Eaton Corporation Q3 2009 Earnings Call Transcript

Oct.19.09 | About: Eaton Corp. (ETN)

Eaton Corporation (NYSE:ETN)

Q3 2009 Earnings Call

October 19, 2009 10:00 am ET

Executives

Alexander Cutler – CEO

Richard Fearon – CFO

William Hartman – VP IR

Analysts

David Raso - Isi Group

Eli Lustgarten - Longbow Research

Ann Duignan – JPMorgan

Robert Wertheimer - Morgan Stanley

Jamie Cook - Credit Suisse

Robert Cornell - Barclays Capital

Andrew Casey - Wells Fargo Securities

Henry Kern - UBS

Jeffrey Hammond - Keybanc Capital Markets

Nigel Coe - Deutsche Bank Securities

Christopher Glynn - Oppenheimer & Co.

Mark Koznarek - Cleveland Research Company

Dan Dowd – Sanford Bernstein

Ted Wheeler – [Buckingham Research Group]

Elliott [Pritchard] – No Company Listed

Operator

Welcome to the Eaton Corporation third quarter earnings conference call. (Operator Instructions) I will now turn the conference over to your host, Vice President of Investor Relations, Mr. Bill Hartman. Please go ahead, sir.

William Hartman

Thank you. Good morning everyone. Welcome to Eaton's third quarter 2009 earnings conference call. Joining me this morning are Alexander Cutler, Chairman and CEO, and Richard Fearon, Vice Chairman and Chief Financial Officer. As has been our practice, we will begin today's call with comments from Alexander, followed by a question-and-answer session.

As a reminder, the information provided in our call today will include forward-looking statements concerning the fourth quarter of 2009 and full year 2009, net income per share and operating earnings per share, fourth quarter and full year 2009 revenues, statements on our worldwide markets, our growth in relation to these markets and our growth from acquisitions.

These statements should be used with caution and are subject to various risks and uncertainties many of which are outside of the company’s control. Factors that could cause actual results to differ materially from those in the forward-looking statements are set forth in today's press release and related Form 8-K filing.

As a reminder, we have included a presentation on the third quarter results which can be accessed on the Investor Relations page of eaton.com. Additional information is available in today's press release, which is also located on Eaton's home page at www.eaton.com.

With that, I would like to turn the meeting over to Alexander Cutler.

Alexander Cutler

Thanks William and welcome everybody this morning. I think you have all had the opportunity to read our earnings press release. We are very pleased with the quarter. We reported operating earnings per share of $1.21, about $0.26 or 27% above the midpoint of our operating EPS guidance which was $0.95 for the quarter.

Our sales were down about 26% from a year ago. Our end markets were down about 24% and foreign exchange also impacted our sales for a negative 3%. Our third quarter revenues were up about 0.4% from the second quarter and as we pointed out in our earnings release about half of that came from currency and about half of it from core growth.

We continue to have strong participation in the developing country economies. About 23% of our sales are coming from those regions. Once again we were really very pleased with our cash flow during the quarter of $471 million for the third quarter of operating cash flow and if you look back over these last 12 months now totals nearly $1.6 billion. Highlighting within that total is really the very effective job that has been done with working capital.

Our inventory management has been quite strong. Our days on hand came down another three days from the end of the second quarter with now a total of 13 days since year-end 2008. Our accounts receivable DSO down a day from the last quarter, down a day from the end of last year as well. So in a period of time obviously that we have been watching costs quite carefully we have also done very well in terms of our cash flow.

If we turn to the next chart, which is chart number four, it gives you a quick break down of the EPS reconciliation versus our guidance. As I mentioned, in total it was up just over 27%. We had a slightly lower reduction in force savings. That $0.01 corresponds to about $1 million so we had about $124 million of savings coming from all the work we have done in that arena.

Our RIF expense was slightly higher, about $22 million versus the original expectation we had of about $16 million. As I mentioned, currency contributed about $0.03 and the lower tax rate contributed about $0.02 and then the big, big news for the quarter was the real effectiveness and improved performance all across the corporation of an additional $0.26 leading to this upside surprise on the top end of our guidance of $1.21.

If we turn to the next chart, chart five labeled “financial summary,” I think you know these numbers having studied the income statement. At this point I would simply point out that if you drop down to the third line and look at the segment operating margin of 10.9% a large step up from where we have been over the last several quarters. You will all recall in the fourth quarter of 2008 our operating margin was 9.4%. In the first quarter depressed by many of the RIF expenses we were taking it was 4.2%. In the second quarter it was 8.2% and now here in the third quarter 10.9% so we think again really giving solid evidence to the fact that not only do we have the company sized correctly but we are beginning to see our markets flatten out and in some selected cases starting to see early evidence of recovery.

