only thing I would add to your -- to the point on the orders, they were up 2% for the quarter. But if you kind of normalize out that project selectivity, our order rates -- order growth rate would be in that 5% to 6%, which is kind of similar to where we were last quarter.

Ajay Kejriwal - FBR Capital Markets & Co., Research Division

Yes, that's very helpful. And then on the Global Products business, you kind of called out the timing of higher-margin products sales. So how do we think about it? Is that business that shows up in the second quarter, or is it more spread out over the rest of the year?

George R. Oliver

Yes, it's business we picked up in the second quarter. A lot of that was timing of our chemical suppression systems, which typically are higher margin, and it was, really, at the end of the year. And so we'll pick up some of that margin. And right now, we are still looking to be mid-single digits -- mid- to upper single digits here in the second quarter within our product businesses. So we'll pick up some of that in the second quarter.

Ajay Kejriwal - FBR Capital Markets & Co., Research Division

Is it possible to quantify what was the impact here in the first quarter because of that?

Arun Nayar

I think we were looking at roughly around $10 million of revenue that was sitting in the docks and the timing of the shipments didn't make it to the year-end closing.

Ajay Kejriwal - FBR Capital Markets & Co., Research Division

Good. And maybe one last one for me before I pass it on. So update on the purchasing and sourcing. You mentioned that you are ahead of plan. Any color on just how much have you achieved? You had talked about $1 billion in spend that you're targeting initially. So where you are and then what needs to be done, and what you should be expecting for the rest of year?

George R. Oliver

Yes, Ajay, as we've said back during the Investor Day, this is certainly a big element of our cost structure. It represents about $4 billion of our cost. We put a big sourcing leader in place, Vivek Kamath, and we've got an organization now that totally aligned across the enterprise. Now what we've done is we've split that buy-up into categories. We've got very experienced category leaders with targets in each one of those, and we're beginning to now see the benefits of the accelerated savings now leveraging all of our combined base across the enterprise, where historically we've had multiple organizations, sometimes buying similar type products or services. And so as we go forward, we're going to be able to better quantify that acceleration with what we believe we're going to be able to see now in the second half and beyond. But I can tell you that by putting the structure in place, setting the targets, putting a real strategic sourcing process in place across the enterprise, we're starting to see some real nice traction and our ability to be able to generate those savings.

Operator

Our next question is from Jeff Sprague with Vertical Research Partners.

Jeffrey T. Sprague - Vertical Research Partners, LLC

The color on margin in backlog is helpful. George, just thinking about the whole selectivity thing, though, just kind of as you manage it through the P&L. Obviously, when you ran that playbook in Europe, right, you were starting with -- maybe not you personally, right, but the whole turnaround in Europe, you were starting with negative margins. So margin improvement on selectivity clearly overwhelmed any headwind from revenues driven by that selectivity. As we look at you running through that playbook now with margins decent, right, room to go up but decent, just how do we think about that handoff through the year? You guided Q2 margins. Should we clearly be kind of coming up through the remainder of the year as we progress and with a kind of a healthy looking exit rate in the '13? Or is there some other way we should think about that?

