Tyco International Ltd. F2Q09 (Qtr End 03/27/09) Earnings Call Transcript

Tyco International Ltd. (TYC)

F2Q09 (Qtr End 03/27/09) Earnings Call

April 30, 2009 8:30 ET

Executives

Ed Arditte - SVP, Strategy, and Investor Relations

Ed Breen - Chairman and CEO

Chris Coughlin - CFO

Analysts

Jeff Sprague - Citigroup

John Inch - Merrill Lynch

Scott Davis - Morgan Stanley

Nigel Coe - Deutsche Bank

Steve Tusa - JPMorgan

Shannon O'Callaghan - Barclays Capital

Steve Winuker - Sanford Berstein

Presentation

Operator

Welcome to the Tyco International second quarter Earnings Call. (Operator Instructions)

Now, I would like to turn the call over to Mr. Ed Arditte, Senior Vice President, Strategy and Investor Relations. Sir, you may begin.

Ed Arditte

Thank you. Good morning, and thanks for joining our conference call to discuss Tyco's second quarter results for fiscal year 2009 and the press release issued earlier this morning. With me on today's call are Tyco's Chairman and Chief Executive Officer, Ed Breen, and our Chief Financial Officer, Chris Coughlin.

Let me remind you that during the course of the call we will be providing certain forward-looking information. We ask you to 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 in our discussions and we ask you to 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 the conference call slides, can be found on the Investor Relations portion of our website at tyco.com.

Now, let me quickly recap our earnings this quarter. Revenue in second quarter was $4.2 billion compared to $4.9 billion last year and we had organic revenue decline of 5.5%. The 35% organic revenue decline in Electrical and Metal Products cost us 3.5 percentage points of organic revenue growth, while our other businesses comprised the remaining 2% of organic revenue decline.

From an EPS perspective, we had a $5.40 loss per share from continuing operations, primarily due to non-cash goodwill and intangible asset impairment charges of $2.6 billion after-tax, however, diluted earnings per share from continuing operations before special items was $0.55 and this compared to our guidance of $0.40 to $0.43.

Compared to the Street consensus of $0.41, our operations were better by $0.03, with the remaining difference attributable to lower corporate expense and a much lower tax rate, which Chris will address in a few minutes.

Now, with that, let me turn the call over to Ed Breen for some opening comments.

Ed Breen

Thanks, Ed. Good morning, everyone. Overall, we are pleased with our second quarter performance and we continue to make progress operationally in dealing with this challenging economic environment. Our results exceeded our expectations in Flow Control, corporate expense and our tax rate, and we delivered strong cash flow in the quarter.

Additionally, we met our expectations in almost every other area. Although our operating margin, excluding special items, declined 150 basis points year-over-year, the operating loss in Electrical and Metal Products cost us 2 full margin points, with the rest of Tyco's operations contributing 50 basis points of improvement to the overall operating margin.

Let me touch on a few items that are important areas of operational focus in the current environment and then I'll comment briefly on each of the businesses. Chris will then provide a more detailed review of our operating performance in the quarter.

First, we are actively managing our asset base and working capital is an important part of this focus. On a year-to-date basis, we have decreased our primary working capital by $117 million, which is a meaningful decline, given our typical seasonal second quarter growth in working capital. More importantly, our working capital days have remained relatively flat on a year-over-year basis despite the significant volume declines.

We are actively managing our inventory levels, which declined in the quarter, and we are pleased with our collection activity, and the quality of our accounts receivable, which remain solid.

Our working capital management was a contributor to the strong cash flow generation in the quarter. Free cash flow in the quarter was $454 million and included $50 million of cash payments for special items, primarily restructuring. Among other things, the strength of our cash flow allows us to continue to fully fund our growth initiatives and we remain committed to doing this despite the economic downturn.

Our capital expenditures, including ADT dealer account investments are at a similar level to last year, as is our R&D investments. These are important long-term investments for us and the strength of our cash flow, combined with our strong balance sheet, provides us with the flexibility to comfortably maintain our investments for the future.

Our operating teams are particularly focused on cost reduction initiatives. We made very good progress on the cost side during the quarter and we continue to pursue additional cost reduction opportunities. Cost containment initiatives recently implemented, including salary, and hiring freezes, and workforce reductions, and furloughs, have contributed to the cost reductions.

Additionally, we continue to remain very active in our sourcing and Six Sigma programs and have challenged our teams to target additional opportunities in order to further improve our cost position.

During the quarter we accelerated restructuring actions and incurred restructuring and asset impairment charges of $108 million primarily in our ADT and Safety Products businesses. These actions include headcount reductions and the consolidation of some high cost manufacturing facilities into a new low cost facility.

We continue to aggressively look at structural opportunities to reduce cost and we now expect total restructuring charges for the full year to approximate $200 million. Overall, I think we've responded quickly to the challenging environment and I'm pleased with our team's operational response to our cost structure and management of working capital.

Now, let me give you a quick overview of what we are seeing in each of our businesses. Starting with ADT, recurring revenue continued to grow on an organic basis, with growth in all regions of the world. This marked the 12th consecutive quarter of growth in our recurring revenue.

The strength of our recurring revenue base was more than offset by softness in our systems installation revenue as our commercial end markets continue to be impacted by the global economic downturn. On a positive note, order rates in our commercial business remained relatively flat on a quarter-sequential basis. Additionally, our cost reduction initiatives and restructuring actions have allowed us to maintain our operating margin, despite the revenue decline.

Turning to Flow Control, we had good topline revenue growth despite the tough compare from our water business and the operating performance was solid. Revenue growth and product mix helped our operating margin, but our performance also benefited from cost containment efforts.

In our Fire business, service revenue represents almost half of our total revenue and continues to be fairly resilient, growing 1% organically in the quarter. A good portion of this service revenue is tied to mandated fire code inspections and preventive maintenance agreements, which is more consistent and predictable On the other hand the systems installation portion of our Fire business experienced the softening in order rates and an organic revenue decline during the quarter. Overall, our operating performance and margin was similar to last year.