As you can see, foreign exchange was still a negative year-to-year for us but still less of a negative than it was in the second quarter. If you recall I believe it was 6% at that time.

If we go to the next chart just diving right into our segments. Let’s start with the electrical Americas segment. Clearly a really terrific quarter in terms of operating margin. We pointed out in our press release this was an all-time record of 17% versus 16% a year ago. You will recall the second quarter was a very strong 16.6% and even on a slight volume drop from the second quarter we were able to record this very strong profit performance.

Our US end markets all have declined with the exception of our engineered services. As I mentioned during our last conference call we continue to see a very strong demand for our engineered service activities here. Bookings were down year-over-year about 20% but were slightly better than they were in the second quarter. Our backlog was down some 18% but remains over $1 billion and each of these last couple of quarters I have updated you where we are versus our own identification. We believe we will have $500 million of shipments in the year of 2010 and then again in 2011 that come from the US Stimulus program.

We have actually booked $95 million in orders so we are continuing to do quite well in that regard. We have identified another $390 million of opportunities so we feel we are right on track to be able to support that $500 million of incremental sales in 2010.

If we turn to the next chart which is the electrical rest of world segment I think there are two very strong pieces of news here. One is the sequential growth from the second quarter. If you recall our revenues in the second quarter were $595 million. We grew to $646 million. We are continuing to see recovery here in Europe and in Asia Pacific and probably most notably our margins have strengthened very strongly. You will recall in the first quarter they were 1.8%. In the second quarter they were 4.4% and in the third quarter they are 8.8% so not up to last year’s 11.8% but we are still operating, as you can see now, some 28% in terms of our volume. This doubling of margin again I think speaks to the increase in volume but moreover really speaks to the sizing work we have been doing within the company.

As you can see Europe and Asia Pacific are both down versus a year ago but the big difference versus a year ago but the big different versus two months ago is we believe we are seeing the European electrical market start to stabilize. That is a different outlook than we had just several months ago.

If you turn to the next chart which is our hydraulics segment, I think the news on market is that it continues to be flat at a very depressed level. Our volumes in the second quarter were $425 million. You can see they are $418 million now, down 34% from a year ago. We are pleased with the margin performance of 4.8%, up from 3.3% in the second quarter and 1.6% in the first quarter. I spoke briefly to the market conditions. They remain perfectly terrible at these low levels and we don’t expect to see any improvement here in the balance of the year. You can see our global bookings down from 36%, continuing to reflect this weakness in this marketplace. We are continuing to work on the cost side and you can see the impact of that in terms of our margins having grown by almost 50% from last quarter.

Turning to the next slide which is our aerospace segment, I think the big news in aerospace is that the end market being a late cycle business are continuing to weaken. That theme will reflect itself on several lines here. In the second quarter our volumes were $409 million. This quarter they are $394 million. Our margins are 15.5%, down a couple of points from where we were running in the second quarter and where we had run the several quarters before that while the aerospace worldwide market was really up at peak levels. Commercial passenger miles and freight carriers continues to decline really around the world as people have been reducing line rates for next year. That means they are reducing their purchases in terms of reducing their inventories and we are seeing that impact here during the third and fourth quarter.

The defense market in the quarter had a slightly negative growth rate as well. So to the question in terms of why are the margins down a couple of points, we are continuing our very active support of major development programs but we have less volume on the top line and that is really what is leading to the lower margins at this point.

Turning to the next slide, the truck segment had a big increase in terms of volumes that we were pleased to see after a long drought. Second quarter was $321 million of volume. This quarter was $401 million, still down 35% from a year ago but an uptick in terms of volume. Most significantly the second quarter we lost $3 million in this business, 0.9% as you can see here now a 6.2% in terms of operating margin really reflecting again sizing this business correctly as well as seeing some upturn in terms of the top line.

U.S. markets and non-U.S. markets as you can see detailed in the two boxes, still down a long way. We are seeing a modest improvement in Class A orders, and I underline the word modest. This is not yet the front end of a map of recovery. The one good piece from a market point of view here in this business is we are continuing to see really very attractive activity level in terms of bookings in terms of our hybrid business. This is clearly the right product for the right time period.