George R. Oliver

Sure. Jeff, let me start with the overall project selectivity strategy and how that's been deployed. And then, I think, specifically, you're asking about North America. When you think about that, especially we're beginning to see -- there are some positive signs that the nonresidential construction market is going to come back. The ABI Index has been positive now for 5, I guess, 5 months. And so we're seeing some of that. And what's important is that as we look at our end markets, that we're focusing on the end markets, we're developing better -- that play to our strengths, where we can develop differentiated solutions that ultimately lead to the recurring revenue. So a lot of that is just a discipline in how we approach the market, because, as you know, we incur a lot of cost upfront, and how we develop those projects will then ultimately lead to the recurring revenue. So what's most critical is the service growth. And so as we have seen, in spite of the project selectivity on the Installation side, we are seeing positive service growth across the globe. And that ultimately is really a big part of the overall strategy, making sure that we're getting that service growth. Now relative to North America, certainly, we were anticipating the dis-synergy cost that we were going to incur with the separation of the ADT Residential Security business. And we took that into account as we outlined our strategy, our cost strategy, which we're focused on not only the sourcing element of it, but also the infrastructure element, so that we can, as quickly as we can, offset those dis-synergies to be able to make sure that, from a margin standpoint in total, that we can be able to deliver increased margins. So for the total year, we're going to be positioned for increasing our margins 20 to 50 basis points. Now when you look at from operations, we're actually getting -- from an EPS standpoint, we're getting about $0.18 from operations, which is ultimately an output of the project selectivity, the increased service growth, and then the overall margin improvement that we're seeing across the globe. And so in North America, although we came out very strong because of the acceleration of our productivity and cost-out initiatives, we will have pressure with the reduced revenue over the course of the year, which will put some pressure on those margins. But as I said during the Investor Day and during the last quarter call, we're going to continue to work to accelerate our productivity program to try to offset as much of that as possible.

Arun Nayar

And Jeff, just -- if we look at our full year, even though we're kind of looking at a similar margin for North America as prior year, but if you normalize it and you take the dis-synergies into account, it's 100 basis points, close to 100-basis-point improvement in the North America margins on a year-over-year basis. So that's reflected in this project selectivity that's in place now.

Jeffrey T. Sprague - Vertical Research Partners, LLC

Right. And just switching gears to a completely different topic, the bolt-ons. When you're doing deals this size, are you able to achieve relatively immediate accretion? Obviously, the deals aren't that big, so they don't move the needle so much initially. But are they quickly accretive? And what you have in the pipeline, would you view as relatively quickly accretive?

Arun Nayar

Jeff, basically, when we do the deals, the first year, we have to deal with issues like purchase accounting, which we kind of keep within our guidance numbers. But once you get back into the full year run rate, that's what we said in the past is, well, they are going to be accretive year 2 onwards. And the other thing is we -- we do these transactions where the ROIC is going to be -- we've kind of maintained a minimum ROIC standard than a weighted average cost of capital. So it should be a shareholder-value-enhancing acquisition. Those are the pricing and the financial disciplines we put the transactions through.

George R. Oliver

In the early stages, Jeff, we -- they are a little bit of headwind initially on the margin rates, but we are quickly working the integration plans to be able to get to similar fundamentals as our core businesses. We've been able to demonstrate fairly quickly we can achieve that.

Jeffrey T. Sprague - Vertical Research Partners, LLC

Yes, I would anticipate a little margin headwind. I thought maybe given their small size and small companies, you may not -- the actual net operating profit might be accretive in year 1. But it sounds like it still isn't. It's more of a year 2 thing.

George R. Oliver

Yes, for the most part, we have had some that we've been very successful in integrating quickly and seeing the benefits early, and that's certainly our goal. But we also want to make sure that we stay disciplined to ultimately being positioned to achieve our longer-range plan for the acquisition.

Operator

Our next question is from Scott Davis with Barclays.

Scott R. Davis - Barclays Capital, Research Division

I just want to go back to that selectivity issue and only because, I think, it's really that important to talk through. We don't have a lot of other companies with this type of a headwind and see it pretty rarely. But give us some background here. I mean, this -- are you implying that you have competitors out there that are still being irrational in the marketplace? Is it a function of your cost position in different geographic locations, where you don't have the quite the cost position to be able to bid on certain things and certain areas? I mean, I guess, help us understand why, at this point in time, presumably right in front of -- after a 60-plus month construction recession and in front of presumably, recovery, I mean, why is the market that unattractive, where you have to pass on such a large amount of pieces of business?