Safety Products performed as expected from a topline point of view, but the operating margin was a bit weaker than we expected. Order rates continued to soften in the quarter and end market demand continued to be impacted by the global economic slowdown. As such, we continue to actively work the cost structure in this segment and accelerated our restructuring actions during the quarter.

And finally, Electrical and Metal Products performed slightly weaker than expected due to lower volume and tighter spreads. Chris will give you more details on this, as well as the implications this will have for our third quarter outlook.

With that, let me turn the call over to Chris.

Chris Coughlin

Thanks, Ed. Good morning, everybody. Before I get into the details of our business segment performance, I'd like to give you an overall perspective of our financial performance in the quarter. As we indicated back in November, when we first discussed 2009, we expected our results to be impacted by two major items, specifically, Electrical and Metal Products and foreign exchange. These two items cost us $0.25 per share of income in the second quarter.

First, the rapid decline in volume and tighter metal spreads in our Electrical and Metal Products business resulted in a $101 million decline in operating income, which was an earnings headwind of $0.16 per share. The second major item is was strength of the US dollar, which cost us $0.09 of earnings per share when compared to last year.

Offsetting these two items, we had good revenue growth in a number of areas, such as our ADT recurring revenue base, the service portion of our Fire business and in Flow Control. When combined with cost reduction activities, which we have initiated across all of our business units and in corporate, as well as benefits from our tax planning activities, earnings per share in the quarter exceeded our expectations.

Looking at our companywide performance from a regional perspective, revenue in North America declined 11% organically, with more than half of the decline due to Electrical and Metal Products. Growth in ADT residential and the Flow Control valves business was more than offset by weakness in the commercial markets in North America.

Revenue in Europe, Middle East and Africa region declined 2% organically due to continued softness in ADT in both the UK and continental Europe, and partially offset the growth in Flow Control. Growth in Asia and Latin America slowed a bit to mid-single digit organic revenue growth rates. And finally, our operations in emerging markets, which represent 14% of our total revenue, grew 15% organically in the quarter.

Now, for our operating results by business, let me start with ADT. Overall, ADT revenue was $1.7 billion in the quarter, with an organic revenue decline of 3%. Recurring revenue, which represented 55% of ADT's total revenue in the quarter, grew 4% organically with growth in all geographic regions. This growth was more than offset by an 11% organic revenues decline in systems installation and service, which continued to be impacted by the weakness in commercial markets.

The operating margin before special items of 13% met our expectations due to our cost reduction efforts. During the quarter, we incurred $43 million of restructuring charges on a worldwide basis as we continue to right size our commercial business for weaker demand.

Let me now walk you through our performance from a regional perspective. First, our US residential business continues to perform well. Recurring revenue, which represents more than 85% of our residential business, grew 5% in the quarter and our operating margin before special items was above 20%.Our account base grew 2% and our average revenue per user grew 3% on a year-over-year basis. Additionally, we saw a slight improvement in our US residential attrition rate, which declined 10 basis points to 13.6%.

Turning next to our US commercial business, about 40% of our commercial revenue is recurring in nature, with the remaining 60% being systems installation and service. Similar to the last few quarters, the systems installation and service revenue portion of our commercial business has been impacted by the slowdown in the retail market, as well as softness in other commercial markets, as spending levels and capital budgets continued to be tightened.

Overall, organic revenue in the commercial business declined 12% in the quarter. In response to revenue pressure, we are seeing in this part of our North American business, cost reduction is a major area of focus. We have accelerated restructuring actions aimed at reducing installation capacity during the quarter. We incurred restructuring charges of $10 million.

Moving on to Europe, Middle East and Africa, we continued to see our recurring revenue base grow modestly on an organic basis. However, this was more than offset by a 10% organic revenue decline in systems installation and service revenue, where we saw continued softness in our commercial markets throughout the region.

Overall, revenue in Europe, Middle East and Africa declined 6% organically, and our margin in the quarter was about 4%, excluding special items. During the quarter we initiated restructuring actions of $30 million.

As expected, in other regions around the world, including emerging markets, growth has begun to moderate with 5.5% organic revenue growth in the quarter. We also maintained our margins in the low teens.

Turning to some of our key metrics, our worldwide account base grew 2% year-over-year to 7.3 million accounts. In addition to our growing account base in all regions, our average revenue per user of $44.07 also increased 2% year-over-year, excluding the impact of foreign currency.

Our worldwide attrition rate increased 40 basis points in the quarter to 13.6% and the increase was driven primarily by our US commercial business.

Turning to Flow Control, we had a good revenue quarter, with strong margin performance. Revenue was $927 million and grew 5% organically, with organic revenue growth of 14% in the valves business, partially offset by a 9% organic revenue decline in water and a 1% organic revenue decline in thermal controls.

Operating income before special items was $141 million and the operating margin before special items improved to 120 basis points year-over-year to 15.2%. Contributing to the operating margin improvement was favorable product mix and cost reduction activities, which more than offset the $25 million currency headwind.

As we expected, order activity slowed in the quarter and was down 23% year-over-year and 19% sequentially, excluding currency. Over the last four months, through April, we have seen our weekly order volume stabilize at this lower level. In addition, we have seen minimal cancellation activity at this point, but we continue to see projects stretching out over longer periods of time. We have seen larger, well financed customers remain relatively on track with their project spending, with some stress on smaller customers and projects.

Now turning to our Fire business, revenue in the quarter was $817 million and organic revenue declined 2%. As Ed mentioned, service revenue represents about half of Fire's total revenue and continued to be fairly resilient, with 1% organic revenue growth in the quarter. The remaining revenue, which is our systems installation activity, declined 5% organically.

Operating income before special items was $69 million and the operating margin before special items was 8.4%. We are focused on cost reduction activities globally given the lower installation volume. On a worldwide basis, the backlog of $1.2 billion decreased 2% sequentially.

Next, Safety Products; revenue up $382 million, resulting in an organic revenue decline of 9%, which is about what we had expected. Weaker end markets and lower distributor inventory levels drove the volume declines in Fire suppression, which declined 10% organically and electronic security, which declined 9%.