Turning to our automotive segment on the next chart, again a volume increase from the second quarter. It was $270 million in the second quarter up to $326 million now. A very significant turnaround in margins. We lost 7% in the second quarter. We made 7.1% in this quarter. This really is the first profitable quarter after three negative quarters in this segment. A very strong rebound obviously in the margins. Clearly the global markets, particularly in the U.S., saw quite a pop in the third quarter from the stimulus programs. We all have seen some of the fall off in that in the subsequent months but it did contribute to positive volume in this particular quarter and we are really quite pleased to see the strong margin performance again.

As we move to the next chart, a quick summary of our market outlook, at this point it looks to us that other than the late cycle markets and we will speak to those being primarily the non-residential construction market which is in our electrical Americas segment and the aerospace market, with those two markets aside most markets seemed to have bottomed in the second quarter and are starting to grow in the third quarter.

We have seen sequential revenue growth in our electrical rest of world, our truck and our automotive segments. We have also seen it in order rates in our electrical Americas and our electrical rest of the world markets. We do feel as we have been saying for several quarters that our late cycle markets are likely to decline over the course of the next year; those being the two I just mentioned. In total, we would expect to see continued sequential growth in revenue fourth quarter over third quarter and we would say that is likely to be slightly above $3.1 billion in the fourth quarter with about one-third of that growth coming from FX and about two-thirds coming from core growth. We would expect to see 2010 grow over 2009. For the first time in some period we are really starting to feel better about the prospects of organic growth.

Chart 13 simply summarizes our current outlook by each of our segments as well as U.S. versus non-U.S. growth look. I would summarize this to say in total we still think the negative 21-22% is about the right number for our end markets for 2009. Minor changes between what we showed you at the end of last quarter and what we are showing you here but in each of the individual segments here.

If we turn to chart 14, this is the chart we had used to to summarize our 2008 to 2009 year-over-year benefits in terms of all the activity we have taken in terms of reductions in force. You will recall last quarter when we showed you this chart the third quarter net number was 109. It came out to be 102. The fourth quarter was 133 and it is now 140. No change for the $270 million or the $220 million figure shown on this chart. I think the real significance of this chart, and it helps to explain why our profitability is much improved in the third and fourth quarter of this year versus the first and second quarter. If you look at the third quarter the net savings are approximately $62 million higher than they were in the second quarter and in the fourth quarter they were $100 million higher than they were in the second quarter. Again, giving you I think a very clear depiction of how important all of these resizing programs have been to allow us to operate profitably at this level of activity.

If you move to the next chart which is the full-year 2009 benefit of both what was shown on the last chart plus that long series of other actions we detailed for you in our second quarter conference call which we called “other actions,” they added up to $495 million worth of year-over-year benefits affecting 2009. There is no change from our prior guidance on these numbers and you can assume that the fourth quarter numbers on a calendarization basis will be roughly equivalent to what they were in the third quarter.

Our chart 16 is our EPS bridge for the year. You will notice most of these numbers have stayed the same with the exception of the fact that the operating EPS guidance now is $2.45. The real big change takes place on the improved operating performance line there where it moved up from $0.34 to $0.60. There are a couple of small changes to other numbers on this chart as well but that is the big impact and that is clearly the big message coming out of our third quarter earnings that the business is running even better now than we had anticipated.

If you turn to page 17, a summary of our guidance, just a couple of comments on this page. The midpoint of our full-year operating earnings per share guidance is now $2.45. It was $2.10. That is an increase of just less than 17% for the full year. On the net income column, the midpoint of our guidance is now $2.10. It was $1.75. That is an increase of 20%. So a substantial change for our earnings outlook both here in the third and fourth quarter.

If we move to chart 18, just a quick summary of a couple of points that have changed on this chart, our market outgrowth is $150 million. We had it at $200 million. If you drop down to the operating EPS on the fully diluted numbers they changed just as I had mentioned on the previous chart, on the operating cash flow and free cash flow we have increased both by $100 million for this year. Confirmation obviously of the very strong quarter we just had in terms of cash flow in the third quarter and our expected strong performance for the remainder of the year.

If we turn to the last chart, chart 19 I think you will recall in the second quarter we included a chart that laid out a couple of prospective points about 2010. We will not be providing guidance for 2010 by segment or in total. It is I think worthwhile noting that back in July we shared some consensus global growth forecasts for GDP and industrial production. You can see they were 2.5% and 4.5-5% respectively. Here we are X months later and you can see that general consensus for global growth has moved up now to 3.1% for GDP and 6% for industrial production, I think very much in keeping with the broader sentiment we have seen the bottom of these global markets and they are beginning to recover.