George R. Oliver

Yes, so if you -- let me try to summarize here. So when you think about the mix of the business within the new company here, we're 20% Products, about 35% Installation and 45% Service. And in that Installation piece, it's all around the priority of the strategy, making sure that we're now developing -- because we incur a lot of cost upfront developing projects that ultimately are important that we get positioned for the recurring revenue, Scott. And so in the past, and it's also making sure that we have the right aligned incentives within our, not only our sales teams, but across the enterprise to make sure that we're prioritizing the projects within the end markets that ultimately lead to that recurring revenue. Previously, within some of the Commercial Security businesses, we didn't have that alignment. And therefore, we're taking on projects that ultimately did not lead to the recurring revenue. And so as we have refocused the business, it's now making sure that we're prioritizing those projects that ultimately position us now to be able to grow service long term with that recurring revenue. And so it is a short period of time of an adjustment. We went through this within our Fire service businesses 2 years ago. And as we went through that, we repositioned very nicely to be able to capitalize on the nonresidential construction growth and still be positioned as the industry leader to gain our -- gain the share that we've historically been able to get, but with a richer mix of service revenue that tied to those installations. And so what we're doing, and especially now that we start to see a recovery, making sure that as we're developing our capabilities, that we're focused on the right projects that ultimately will lead to that longer-term service revenue on a recurring revenue.

Scott R. Davis - Barclays Capital, Research Division

Sure, okay. That's actually very helpful. I get it, finally. The next question really relates to the buyback and the timing. It sounds like, when -- well, based on Slide 10, that you're expecting a weighted average share count about the same really as 2Q versus 1Q. I mean, why would you not be in there now buying back stock with such a large buyback? And maybe said a slightly different way, given what -- the pressure that your old sister company, ADT, was under, is there any sense of urgency to make sure that you have a more efficient capital structure and kind of keep the critics at bay?

Arun Nayar

Scott, let me take a first crack at it. First of all, our capital strategy, the capital allocation strategy that we laid out still holds very strong in the sense that we are highest -- the highest priority of allocation of our capital is to the organic and inorganic growth, both the organic and inorganic. And we have a -- we are very excited. Like George said in his opening comments, we are very excited about the pipeline of potential acquisitions that we are looking at right now. Having said that, there is -- the acquisitions themselves can be lumpy. And to the extent that we are sitting on cash, we will deploy that cash to buy back shares. Now let me give you an overall view of how the cash allocation looks like from our vantage point today. To begin with, we are looking at about $800 million of cash flow that we expect to generate this year. Of that, about $300 million, just short of $300 million is going to be in the form of our dividends. Then, we have roughly about $300 million, $200 million from last year and $100 million incremental this year, relating to separation activities that we have to deploy. And then we have, potentially, we do not know the timing of this, another $175 million relating to the legacy tax payments. And we do not know exactly when it's going to happen. It could be in 2013, could move into early part of 2014. So if you look at all these cash outflows that are taken -- already accounted for and we expect about $200 million to $300 million of M&A activity, from a cash flow standpoint that doesn't leave you too much for share buybacks. But as I said, the M&A can be lumpy, and to the extent that it gets deferred into 2014, the timing of it gets deferred, we would have the opportunity to conduct share buybacks. And the new authorization gives us the flexibility to do that.

Scott R. Davis - Barclays Capital, Research Division

I totally get it but presumably you're still underlevered by a minimum several hundred million dollars, if not closer to $1 billion, I mean, is that not something to be taken into account?

Arun Nayar

Yes, Scott, again, this is what we have said in the past as well, that for us, we like the A- credit rating that we have. As you know, it's on the lower end of where our peers are. And as we compete for long-term service contracts, it's important for our clients that we maintain that strong investment grade rating. And with that rating, we have very little marginal incremental debt capacity today. Now that will grow. In 2014, as our EBITDA grows, that capacity will grow as well. And we definitely want to have a capital structure, which is in sync with that credit rating that we have targeted.

Operator

Our next question is from Nigel Coe with Morgan Stanley.