Weaker municipal funding was the primary contributor of lower revenue, with our life safety business which declined 8%. The operating margin before special items of 12.8% was a bit weaker than expected, primarily due to product mix and under-absorption in our manufacturing facilities due to the decreased volume levels. Despite the weaker environment, we maintained our sales and marketing and R&D investment spending in the quarter. We also accelerated our restructuring and incurred $37 million of charges.

Now, I'll turn to Electrical and Metal Products, where the economy had the most significant impact on our results. Revenue was $330 million and the organic revenue decline of 35% was due to lower volume levels. We continued to see historically low volume, with steel volume declining almost 50% year-over-year and copper volume declining over 10%. The lower volume reflects continued weak demand in end markets and lower distributor inventory levels.

The volume decline and tighter spreads due to slower liquidation of the higher priced inventory resulted in a modestly larger operating loss before special items in comparison to our previous guidance, $26 million versus our guidance of $15 million. Despite the operating loss this business generated strong cash flow in the quarter, as we continue to reduce and tightly manage our inventory levels.

Based on our current volume outlook and the pricing level in our core markets, we anticipate revenue of $350 million in the third quarter, with an operating loss of $20 million. This is clearly in sharp contrast with the $146 million we earned in last year's third quarter.

As you all know, forecasting our results in this business is a challenge in any environment, let alone the current environment, but based on our year-to-date results and our guidance for the third quarter, we are now expecting our full year results in Electrical and Metal Products to approximate breakeven.

Before I turn the call back over to Ed, let me touch on a few other important items.

Based on the significant downturn in the global economy, we performed an assessment of the fair value of our goodwill and intangible assets to their carrying value. This assessment resulted in a non-cash goodwill and intangible asset impairment charge of $2.6 billion after-tax in the quarter.

Additionally, during the quarter we resolved a number of legacy legal matters. As a result, we recorded a net pre-tax charge of $101 million related to these items and to cover the remaining open legacy legal matters. These charges were recorded in corporate expense and are treated as special items.

Next, our corporate expense, excluding special items, was $96 million in the second quarter compared to our guidance of $125 million. This significant reduction was a result of our cost containment initiatives, as well as the quarterly timing of certain expense items. It is important to note that we tend to have a pick up in corporate expense in the second half of the year.

With that said, given our lower spend through the first half of the year we expect our full year corporate expense to be approximately $450 million.

Turning now to tax; excluding special items, our tax rate for the quarter was 12.1%, reflecting the positive impact of our tax planning activities and a change in the geographic location of our taxable income. For the full year, we now expect our tax rate to be in the 16% to 18% range.

Now let me turn it back over to Ed Breen to wrap up this morning's call.

Ed Breen

Thanks, Chris. Let me wrap up with a few comments on what we are seeing in our end markets and an update on our guidance for the third quarter and full year. As you've seen in our results over the past two quarters, our recurring revenue and service businesses have held up quite well in this environment.

For Tyco, overall, we expect our service businesses to generate approximately $7 billion of revenue in 2009 and represent approximately 40% of Tyco's full year revenue. Importantly, these portions of our business are expected to grow modestly year-over-year and generate good margins.

The strength and predictability of this revenue provides a very solid base and clearly helps cushion the softness that we are seeing in some of the product businesses like Electrical and Metal and safety products.

In looking at Flow Control and Fire, both our backlog oriented businesses that have held up quite well given the size and strength of our backlog. Our order activity is lower and we would expect our backlog to continue to decline over the balance of the year as our shipments exceed our bookings.

Our orders of Flow Control in the quarter declined 23% year-over-year and our orders in systems installation portion of Fire, which is about half of Fire's total business, declined approximately 15%. As Chris mentioned, we've seen some signs of stabilization at these lower order levels, but I think it's too early to indicate whether or not we've reached the bottom.

In ADT, our commercial orders are down 19% year-over-year in North America, and 15% in the UK, but both markets were essentially flat on a quarter-sequential basis, excluding currency. Again, it's too early to say that things have stabilized but the sequential order activity is somewhat encouraging. In addition, our order activity in ADT Asia grew 8% year-over-year and saw double digit order growth sequentially.

Now let's turn to our outlook.

Since our last conference call, we have seen two major shifts in our outlook for the second half of the year.

First, our Electrical and Metal Products business has experienced a significant decline in volume and metal spreads remain at low levels. As Chris mentioned, we are expecting our operating loss in the third quarter of $20 million and our full year outlook is for approximately breakeven results. This compares to the $110 million of operating income for the full year that we guided to last quarter and the change equates to approximately $0.18 per share.

Secondly, the progress we have made on the tax front has reduced our full year tax rate outlook, which provides us with a second half of the year tailwind of approximately $0.07 per share. The combination of these two items results in a net second half headwind of $0.11 per share. With that as a back drop, let me now turn to guidance for the third quarter and full year.

For the third quarter, we expect revenue of $4.2 billion to $4.3 billion, with a $525 million foreign currency headwind, which would equate to an organic revenue decline of 9% to 10%. It's important to note that Electrical and Metal Products will account for approximately 5 percentage points of this decline, with our other operations declining 4% to 5%.

We expect our operating businesses to have third quarter revenue and operating income that looks quite similar to the second quarter, but we do expect our corporate expenses to increase to the $125 million level. When this is combined with our estimated tax rate in the 16% to 18% range, our EPS from continuing operations before special items is expected to be in the range of $0.43 to $0.45 per share.

For the full year, we now expect our EPS from continuing operations before special items to be in the range of $2.15 to $2.25 per share. Effectively, we have simply lowered the low end of our guidance primarily for that $0.11 headwind and adjusted the high end of our guidance downward for this headwind and to reflect a more tempered view of the economy for the second half of the year.

Thanks for joining us on the conference call, and with that, operator, would you please open up the lines for any questions.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Jeff Sprague of Citigroup.