We do expect still good incremental profits as sales rebound and the last comment was really meant to help you work your way through these two sets of figures; of the $225 million of other savings that we said should not be counted upon next year because they were actions we took this year we would not expect to repeat next year but to note that there are a carryover of about $220 million of year-over-year additional benefits to come from our RIF activity so they will basically offset one another going into 2010.

In summary, we are really very pleased with the third quarter and the tremendous additional operating leverage that was achieved within the company. We believe we are seeing the markets starting to recover modestly. That is why we have increased our guidance for the fourth quarter and the full year as well.

With that we would be pleased to take questions.

William Hartman

Thank you Sandy. Operator, we will now get into the Q&A portion of the call please.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from the line of David Raso - Isi Group.

David Raso - Isi Group

A quick clarification on the sales comment about sequential growth. Your business is really not that seasonal when you book revenues. Can I take that comment literally about 2010 that you see 2010 up from 2009 and actually could see quarter-by-quarter you are assuming revenue progression up each quarter through 2010?

Alexander Cutler

We are making no forecast about quarter-by-quarter in 2010. That is why I specifically mentioned we expect 2010 to be over 2009. We will address the quarters when we get to January. There are some seasonality elements in our business particularly as addressed in the earliest part of the year.

David Raso - Isi Group

My question on profitability. You raised the full-year guidance to $0.35 and the two drivers were $0.26 from improved performance and $0.12 from a lower tax rate. You already captured the $0.26 in improved performance in upside for your third quarter versus the prior guidance. It looks like you are not implying any improved performance in the fourth quarter but each quarter we have seen $0.31 upside to your guidance on improved performance. Second quarter $0.34 and we just got $0.26. I guess the question is why wouldn’t you get further improving performance in the fourth quarter? Really can you help define exactly what is in the improved performance line item?

Alexander Cutler

I think the way to think about the third and fourth quarter is on a relatively small increase in volume, part of which will be FX. We actually have a change in mix that does occur and you have seen it occur in previous fourth quarters for us. This year I think what you are seeing is the late cycle businesses which are embedded in both our electrical Americas segment and in our aerospace segments, two of our highest margin businesses, are at a time period when they are beginning to decrease in quarter-to-quarter volumes. The businesses that are beginning to accelerate in terms of their volumes have been our automotive, truck and our electrical rest of the world businesses and they at the present time are slightly lower margins. So the real interplay between the third and the fourth quarter is around that issue of the mix of businesses and their respective margins they are each generating currently. That is why you end up with a relatively flattish look, if you will, over the third and fourth quarter in terms of our actual earnings guidance.

David Raso - Isi Group

Cost savings versus 2009 likely to be neutral. Can you clarify what that means?

Alexander Cutler

That was meant to clarify the comment that I shared at the end of my comments that we had about $220 million of year-over-year additional carryover benefit from the RIF actions we took during 2009. Offsetting that was this group of what we call “other savings,” the $225 million that were issues such as the one-week time off without pay that employees had taken throughout the company per quarter that we do not expect to repeat next year. So that $225 million would disappear off benefits. It would be replaced by the $220 million of the carryover benefits in the RIF so they would basically offset one another.

David Raso - Isi Group

That kicks in right away, right? It starts the year neutralizing each other?

Alexander Cutler

Yes. That is exactly what we would be suggesting in terms of people’s expectations.

Operator

The next question comes from the line of Eli Lustgarten - Longbow Research.

Eli Lustgarten - Longbow Research

You talk a little bit about the later cycle businesses, non-res and aerospace, we saw the impact in aerospace margins at yet we have these phenomenal margins even though the numbers have gone down in electrical. Can you talk about the outlook for the new electrical America business particularly the fourth quarter? How far down have we come from the 17%? I think it was like 15.7% last year. Really the outlook, what would be a more normalized margin? Are these margins going to go down over the next 12 months as non-res unfolds?

Alexander Cutler

I think there are a couple of macros to think about. About 40% as we shared in our February New York session, about 40% of the electrical Americas segment is generated off of the non-residential construction market. Remember the assemblies type of product which is generally what goes into non-residential, tends to have a slightly lower margin than does the component side of the electrical industry. More of the component side will start to get driven by some of the early and mid-cycle businesses and we would expect to start to recover whether that be single phase, power quality, whether it be residential or whether it be industrial controls. The real mix issue is going to go on within the electrical Americas segment as it is a late cycle, non-residential come down while some of the early and mid-cycle businesses that I just mentioned will start to come up.