Nigel Coe - Morgan Stanley, Research Division

Just wanted to dig into the North American organic growth because, obviously, we have this confusion over the project selectivity. But can you just delineate the organic growth between the North American Security and Fire businesses?

George R. Oliver

So, explain -- what were you trying to get at now, Nigel, the North America Commercial Security?

Nigel Coe - Morgan Stanley, Research Division

Well, yes, if you can just call out what the Fire organic growth was in North America?

Antonella Franzen

Yes, Fire was up a couple -- about 2% or so for -- in the first quarter. And I would say North America was relatively flat. And the reason why North America was relatively flat because this will not be the pattern you see in future quarters is because we had the conversion of year-end backlog. So that's what helps maintain the revenue level on the Security side. And then as Arun had mentioned, order rate in the Fire business is pretty much growing in line, with a little bit of GDP, GDP plus.

Nigel Coe - Morgan Stanley, Research Division

Okay. So I'm just trying to figure out the impacts of this -- the selectivity initiative, because Fire is more aligned with Installation business. It's more of a new-builds exposure than Security is. So I'm wondering if you weren't going through this process, maybe the normalized growth rate of the Security would be, I don't know, 5%, would that be about right?

Antonella Franzen

Well, I would say that the Fire -- I would say both Fire and Security are aligned to both new-build as well as retrofit and upgrade. And I wouldn't really make a big distinguishment between the Fire side and the Security side in regards to that extent. I mean, where clearly you'll see the impact of project selectivity more is going to be on the systems install side of Security as we move forward. I mean, we do expect that, from a Service perspective, we would at least maintain and even grow a little bit on the Service side, and where you see the impact of project selectivity, again, is really on installed on the Security side only.

George R. Oliver

And think about this, Nigel, because there's a lot of work in the Security and Fire space where it's purely installation, right, just contracting. Now at the end of the day, our strategy is to make sure that we're positioned to be able to leverage the technology that we're developing in our product businesses, differentiating solutions that are focused on the key end markets that we see as being most attractive and, ultimately, getting at that recurring revenue. And we incur a lot of cost in developing these projects right upfront within the installation space. And so when we looked at the mix of projects that was in the backlog, it certainly was not in line with the strategy longer term. And that's why back at the Investor Day, you were right in line with what we communicated back then relative to where we were then, how now this is playing out and what we see going forward, especially as we look to now accelerate the service growth that's an output of those project installations.

Nigel Coe - Morgan Stanley, Research Division

Understood. But what I'm trying to figure out is once we get done with this phase of backlog management, to what extent do we spring back in '14? And if the baseline, this normalized baseline is only 1% to 2%, maybe a bit better than you had in 2013, then '14 could be 3% or 4%, 5%. That's what I'm trying to figure out here.

George R. Oliver

Yes, when we went through this process within Fire, it was somewhere around 12, 12, 15 months relative to as we go through the backlog and actually started to build the new backlog with the new focus with how we're driving projects that ultimately drive service. And so it'll be the better part of this year that we're going through that. And what you will see is that by the end of the year, we'll start to see the acceleration of service as an output of the projects that now we're developing.

Antonella Franzen

And then if you look at kind of over the 3-year horizon, maybe to put it in this perspective, I mean, clearly you'll see the decline in North America this year in the 2% to 3% range, as we mentioned, as we laid out, we do expect over the 3-year period for this segment to grow 1% to 2%. So you'll start to see some of that growth in '14 and you'll obviously see more accelerated growth in '15 that will get us to that 1% to 2% CAGR over the 3-year period.

Nigel Coe - Morgan Stanley, Research Division

Okay, great, that's very clear. And then switching gears to Products. And you called out the year-over-year decline in margins there in your 1Q guidance. Obviously, it came in a bit weaker. I'm just wondering here, what drove the big increase in R&D and marketing in 1Q? Is that getting ahead of a new product launch cycle? And what's causing R&D to be quite lumpy, because normally that's quite a stable expense line?