Jeff Sprague - Citigroup

I wonder if we could drill a little bit further into ADT to begin with, not to make too much of a 10 basis point improvement in the attrition rate, but do you actually see something behind that, is there a change in marketing plans or reconnection activity or something that you would point to that's driving that?

Chris Coughlin

Jeff, I wouldn't say I would point to anything. Obviously, we have continued our marketing efforts and we've continued to invest in that business as it's grown. I think the biggest single factor is we've seen a continual reduction in relocations, which again is always the largest portion of the disconnect. So, as the economy has hit the housing market, that has been on the positive side. We have seen a little uptick, as we've seen throughout this period, in slow payments, but essentially, I think that it's the relocations coupled with the strong growth that we have continued on new accounts.

Jeff Sprague - Citigroup

And I think that ARPU number you gave us is the blended fleet average. Can you give us a sense of what ARPU looks like on new accounts coming in?

Chris Coughlin

The new accounts, again, are the real driver for that increase in ARPU, as we've not been increasing recently the price on the base.

Jeff Sprague - Citigroup

And could you give us some sense of the embedded cost savings from the restructuring actions that you expect to achieve in '09 and the carryover impact that you'd have in 2010?

Chris Coughlin

Yes, I think, Jeff, from our restructuring, some of which we initiated last year, where we'll have carryover benefit into this year, and then the additional programs that we are putting into place and really started in an aggressive way in the second quarter, but obviously, these will take some time. We're in the $60 million to $70 million range of savings this year and I would say about $150 million in 2010.

Jeff Sprague - Citigroup

Then just finally, Ed Breen, just on the capital allocation standpoint, it appears you guys are still in kind of hunker down mode, letting the cash pile up. You addressed spending on R&D and CapEx, but what should we expect to play out over maybe the next six to 12 months?

Ed Breen

I would say for at least the next quarter or two. We're going to play it very conservatively. I think you know we're advocates 0of not sitting on too much cash and would look at share repurchase, and as you know, we have an open program, authorized program. Still $900 million left on that. So I would think at some point, we're going to take a look at that again, but until the clouds dissipate a little bit more, we're going to play conservatively and keep a very strong balance sheet.

Operator

Our next question comes from Mr. John Inch of Merrill Lynch.

John Inch - Merrill Lynch

Good morning, guys. What was pure restructuring in the quarter, I think you had originally guided to restructuring of $100 million to $150 million, so it's like now you're saying $200 million right?

Ed Breen

Yes, that's right, John. We've upped it with the actions we took this quarter and just so I think we ended up with about $103 million in restructuring charges in the quarter, which was much more quite frankly than we planned going into the quarter. And so, we've upped the total year to about $200 million from I think about $150 million we thought when we talked to you at the last quarter.

Let me just stress, we are continuing to look for other opportunities. I think it's going to end around $200 million this year, but we're going to keep looking and see if we have any structural moves we can take to lower our breakeven point.

John Inch - Merrill Lynch

If you take the mid point of what you had before, it's now like $75 million more, that's sort of the $0.12 to $0.15 drag, why wasn't that in your guide walk or is that just embedded in the ops or what, or are you getting net savings offsetting? How should we think about that?

Chris Coughlin

We certainly are getting savings and we'll get savings, but as we've seen the decline in certain of our commercial businesses, we have just aggressively ramped up looking at how we can reduce our fixed cost base over the next year in anticipation of continued weak demand. So as we saw things move since the last time we gave guidance, we had indicated we were going to be as aggressive as we could be in these cost reduction activities and that's really what you're seeing now.

So again, we've moved aggressively, as you've seen on our Safety Products business, for example, where we saw a much more significant drop in the second quarter in our orders and in our revenue. We have taken actions to move more into some low cost manufacturing facilities on a quicker basis than we would have anticipated before.

Ed Arditte

John, as a general rule of thumb, you should be thinking in terms of the savings that we would generate from the restructuring to be about half of the amount of the charges, but the timing of when this gets done and when the savings start to show up in our numbers is really perhaps the more important point as Chris mentioned in his comments.

Some of the savings from what we're doing this year will show up this year. Most of the savings we generate this year is carryover from actions we took in the previous year, and then from most of the activity that we have this year, the savings will show up next year.

Chris Coughlin

Which is the $150 million or so we think we'll have in savings next year in fiscal 2010.

John Inch - Merrill Lynch

That makes sense, but still, I go back to the point that, you're incurring another $0.12 to $0.15 of charges, so that's going to affect the $228 million to the $250 million down to the $215 million to $225 million is it not?

Ed Breen

No it's not, because it's out of our guidance. The restructuring as you know is treated as a special item.

John Inch - Merrill Lynch

Okay. So this is excluded from the guidance. I got it and no net new benefit from that in there, or is there?

Chris Coughlin

Very little. You'll get most of it in 2010.

John Inch - Merrill Lynch

How did the retailer business of ADT do? I apologize if you mentioned it already, and what's the outlook?

Chris Coughlin

The retail business, as we mentioned in our comments continue to be weak. That really was the first business that we saw in 2008 that's been impacted by this and started in North America and we've seen that slowdown really on a global basis. So we've seen some signs of stabilization. As Ed has mentioned, it's too early to say whether this is the bottom, but that has remained weak.

Ed Breen

There's nothing on the horizon that would cause us to think there's an upturn in that market. Clearly, there's stress amongst most of the major retailers and so we're not anticipating and we're not running the business in anticipation of any type of an uptick in retailer.

John Inch - Merrill Lynch

Right, but how much was it down and did it get a lot worse?

Ed Breen

The orders were down in the high teens like 18% to 19%, John, in the retailer vertical.

John Inch - Merrill Lynch

Just one final one from me. There's this perception that you're very late cycle and I think a lot of that really ties, excluding Flow Control, to just your tie into non-resi construction. Where is the inflection point? I mean you're seeing a little bit of signs of stability. But do we get past a certain point in the year, given sort of the declines of new construction, where you say, we're feeling good about the run rate because we've anniversaried a lot of that new construction impact and now it's just kind of more of a keep steady as she goes type of dynamic?