Having said that, we had an absolutely terrific third quarter. We would expect margins to come off that in the fourth quarter. We are not giving any guidance for next year until we get into our full planning process which we are not all the way through but I think you can continue to see volumes come off sort of like they did from the second to the third quarter and come off here again in the fourth quarter. There will be a decremental margin on it. I think using these numbers of 30% incremental decremental won’t take you far up field.

Eli Lustgarten - Longbow Research

Is the aerospace margin we saw in the third quarter more of a steady state number for now?

Alexander Cutler

I think that is a good assumption at this point because we see the volumes basically on aerospace as late cycle weakening through this time period. I think that is a good way to think about it.

Eli Lustgarten - Longbow Research

Can we talk about the businesses reversing, how sustainable is that automotive margin given that cash for clunkers is gone? I assume truck is sustainable for the fourth quarter since production has gone up. Is that also the kind of number we should be looking forward to in the future and obviously rest of the world electrical the same [comment]?

Alexander Cutler

I think your thinking there is very much on point. Cash for clunkers provided the industry with sort of a shot in the arm that isn’t going to repeat itself in the fourth quarter. Our cost benefit in that will but we won’t get quite the volume pop we got the benefit of here in the third quarter. The truck business ought to continue to improve here as we are expecting I would call it marginal higher volumes in the fourth quarter due to the NAFTA heavy-duty side. I wouldn’t call it a pre-buy. I would call it a speed bump. I think as people have watched the various different forecasts and you can see ACT’s forecast that is out for 2010, it does call for a fairly substantial increase in the NAFTA heavy duty market. Albeit it is going to be fairly second half loaded.

Eli Lustgarten - Longbow Research

Is the rest of the world electrical sustainable? The improvement continuing to sustain itself?

Alexander Cutler

Yes. We are seeing those volumes on both Asia and in Europe starting to recover. The other benefit we are clearly seeing here is we are working hard to integrate both the Molar and Phoenix Tech acquisitions and we are seeing the benefit of many of those synergy benefits coming through as well so yes they are sustainable. We would expect those to continue to improve.

Eli Lustgarten - Longbow Research

So getting close to a double digit margin in the rest of the world is not impossible in the fourth quarter?

Alexander Cutler

Not impossible but let’s not go off the charts here.

Operator

The next question comes from the line of Ann Duignan – JPMorgan.

Ann Duignan - JPMorgan

I just wanted to ask the question that I think people have been asking a slightly different way, if we take your $1.20 in the fourth quarter and use that as our base going into next year that would give us a $4.80 base for next year. What are the risks to the upside and downside of thinking about next year like that both on the operating side and the non-operating side?

Alexander Cutler

I think as we have been kind of sharing with people here over the last 3-4 months we have been saying yes if you annualize it you get up to a $4.80 type of number. You would then have to tax adjust it because obviously we have this large tax credit this year and we talked about taxes going back to our more normal rates in 2010. That gets you down to a figure that is just over $3.00. On top of that you put whatever you feel the volume increases would be for Eaton’s end markets, our end growth and our incremental margin but I would note that people need to do the tax adjustment because that is a fairly significant adjustment in terms of we would expect we will obviously have a tax next year not a tax credit. That is the big piece. The reason we shared, to Dean’s earlier question, in terms of the cost savings would be neutral is to be sure that people take the 225 out and add the 220 in. Don’t leave one or the other out of that equation. That would lead you I think to the wrong conclusions.

Ann Duignan – JPMorgan

So it is the [net] but a cost savings versus the costs that come back in would imply that volume alone will drive upward leverage next year? Is that the way to interpret that?

Alexander Cutler

Exactly correct.

Ann Duignan – JPMorgan

On the hydraulic side, given your mix of business there both industrial and mobile, can you talk about the difference between the two differences right now? Then within mobile what are you seeing in construction versus Ag and are you seeing anything on the industrial side even at the distribution level given your update of industrial production being stronger than you might have anticipated a quarter ago?

Alexander Cutler

I would say not noticeably. You could treat really the two sides, the mobile and the stationary and industrial are fairly similarly right now. Again the way we tend to think about the industrial side is as corporate profits continue to improve here you are going to start to see CapEx start to increase in that we really need to see the CapEx side of the equation start to increase before you are going to move those industrial markets substantially. That is probably more of a mid-2010 story than it is first quarter 2010. That is the way we have been thinking about that.