George R. Oliver

Nigel, when you look at -- if you go back over the last few years, on a year-on-year basis, we have been continuously increasing our R&D double digits. And I think you've seen the output of that reinvestment over the last couple of years with consecutive years with double-digit growth, revenue growth. And so this is very much in line with our strategy. As we look at our position, whether it be in Fire protection products, in suppression, whether it be water or chemical; or if you look at our Security products business, in intrusion, access, video; or in our Life Safety business; the position we have in Fire services, or supporting the industrial space or military and civil defense, in every one of those markets, we have a very detailed pipeline of projects that we're investing in and ultimately know what the projection of the revenue growth from those investments will be going forward. And so I shared some of the highlights of the ones that recently we brought to market. But I can tell you that we have a lot of discipline in making sure the investments we're making we're actually beginning to see the revenue uptick as we've seen over the last couple of years.

Arun Nayar

Right, and I think the other thing is, Nigel, that this is not a one-quarter thing. We've embarked on this incremental spend on R&D, higher spend rate and growing it at this double-digit rate that we are seeing over the last couple of years now. So for this year, for instance, we spent an incremental R&D and sales and marketing of about $13 million to $15 million Q1. We expect another $11 million, $12 million in Q2. And it's more like $45 million to $50 million for the full year. So this is something which is an ongoing thing for us. And we are seeing the results in the mid-single-digit organic growth that we're seeing in our Products businesses.

George R. Oliver

And this is part of -- Nigel, this is part of -- as we look to achieve over $100 million net productivity each year, this is part of the reinvestment that we put back to be able to accelerate our organic growth.

Operator

Our next question is from the Julian Mitchell with Crédit Suisse.

Julian Mitchell - Crédit Suisse AG, Research Division

Yes, I guess, firstly, can you just talk a little bit about the phasing of the free cash flow? Obviously, on an adjusted basis, it was, I think, negative $30 million. How quickly do you anticipate that getting back towards a sort of a net income type number over the course of the rest of the year?

Arun Nayar

Julian, yes, we -- this is very typical of our first quarter. Typically, in the first quarter, we do have a negative cash flow, and then it builds up during the course of the year, with the highest cash flow coming in the fourth quarter. So you would see a progressive improvement in the cash flow. And our objective is that for the full year, we should still convert to about 90% of our net income, which is about $800 million or so of cash flow that I was referring to earlier.

Julian Mitchell - Crédit Suisse AG, Research Division

Got it. And then, just secondly, on the orders, I know that they were up 2% x currency. What were they up, excluding acquisitions? So x FX, x M&A, what was the organic order?

Antonella Franzen

Well, we have the orders -- actually, well, as you mentioned, it excludes FX. It actually does include the impact of acquisitions. But I would say acquisitions, really, the biggest impact they had was on the Products side of the business. I don't have the exact number on the organic side, but I think it was a little bit below where our organic was for the quarter. So let's say it was in the lower single digits on the Products side on an organic basis. The other 2 segments, I don't think, were really that impacted by acquisition.

Julian Mitchell - Crédit Suisse AG, Research Division

Got it. And then is there any kind of clarity you can give around sort of price versus volume in that backlog or in the order intake, Arun, going back to your point on selectivity? Is there any kind of overall number you can put on price versus volume in orders or not really?

George R. Oliver

Well, Julian, you have to look at all 3 pieces. So when you look at Products, we're very disciplined with our strategic pricing, especially as it relates to our new product introductions that we bring into the market. And so we're -- we've demonstrated here over the last few years that we continue to get price within our product businesses. When you look at Installation, it's more around making sure that we're disciplined in not only how we price the project, but how we execute on the margin within that project. And then Service, we build that into our contracts. And so we have that escalation built into the contracts that, in line with other escalation, we're getting price automatically with those contracts.

Operator

Our next question is from Steve Juso with JPMC.