Ed Breen

John, again, I don't want to overstate it, and as I mentioned in my remarks earlier, I think it's too early to indicate that we've seen the bottom, but I will say again, almost in all of our business across-the-board during the quarter and into April, we did not see further decline. We kind of saw order rates moving sideways in our non-recurring businesses, our recurring as you know are still holding up nicely, so it seems like we're at least bobbling along at that lower level in the businesses.

I would also point out, I think we've seen a lot of the stress already in whatever you think our cycle is, I think we've already seen it pretty significantly in the commercial side of our business and I would suspect that's why we're near a bottom and kind of hanging there. When you kind of break it into its pieces, let me just give you a couple things I think are important on this.

Remember that in ADT, two-thirds of our revenue is either recurring or service that's pretty predictable, so you've got another third that I would put more into truly installation business, and in our Fire business, you've got half the business which is recurring because of service, the other half which is more installation.

When you kind of peel that back a little bit more, and you look at well what's new construction, because I think what's most affected here is new non-resi construction. You'll find that between ADT and Fire, about 20% to 30% of the business, which is the systems installation side, is tied to new construction, and the rest is not new construction. So I think that's important to peel back a little bit.

ADT is a little higher. About 25% of systems installation is new construction and on the Fire side it's about 20%. Then when you take those pieces of it and you peel it back, we've seen our commercial orders, including retail, down about 18%, 19% in the quarter, although again, this one also did flatten out through the quarter and into April. So I think you're seeing a big drag from that already. I don't suspect it gets too much worse, but I don't want to call that yet.

John Inch - Merrill Lynch

Ed, the 25% of the third that's installation on ADT and the 20% of the half its installation on Fire, how much is the new piece down?

Ed Breen

New piece is probably down another 10 percentage points closer towards the 30% range. And John, it's a very important point, because what you're seeing is other verticals, it's not necessarily new, but it's a lot of mandated and maintenance. For instance, our hospital vertical, we do a lot of public buildings, education is a big vertical for us. Those verticals are holding up much, much better even on the new construction side, but we do a lot more work there, routine work that's holding up better that's not related to new construction.

John Inch - Merrill Lynch

So in other words the stuff that's going to be swinging the most, you're probably already seeing on the new side numbers that are down commensurate with the steep declines in non-resi construction?

Ed Breen

That's my take. When you look at the non-resi construction numbers and you kind of equate it back to verticals, and then you got to look at it by verticals, because there are some verticals that are down 60% like warehouses. So you've got to go to the right verticals, and then when you do that, peel it down to new construction versus upgrade maintenance work, and that's how you get to the numbers I was talking to.

Operator

Our next question comes from Mr. Scott Davis from Morgan Stanley.

Scott Davis - Morgan Stanley

I think a lot of my questions are answered, but if we can talk about a couple things, first the tax rate, the 16% to 18% is pretty amazing actually. How do you view that? What happens over the longer term? Is this sustainable through kind of 2010? Does it gradually rise over time, or is this something that's more sustainable?

Chris Coughlin

I'll tell you, I am really proud of our team in both tax and our operating units that have worked really closely together since the separation. If you think our tax rate at that time of separation was just over 30%, last year we were down to 25%, and as you've heard now, the mid-point of our range would be about 17%.

There's a lot of variables here, including what might happen with governments and what they do to tax rates about sort of the future 2010, but I will say that you think about it, about two to three points of our tax rate this year is actually the impact of lower earnings in high tax rate countries like the United States.

So you think about Electrical and Metal Products, as an example, we made over $380 million in operating earnings last year, the vast majority of that here in the US, and we just expect to breakeven this year. So two to three points of that tax rate decline is really geographic location and moving more of our revenue is being generated in lower tax rate jurisdictions.

So again, if the US income increases dramatically in the next year, then that could put some pressure to move that tax rate back up a little bit, but essentially, the base that we've seen in tax reductions should stay with us going forward, so it's more in the 20% range.

Scott Davis - Morgan Stanley

On our model, a big chunk of the beat in this quarter was on flow, which I think is a business that's concerned a lot of folks, just given the very late cycle nature of it. When the margin beat and just to focus on that, how much of that was something like mix or price versus your material cost that dropped? I mean that's the first part of your question, and then clearly the obvious second is just, your backlog is down 9%, and how does and what is the timing of when that starts to flow through revenues more aggressively?

Ed Breen

Yes, Scott, look. The two things on the margin side to answer that first, we had good mix in the quarter with valves being up a little bit more just so very good organic growth up around the 14% on the valve side, so mix helped us from a margin perspective. I would also point out, I'd say probably about half of that kind of improvement we saw was mix, the other half of it was really the cost actions that we took during the last four months or so and we'll continue to take in that business.

So actually, that to me was the better sign, because that lowers the breakeven of the business permanently and we'll continue to look at those types of opportunities. I would point out and again, I want to say that this is for sure yet, but one of the things during the quarter we did see, and again this played out through April is, we did see a reduction, as we mentioned, in order rates in flow. However, they kind of moved along the bottom and did not continue to decline as we went through the quarter and into April, so kind of moving along there and hopefully that's a good indicator, but again we'll see.

Look, we still have a very large backlog in the business, by the number you can see a third of our business in the year was kind of sitting in backlog, as we speak, and our backlog plays out over a nine, 10-month period, something like that. So you can extrapolate and look the key is, what do we see in the next quarter or quarter or two in orders in the business.

As Chris mentioned earlier, I will say we've talked to a lot of customers in this end-market and where we've seen the softness is really, I don't mean to call them small, but smaller companies that needed funding to do some of these projects. And the bigger customers, and you know who those types of players are; most of them are continuing with their CapEx budget where they thought they were going to spend and are holding on their major projects and that's what's holding up well for us. So again, let's see how the next quarter or so goes.

Scott Davis - Morgan Stanley

Okay. Then just lastly, on the goodwill impairments, I know you guys test probably quarterly a lot of people, when you see charges like this they end up at the end of the year, this is kind of a strange mid-year charge, but was the catalyst purely just a macro decline? It kind of seems like a strange reason to take a goodwill impairment just given the cycle.