On the construction side things are still very weak. The AG market you obviously have seen is continuing to weaken. Those three primary drivers of the hydraulic markets is why we have been seeing these terrifically tough quarter-to-quarter numbers in terms of market activity. We don’t see that changing in the short-term.

Ann Duignan – JPMorgan

Further on the AG side what are you seeing in Brazil and the [Pagosi] business in trucks?

Alexander Cutler

It is better than it is here in North America and it has started to increase but we are not at the levels we were at in the peak.

Operator

The next question comes from the line of Robert Wertheimer - Morgan Stanley.

Robert Wertheimer - Morgan Stanley

I wanted to circle back on the margin question on electrical Americas which is obviously very, very strong. Could you talk about whether there is any large mix impact on that? You mentioned both ways I think their being high margin businesses embedded, late cycle businesses embedded in electrical as well as some of the componentry businesses in the early cycle. Was there a big mix effect in there? The second part would be was that affected by your rolling temporary layoffs and whether that would be an abnormally low cost base for the quarter.

Alexander Cutler

No I would call it a very clean quarter in terms of no items really distorted it. If you recall we were at 16+% in the second quarter and we were still at a point where we were continuing to do reductions in force and resizing the business so we got more of those benefits here in the third quarter but frankly those benefits will carry into the fourth quarter and they will carry into next year as well so we came up with 16.6% return on sales. Therefore the operating margin of 17% now. I would say no there wasn’t any distorting mix that occurred in there.

I think the real issue to think through as I was pointing out earlier as we move into 2010 is we do expect the non-res to continue to decrease as we have all talked about and it has been decreasing as we go through this year but we will start to see sections of the business such as residential with no heartbeat for 18-20 months now and the industrial we will continue to see utility strength and we will start to see some of those component businesses come back. It is the interplay of those two and the only reason I mention all of that detail is that I know many of you have been concerned and have sometimes made the assumption the entire electrical Americas business is driven by non-res. Please remember we have worked very hard to build a large, single phase power quality business, residential business, industrial business, utility business and all that adds up to almost 60% of that segment. That is how we see there is a balance as you think about margins and activity levels for 2010.

Robert Wertheimer - Morgan Stanley

Could you mention what is getting better in Europe in construction?

Alexander Cutler

What we have seen is it not all construction. You saw obviously the German exports market I think surprised people on the upside here during the summer. We have seen orders from machine builders. We have seen orders from distributors that are in excess of what we had expected to see. Again, I wouldn’t take this one off the charts in terms of saying we are in a blowout upside condition but it has come in a little stronger than we thought. The decline stopped a little quicker than we thought so we are encouraged by the more recent indications we have seen in the electrical business in Europe in that the rate of decline has significantly decelerated and we have actually seen some evidence now of some uptick.

Robert Wertheimer - Morgan Stanley

Would you have booked an incremental reserve for the ArvinMeritor jury decision this quarter or would it be next quarter if you were going to do one?

Alexander Cutler

Let me just address that question in total because I know a number of you have posed this question about the litigation and I will answer this once. It is an active matter so we really can’t comment to any great extent. However, I will comment that the allegations in the lawsuit are without merit. We are obviously disappointed in the jury’s verdict in the liability phase of the case particularly as the court had previously disallowed ArvinMeritor’s damage expert having concluded that his opinion was not based on reliable data. We believe we have fully complied with the applicable laws in the context of our business and are examining our options including an appeal.

To the questions that surround numbers that have been out there we believe there is no basis for the number. As I mentioned, the expert retained by the plaintiff was specifically excluded from the case by the judge and as a result there has been no finding relative to damages. To the question of reserves, Rick if you want to address the reserves question?

Richard Fearon

As a matter of course we don’t comment on specific reserves related to any given case but I can tell you we believe we are appropriately reserved at this point in time.

Operator

The next question comes from the line of Jamie Cook - Credit Suisse.

Jamie Cook - Credit Suisse

On the electrical rest of world can you remind me if there was any benefit on the operating profit line from FX? My second question is a follow-up relative to Anne’s. I know you haven’t given any guidance for 2010 but given your strong performance in the third quarter and what we will expect in the fourth quarter your core operating earnings should still theoretically be higher than what you thought in the second quarter. Now it looks like we are about 120-125 each quarter, you have the tax affect before we were thinking one. So you are theoretically raising your base?