Charles Stephen Tusa - JP Morgan Chase & Co, Research Division

So I just wanted to -- I know everybody has asked this question. Maybe I just wanted to get a little more detail. Can we assume that the North American Install business, which I think is 50% of that segment, a little over half of that is Security, just looking back at kind of the old numbers you guys have given us over time?

Arun Nayar

I think, generally speaking, for North America, it's about half-and-half between Fire and Security, if we look at it right now with our project selectivity going on in the Security business.

Charles Stephen Tusa - JP Morgan Chase & Co, Research Division

Okay. So that means Security had -- has been half. So Security is half of it, and that's where most of the project selectivity is. Does that mean Security was down like 40% or something like that, if you look at the install orders down 19%?

Antonella Franzen

No, I mean, I think someone actually asked earlier from an organic growth perspective, in the first quarter, the Fire business was up a couple points and organically, North America Security was actually flat.

Arun Nayar

Yes. But I mean...

Antonella Franzen

Because if we had the benefit -- the orders are not going to necessarily coincide with your revenue line except from backlog.

Charles Stephen Tusa - JP Morgan Chase & Co, Research Division

No, I meant orders. I meant orders. I meant orders, not revenues. Orders.

Antonella Franzen

Yes. So from the order side, really that 19% decline in systems install was predominantly driven by the Security side.

Charles Stephen Tusa - JP Morgan Chase & Co, Research Division

Yes, so Security had to be down dramatically. If Fire was flat, that means Security had to be down 40% or something like that to get to the down 20%, right?

Antonella Franzen

Yes, I mean, Security was down more.

Charles Stephen Tusa - JP Morgan Chase & Co, Research Division

So what, I mean...

George R. Oliver

Just a note on that, that when you compare -- because installation projects are lumpy with how they actually come through orders, they compare on that also. We had a peak in the orders on the compare a year ago on the Security -- within in the Security segment.

Charles Stephen Tusa - JP Morgan Chase & Co, Research Division

So I guess, what were these guys, I mean, what were these guys bidding on? I mean, was this -- when you got in there, were you just like shocked that -- as to the how uneconomic of an approach they were taking? And I guess, just mechanically, maybe a couple of anecdotes because we weren't able to go on a 10-year, your roadshow meeting that I think you talked about this a little bit. But like -- what are some of the anecdotes about what you're actually changing and how uneconomic they were actually approaching? Because that is just a massive decline, comps or not?

George R. Oliver

Well, when it comes down to, Steve, when you look at the install and service businesses, what's most important is making sure that you're applying your resources and cost to projects that ultimately lead to service. And so when you looked at the backlog of projects, although they were large, and there was a lot of installation contracting type work, it ultimately did not lead to the Service pickup, which ultimately, when you look at -- from an economic standpoint, when you take on these projects, it's very important that from a profitability standpoint, you get some of that mix of service. And so what we've done is gone back and refined the strategy, making sure that as we're now proceeding, we're looking at the overall economics and that we're prioritizing our investments or resources into projects that really do position us to be able to accelerate that recurring revenue.

Charles Stephen Tusa - JP Morgan Chase & Co, Research Division

All right, I got you. So this is...

George R. Oliver

Making sure, Steve, it's simple as making sure that now in the operating company that we've put together from Fire and Security, we've got similar incentive now that are aligned to not only growth, but also making sure that we're positioned to execute on our margin growth and making sure that when you look at the parts of the strategy, that when we execute, they're all aligned to ultimately achieve that.

Charles Stephen Tusa - JP Morgan Chase & Co, Research Division

Okay. And then one other question. You mentioned you had -- you had seen some signs. You mentioned EDI [ph]-- you had seen some signs of nonresi picking up a little bit. Maybe just, again, maybe a couple of specific anecdotes as far as customer behavior is concerned. I think there's a lot of debate out there around nonresidential construction. Just curious as to a couple of data points from you guys on that front.