Ed Breen

Yes Scott, let me comment on that, because clearly, under the accounting rules, at the end of generally your fourth quarter you do a very detailed analysis of your goodwill and intangibles. However, with the macroeconomic environment and the fact that our year-end was in September, things really started to get nasty in the calendar fourth quarter and then going into the first half. Where the equity markets are, the equity values of companies, you do have the obligation obviously to look at it and monitor it each quarter, which we've done.

We have disclosed in the last couple of quarters that, when we looked at it in a number of cases that we were sort of close to the line, we have about $14 billion of carrying value of goodwill and intangibles. So again, with the continue decline in the global economic environment, coupled with this corresponding drop in the equity markets, we really decided this was a time to take a hard look at it.

You look at businesses that are likely to have decline and we talked about earlier in the retail business as well as our Electrical and Metal Products businesses, they were the big contributors to the write-down. Having said all that, I will point out that these impairments are strictly due to the economic environment and they are not due to a loss of market share or other business unit specific items, and as the economic picture brightens we would expect these businesses to recover nicely.

There's also some strange accounting here that once you trip even by a very small amount of the test, you essentially then have to write-down almost all the goodwill, so that's just the accounting. And again, this goodwill goes back to many years ago in late 90s, early 2000s and the goodwill accounting was different, that also impacts the size of the write-down.

Operator

Our next question comes from Mr. Nigel Coe of Deutsche Bank.

Nigel Coe - Deutsche Bank

Anything to talk about in terms of competitive behavior, anything unusual there, one of your big competitors in the commercial security space is talking about some market share opportunities. So are you seeing anything unusual in that regard?

Chris Coughlin

Well, Nigel, I'd mention a couple we've been talking to our team about pretty consistently. Look, in most of our spaces here, at least in our three global businesses, we have a few large competitors and then kind of 70% of who we compete against, either in security and fire or flow, a lot of very small and some small but regional players in the market, and by the way I wouldn't just say us, I won't mention other names but I think there is a few of us that can gain some share in this environment.

I would really say especially in our tougher part of the market right now, the systems installation portion, we're talking to a fair amount of customers and they want to do business with someone that's going to be there tomorrow. They are very worried about some of the smaller players and they kind of (inaudible) them out and we're not, so we're really pushing in those areas kind of in this commercial install side to pick up a little bit of share.

I would also point out, I think this goes to the competitive environment. We are not seeing a lot of pricing pressure in the business. I think there's some, but generally speaking, like in our flow control company and all, when we look at the backlog we book during the quarter, there's a couple isolated spots, but by and large we're holding good margin in the backlog, so that's a pretty good indicator also.

Ed Breen

I would also add, Nigel, on the residential side that again we're seeing that small installers having trouble as their cash flow may be squeezed and there are fewer large competitors in that business, so again, we're continuing to aggressively market and grow that business.

Nigel Coe - Deutsche Bank

Okay, that makes sense. You answered a question on share buybacks already, but you've got $1.4 billion of cash right now, current run rate you've got over $3 billion by the end of the year, obviously, a good thing in this environment, but how much cash is too much?

Ed Breen

Well, it's more timing, Nigel. Look, we're in very good spot, so I hear what you're saying. I want to see another quarter or so that the wheel doesn't fall off the economy here, and I think you know we lean towards spending the money, so it won't be long before we look at doing something. We don't plan on sitting on it for some extended period of time.

Chris Coughlin

And again we just want do see a continued stabilization of the debt markets as well before we move aggressively.

Nigel Coe - Deutsche Bank

It makes sense. Then just a final one from or me; in terms of 2010, not looking for any guidance or anything, I just want to confirm with you, unless steel process halve from here, E&M looks like it's going to be a tailwind next year, would you agree with that?

Ed Breen

I would sure hope so.

Chris Coughlin

Yes. We would think so.

Nigel Coe - Deutsche Bank

Okay. And then pension is not a big issue for next year?

Chris Coughlin

As you know with the market conditions being what they've been since the beginning of the year, it's had a negative impact on everybody's pension assets. Most of our US plans are closed. So really it's going to depend on where the equity markets are at the end of September, because that's when we have to do our analysis of what our expense is going to be for next year, as well as the discount rate, those are the key drivers. If the markets stayed where they were today, it would be a very modest headwind of a few cents a share, probably $0.03 to $0.05 range.

Chris Coughlin

Nigel, I'd also point out and I'm not going to get into detail of 2010, but look, there will be some tailwinds and some headwinds, but remember you do have a tailwind of $150 million on restructuring which a lot of that obviously will drop to the bottom line. It would be hard to imagine Electrical and Metal wouldn't have a better year than 2009 and that somewhat is the cycle of the business.

Back to a point a few minutes ago, on the Flow control area, we might see some softening there, but we do get out of a tough compare on water and we actually think water could pick up a little bit in the Pacific region as we've talked about before. So there will be some gives and takes as we go into next year.

Operator

Our next question comes from Mr. Steve Tusa of JPMorgan.

Steve Tusa - JPMorgan

Just a question on Flow Control, a little bit of follow-up to Scott's question; so is there some point here where you're going to expect to see negative comps heading in through the end of this year and into 2010? I guess you do have a pretty decent amount of backlog so you can withstand some order weakness near term, but if you say orders are bottoming here, aren't there some tough comps coming up? So maybe you could just talk about the dynamics through this cycle at Flow Control and how bad or how stable you expect it to be?

Ed Breen

Well, Steve, I think we ought to watch order rates obviously over the next month here, but I would think the comps start getting a little tougher in the fourth quarter and going into the beginning of next year if order rates don't pick up, if we keep bouncing along the bottom. But again, we still have good backlog, the comps won't get ugly, but they certainly will get worse, again, if order rates stay down at this level.

A point I made a minute ago, we might and I say might, get a decent comp coming on a third of the business, which is the order business, which we've been in a trough this year as we've talked about. So we'll get some offset there, but growth rate in the fourth quarter could be marginally positive, single-digit, low-single digit something like that if we see orders stay at these levels.