Alexander Cutler

On the rest of world, in terms of the sales level FX was actually a negative five.

Jamie Cook - Credit Suisse

And on the profit?

Alexander Cutler

A slight negative. $1 million negative. On the question on our third and fourth, I think the way to think about the third and fourth operating earnings per share from our guidance are really quite close to one another. Again we think the mix change going back to Dave’s original question, is the big reason that one might expect the fourth quarter to be higher but it won’t be because of the mix change between the individual segments, some of which are more profitable than others. It does give us, as you say, this sort of $1.20 operating run rate for these last two quarters, each individual quarter. That leads us to the question Anne brought up earlier about this kind of $4.80 run rate. You have to remember to tax adjust that to get it down to the right run rate to think about next year. Does that address your question?

Jamie Cook - Credit Suisse

The question is, the base for 2010 is now higher versus what we thought in the second quarter?

Alexander Cutler

Correct.

Operator

The next question comes from the line of Robert Cornell - Barclays Capital.

Robert Cornell - Barclays Capital

On the $0.60 better performance, how much can you attribute to that to the temporary cost take out? The structure cost take out and other issues associated with business management integration of Molar, Phoenix Tech and other things? Can you take that $0.60 and sort of disaggregate it into some of the component parts?

Richard Fearon

I think the way to think about it is you take the $495 million of RIF savings and other savings, this is beyond that. That is already accounted for. This really gets to be crossed actions, mix issues and running the business better and so many small pops that we have not been able to kind of add it up and put it into a big summary, if you will. I think the way to think about it is the company is getting the full $495 million of cost reductions through all of the cost efforts we have had and in addition to that we have been able to drive additional improvements I think really just because the tone has been set and the work that is being done all through the company.

We are not able to kind of put our hands on a nickel here and a nickel there if you will. I think the good news out of it is that the company has been repositioned successfully to be able to operate at these levels of activity and we are delivering even higher earnings than we had thought was possible just a month ago.

Robert Cornell - Barclays Capital

I can recall when the electrical North America before power quality was struggling to get margins into the low double digits and now we are 17%. Can you give an overview comment on how we have come so far over the last five years? You mentioned earlier it wasn’t mix so you don’t have a lot of paddle boards and switch boards dragging the margins down. What really is driving those margins up to those levels?

Alexander Cutler

I think a couple of items. First of all if you take the whole electrical business it is obviously now close to 50% of the business so it is a big repositioning at the corporate level. Within the business you will recall we have built a fairly large power quality business now. It started with the Powerware acquisition and has been added to with some smaller ones as well as MGE and that has advanced that business. We have told you that side of the business tends to grow a little more quickly and it is quite a profitable business for us.

Enormous structural changes in the base business and we clearly have changed the product mix of the traditional power distribution business really moving it up with very proprietary products which as a result tend to command a higher margin as well. It has been a multiple year process of advancing margins by about a point or a little higher per year, each year in a row and that is what has led us to this really superlative performance now.

Robert Cornell - Barclays Capital

A comment on pricing. The material costs have come down and I’m not sure how much you hedge on a quarterly or annual basis, so steel and copper have come down from awhile back. How are you doing in terms of price costs and was that an uptick in the quarter?

Alexander Cutler

Not a substantial uptick in the quarter but we have had a good year in terms of our cost price mix has been pretty much as we had anticipated it would be this year. I think that is one of the reasons we are not seeing, and a number of you have asked this question, we are not seeing what we have witnessed during some of the past deep downturns which is a real implosion of prices. Costs have not come down as far as spot purchase costs have come down as far as some of the commodities trades would suggest. As a result there is better price stability through this time period than we have seen historically. That is good news.

Robert Cornell - Barclays Capital

You talked about the orders and the stimulus and the $95 million in orders and some of the visibility into 2010. A little more detail around what to expect there. When you might see the revenues and what sort of projects at what sort of margins?

Alexander Cutler

As a very, very large player in the whole arena of non-residential construction we have an unusually good window into all of these projects. So we think we have got a very good understanding of timing and pace and it is laying out pretty much as we expected with the majority of actual spending being in 2010 and 2011 with very small wings in 2012 and a very small wing in the late part of this year.