George R. Oliver

The data points we have is that certainly, there's activity. The ABI suggests there's been -- and we also see that over the last 4 or 5 months that there's activity. And that I think for us, we are getting -- I mean, we're seeing some good opportunities in the pipeline that we're working as a result of that activity. So we're in the early stages of really claiming success, but we are starting to see some of that come through the pipeline.

Arun Nayar

Another thing, as we mentioned in our comments as well, Steve, first quarter and 5 quarters for the fire install business to show a positive organic growth. So that's just -- we don't want to make a trend out of this yet. But certainly, there are some green shoots out here that are encouraging.

Operator

Our final question today is from Gautam Khanna with Cowen and Company.

Gautam Khanna - Cowen and Company, LLC, Research Division

Yes, just maybe 2 quick ones. Can you -- you mentioned that the North American install selectivity had a tough comp in the quarter. Could you remind us what the compares were when this began so we can calibrate how these orders are going to look as we move through the year?

George R. Oliver

So what we -- we began to, if you go back last year when we announced the separation a year ago September, we began to integrate the Commercial Security businesses with the Fire protection businesses back a year ago January. And so when we began that process is when we -- as we looked at the integration and really done -- did a deep dive on strategy, really now positioning to leverage our combined capabilities, not only on the technology side, but within our footprints of Installation and Services, is where we began to work that and start to really start to change the strategy with our approach, especially as we think about installation. And so it was during the first -- it would have been the second quarter last year and then third, fourth, and now we're into the first quarter. So it's been about a year.

Antonella Franzen

And Gautam, I wouldn't want necessarily forecast orders because, quite honestly, they're very had to forecast. But clearly, based upon what we've seen so far and what we saw when we deployed the strategy in Fire, you can clearly expect that as we move quarter-by-quarter, throughout fiscal '13, we're clearly going to see that organic decline get steeper each quarter as we progress. And clearly, the elements are going to be -- they are going to continue to have service revenue growth. But you're going to see that decline in install get more of a decline each quarter as we progress through the year.

Gautam Khanna - Cowen and Company, LLC, Research Division

Okay. And then just perhaps, could you just -- because the magnitude of the decline is fairly large, and for explainable reasons, but do you have any data on whether your win rates or anything of that nature declined as well so that -- I mean, are you comfortable that there's absolutely nothing we should infer regarding market share?

George R. Oliver

No, this isn't -- or of being able not be competitive or win rates. This is more around -- this is right in line with the strategy that we defined back during the Investor Day. We're right on track with that in making sure that we've got the right discipline in how we're approaching the projects that become available in the market. And with that, we've been very successful. And I think if you go back and look at the SimplexGrinnell business, our Fire service business in North America, we've been extremely successful in deploying that strategy, which has positioned us to be able to accelerate service growth. And from an installation standpoint, be much more disciplined and predictable in how we execute installation projects.

Arun Nayar

Yes. And Gautam, going back to the earlier comments as well, this is a very fragmented market. And so it's not that we are the losing any jobs, it's just that we are focusing on those projects that have the right margin for us. Now the fact is being a fragmented market, there are other, local players that are -- they don't have the same demands on return on investment and return on capital as we do. So they may be willing to take on jobs at a different margin rate. Our focus is to get the jobs at the right margin for us, and then to turn that into a service contract at the end of the project. So those 2 combined together, we are winning the jobs that we are going after. That's the important thing we have to remember.

George R. Oliver

And if you look at the projection that we had for 3 years, what's important here is although this year we'll be down 2% or 3% in North America, which this is a big part of, we will be positioned to be able to accelerate over the next 2 years to get to a CAGR, a growth CAGR of 4% to 5%. And from an operating margin standpoint, be positioned to continue to improve operationally our margins by 80 or 100 basis points a year.

Antonella Franzen

Operator, that concludes our call.

Operator

Thank you. This does conclude today's conference. Thank you very much for joining. You may disconnect at this time.

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