Steve Tusa - JPMorgan

Okay. So you could basically go through this cycle without seeing negative revenue comps?

Ed Breen

If it stayed down, we would probably go negative some into next year again, pending what happens on the water side.

Steve Tusa - JPMorgan

Right, and then on the profitability there, you said you've taken some cost out, how do we think about trough levels of profitability assuming a normal cycle here?

Chris Coughlin

Again we're working hard on the cost side. We'll have to see how orders go. It does take a little bit of time in that business to hire fixed cost business and manufacturing to get the cost out, but we've done a good job in maintaining our margins. Again, we're maintaining our pricing so we would be holding margins here this year.

Steve Tusa - JPMorgan

Just one last question. You guys have done a great job in the last quarter. I think the quarter before you gave segment dynamics for at least the forward quarter. You gave us Electrical and Metal can you maybe talk about ADT flow and the other two businesses? Just I guess from a margin perspective for the next third quarter how you would expect it, either year-over-year or relative to the second quarter?

Ed Breen

Yes. Steve, let me just touch that briefly. We did say in our remarks that we expect the revenue and the operating income from the operations other than Electrical and Metal Products in the third quarter to approximate the levels that we saw in the second quarter. So there aren't any big moves between ADT, Fire, Flow, or safety products in Q3, relative to what we saw in Q2.

The big items that move in Q3; a little bit of change in Electrical and Metal Products, a change in corporate expense, and as Chris mentioned, obviously, the benefit of the tax rate, although, tax rate Q3 over Q2 will be relatively flat as well. So really, it's corporate expense and a little bit of Electrical and Metal.

Steve Tusa - JPMorgan

Okay. Then just one last question just on pension; I forget, in the fall did you adjust your equity for the market returns as we saw them through the fall? Is there potential equity charge coming, given that your fiscal year end is always earlier than others?

Chris Coughlin

Well certainly, we did our analysis at the end of last year, so the impact from October forward would be really calculated at the end of this year, and that's where I said if the markets stayed where they were today we'd have a modest headwind. We're estimating right now and it's very early, but if everything stayed the way it is today it's probably a $0.03 to $0.05 kind of a headwind.

Steve Tusa - JPMorgan

Right but the balance sheet from under-funded status?

Chris Coughlin

I think in terms of contributions, we would expect potentially to have to make a payment. It wouldn't be more than $100 million this year and it would be probably in the same kind of a range next year.

Operator

Our next question comes from Shannon O'Callaghan from Barclays Capital.

Shannon O'Callaghan - Barclays Capital

Just a little more follow-up on Flow; Flow was always a business that you had some more cost work to do on and arguably the margins weren't what they could have been, and now we're seeing some nice margin improvement really at a time when I know organic revenues are still up with some help from the backlog but it's not huge organic growth. So what do you read from this, especially, if you have similar results in the third quarter? As you look a little further out, is this a high teens margin business in your mind in a normal market? It looks like you've taken a fair amount of cost out. What's your view on that?

Ed Breen

I'd say Shannon, there's clearly some more progress we can make in the next few years on the margin side, so we aren't going to pop up the 500 basis points here in a year and a half if the market was good, but I think you'll see some steady progression from us, assuming dynamics hold okay, because margins should be very good going forward in our thermal business, there's some big projects out there that we're looking at.

I would think we'll do well margin wise and the valve business I think will hold and continue to progress a little bit on the margin side, and remember we're doing this despite the downturn, significant downturn on volume, compare-wise on the water side, where actually margins have decreased a little bit because of the revenue pressure.

So dynamic actually, the other two businesses are little better than what you're actually seeing on the surface because of the water piece, so if we see pick up on the water side. By the way there are indicators in the market with some of these stimulus packages and announcements in the Pacific rim area, specifically, Australia, and some projects we see in the pipeline for 2010, where again that could pick up and also help us.

Now again, if our business degradades a little on the topline that will obviously put some pressure on margins, but there is opportunity for us to continue there. One of the things, as Chris and I mentioned, we will continue to really look at cost reduction opportunities in this business. It doesn't happen overnight, to Chris' point, because there is a lot of brick and mortar here with fixed costs, but we know we have a few year at least progression still to bring the breakeven of the business down, and we'll stay focused on that.

Shannon O'Callaghan - Barclays Capital

Okay. In ADT Europe, I see you're taking a lot of the restructuring there. Is this a time and is there an opportunity to sort of reassess what you're doing there in a bigger way and just scale back? I mean, I know you've had the pressure from the install side, but we're still stuck at a 4% margin. It's been going on for a while. Is there an opportunity to do something even more aggressive over there at this time?

Ed Breen

Shannon, we're making some fairly aggressive moves right now. We are pairing back in some areas. We're focusing on core, what I call, large markets and pruning a lot of what I'd call the not large markets. Let me just give you a quick color on that. One of the things that happened to legacy in the company was, as they expanded in Europe, they kind of went for everything. You really look at the dynamics of an install business you want to really have big geographic tight locations, where you're sending your vans around and not driving 50 miles out into the suburbs somewhere.

So it's hard to describe, but if you look at us country by country what we've been doing is really pruning a lot of that outlying area and getting more focused on where the big geographic population opportunity is for us, and that's part of the restructuring that you're seeing us still do.

Let me also point out though that Europe is almost all systems installation and business. It's not a big recurring resi business, so when we see the drop off in orders of 19% or so, it's really hitting Europe, and I'm not bragging about a 4%, but I'm pleased we're holding the margin. And if the business volume would pick up with where we've taken the breakeven, we will see the margins in that business turn up with the cost actions we've taken, because it has seen the biggest overall downturn of any of our areas.

Shannon O'Callaghan - Barclays Capital

And is there a desire to balance that region a little more towards the resi recurring side?

Ed Breen

Yes, but that takes time. Clearly one of our focuses is to grow on the recurring side, but Shannon, that does not happen quickly in the business.

Chris Coughlin

One of the issues there, Shannon is, as we've talked about before, again in the United States which really is where that business is, the police force and what-not will respond to alarms and monitoring. In many countries that won't happen, so you've got to figure out how to do that in a way that you really can generate that recurring revenue base.

Ed Arditte

And in the EMEA region, our recurring revenue is growing modestly and has been for a while, but to make it a bigger percentage of the total is a long-term proposition.

Shannon O'Callaghan - Barclays Capital

Aside from these systems install declines are you kind of happy with what Europe is? When the volume comes back do you think you get it to that 10% target and that's where it stays, or how are you viewing what you want that region to be?

Ed Breen

I'd say, Shannon, if volumes came back, we grow and I'm not going to say overnight, it doesn't bounce that, but we grow that business to about a 10% margin business. Optimally, it's a 10% to 12% at some point and that's why we've targeted 10%, if volumes pick back up. The good news, remember it's a little bit like our fire business also, you have great returns in that business, if you get the margins into that range, because there's no capital in the business. Everywhere else in the world it's a very high return on invested capital business, either in fire or systems installation at ADT. And if we can get Europe up, which we should if revenue pops back here, we end up with a very good return business there at the 10% level.

Operator

Our next question comes from [Steve Winuker of Sanford Bernstein].

Steve Winuker - Sanford Berstein

My first question as a follow-up is on operating leverage in the first versus second half. In the first half or in the quarter anyway it looks like it was around 1.5 times, and if I take the mid-point of guidance for the second half of the year, it looks like it's more 2.5 times deleveraging. How should we sort of think about it? Are you expecting something materially to change or is that just a function of some of the one-time cost actions? This is excluding goodwill that I looked at.

Chris Coughlin

Steve, I don't have your calculations in front of me, but when I think about the second half versus the first half, there are three things that come to mind. Obviously, we talked about the drag from Electrical and Metal Products. We talked about the benefit that we get from tax and the only other meaningful item that comes to mind is second half versus first half would be corporate expense.

We ran in the first half of the year about $100 million a quarter. We guided for Q3 at the $125 million range, and Chris indicated that we expected $450 million for the full year, which would imply $125 million for Q4 as well, so other than that, I can't think of any other items that would be impacting the calculations.

Chris Coughlin

And clearly the third quarter, revenue is pretty darn similar to the second quarter, and we said bottom line, ex the things that we talked about, like the Electrical and Metal is very similar. We might want to look at it with you Steve off line.

Steve Winuker - Sanford Berstein

I was looking at sales down 15% and EPS down 41%. The next question is around the follow-up to the attrition rate point. This is the fourth consecutive quarter of increases in that rate and not to make too big a deal out of it, you talked about it a little bit before but the prior peak was around that 16% range. And assuming no major additional deterioration economically or what's baked into how high up you're expecting that to go this year and next?

Chris Coughlin

Well, I don't have a forecast for this year, but I would tell you that based on what we saw in resi this past quarter, based on what we're seeing in our book of business in terms of our outlook for the next several quarters, it could step up here a little bit. I don't think any of us are comfortable in saying that it won't. It could very well step up. Our peak as you know was the 16% level. We have some room there.

Importantly though, while that is a bit of a headwind from a recurring revenue point of view, compared to the last time that we hit our peak what's different today is we're adding to our account base in a high quality way and we're adding to our ARPU in a quality consistent way, so the combination of those two, even with the modest tick-up in attrition is still allowing us to grow our recurring revenue base.

So increased attrition is a revenue headwind. It's a revenue headwind. 1 point as you know is worth about $40 million of revenue for a full year, and granted, that is good margin revenue, but again, it's not a big deal to ADT's recurring revenue given the progress that we continue to make in adding accounts and given the progress that we continue to make in generating more ARPU.

Ed Breen

And Steve I would just point out that if you want one of them to stabilize better, resi counts as more dollars on attrition which actually improved slightly, as Chris mentioned, this quarter and commercial deteriorated a little bit more and possibly will a little bit more.

Chris Coughlin

The US commercial business.

Ed Breen

Right but it has less of an impact on the commercial side from a pure dollar standpoint.

Chris Coughlin

The US residential business from a recurring revenue point of view is twice the size of the US commercial business.

Steve Winuker - Sanford Berstein

Okay. You said about $114 million on accounts; you expect that kind of rate to continue for the rest of the year?

Ed Breen

Give or take, that's the range we're running. We're seeing good opportunity to get quality accounts. By the way both on our dealer side and the leads were getting internally with our own sales team, so it feels like that momentum is continuing into this quarter, so I would think we'll spend that.

Steve Winuker - Sanford Berstein

Okay. Just to be crystal clear on the non-res commercial construction exposure, because I was trying to sort of guess that out of that last answer. That 20% to 30% that you talked about, is that 20% to 30% of your entire sales base that you're viewing as non-res new construction exposure, is that so?

Chris Coughlin

No. Let me take a shot at it and try to clarify it for you. The 20% to 30% that Ed referred to in ADT and in fire, and ADT and I think 20% in fire, is really the percentage of our systems install business, which is roughly half of each of ADT and fire. So relative to all of ADT, you're talking about something in the 10% to 15% range and similarly for fire.

Steve Winuker - Sanford Berstein

That would be non-res new construction?

Chris Coughlin

That would be new construction related. There is some new construction related activity clearly in safety products and we estimate that at maybe a couple hundred million dollars. Just to be clear, I'm excluding from this because the dynamics of the business are very, very different, the Electrical and Metal Products business, because there we have the combination of volume and steel prices and steel spreads, much, much too difficult to factor that into the thinking.

Steve Winuker - Sanford Berstein

And excluding all Flow Control as well, right?

Chris Coughlin

Yes.

Steve Winuker - Sanford Berstein

Okay, great. Thank you.

Chris Coughlin

Okay. Ladies and gentlemen, thanks for joining us for the second quarter conference call. Look forward to speaking with you again in late July to review our third quarter results. Certainly, if you have any follow-up questions we're available to help. Thanks very much.

Operator

Thank you for joining today's conference call. You may disconnect at this time.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: [e-mail]. Thank you!