So that piece is not surprising us. You are all reading about where many of these projects are from military base work to government building efficiencies to a lot of work in K-12 buildings as well. All of those areas happen to be quite strong for us. Wastewater treatment being another area of real activity. So a very large platform we have built here in the Americas in our electrical business gives us a great window to it. That last piece I would mention as I mentioned it up front is our ability to do detailed energy studies and do that work for our customers as they are trying to think about how to make their facilities more energy efficient plays right into our engineered services capability that we have shared with you is really quite substantial in the Americas.

Robert Cornell - Barclays Capital

Is that going to help you out of the gate in 2010 or is this something that is going to ramp as the year goes on?

Alexander Cutler

Well these orders right off the bat that we have of the $95 million we have got and the projects we are working with should help us right off the bat.

Operator

The next question comes from the line of Andrew Casey - Wells Fargo Securities.

Andrew Casey - Wells Fargo Securities

A question back on electrical. Can you walk us through what you are seeing in power quality markets by region given you noted the North American single phase improvement is there any sequential improvement elsewhere or even in three phase?

Alexander Cutler

I would say the easiest way to think about it at this point is the single phase market, which tends to be more of an early to mid cycle business, is starting to come back into where you are seeing stocking. You are starting to see depots fill. You are starting to see some of the IC retailers have more activity on small business and individual so you can understand how that kind of relates to that portion.

The three phase side, which tends to be more of the large data centers, more of the big construction, fewer projects being bid than was true a year ago. Still some very big ones and we have been very pleased to be successful on a number of those. If you envision the three phase business will become a lower level of activity and the single phase is beginning to pick up. That is pretty similar around the world.

Andrew Casey - Wells Fargo Securities

I know markets are bottoming but I have to ask the question, coming out of the last downturn I believe you encouraged your internal businesses to really look for CapEx and make sure they were positioned to grow the business in an upturn. What are your feelings there given most people are really deferring CapEx at this point?

Alexander Cutler

Our CapEx, if you recall, is $200 million for this year so it is clearly much lower than we have been running the last couple of years. I think we will be like many other industrials that as corporate profits begin to increase we are obviously going to be opening up the purse strings in terms of the important activities in most of our CapEx we are doing this year is around either employee safety or around the issue of new product generation. We have got plenty of capacity right now. That is not our issue. So I think we feel very well positioned in terms of a lot of our new products. Again, the big driver for Eaton Corporation is energy efficiency for our customers. We only have to look at what has happened in oil prices again in the last two weeks that has surprised people that energy is going to be more expensive going forward over the next couple of years whether you look at it from an extraction point of view or whether you look at it from a utilization and potential penalty point of view. That is driving better demand, new value propositions for our customers. It doesn’t matter if it is a truck, car, airplane, a building or a piece of equipment that uses hydraulics, everybody is looking for these more energy efficient activities. That is why we will continue to spend the CapEx on the R&D side here.

Operator

The next question comes from the line of Henry Kern – UBS.

Henry Kern - UBS

I am just wondering if you could chat a little bit about what your customers are telling you about North American truck as we go into 2010. I know orders have picked up off the bottom but are they expecting to produce a little bit more in advance of things getting better maybe in 2011?

Alexander Cutler

I think the best way to look at that is really to look at the ACT forecast that is out there right now which does provide I think some visibility to both the shape of what demand will be and to the fact we have been through a number of years of quite depressed consumption. That is really true in almost every capital goods market. So we do expect a rebound in 2010. We have not put our own forecast out but I think the ATC is out just over 150 for next year. Again, I think those of you who are students of the truck industry know that there will be arguments about whether there will be some hangover in terms of whether people have bought things here at year-end or not. We think that is less likely to be a really big factor because there hasn’t been a huge purchase so far at the end of this year.

I would guess like all the rest of these you will see the truck market tend to be back-end loaded so it will start a little slower in the first half and then accelerate going into the second half and 2011 will probably be a bigger year than 2010.

Henry Kern - UBS

As a follow-up, could you talk a little bit about the financial health of your competition? Is there any chance to take some share from competitors who may be teetering? If so, which segments could we see some benefit from that?

Alexander Cutler

We wouldn’t speculate on the issue of where competitors stand. I would say one of the things we are quite pleased about is if you think about the guidance we have provided about our own balance sheet we have said that our net debt to capital ratio by year end would be in the 30-31% range and we obviously got there a quarter early. That is good news in this environment because credit is still tight and liquidity is really king through here. I think one of the very strong points of performance for Eaton is we have been able to resize the company and maintain very strong liquidity and in fact have gotten there a quarter faster than we thought was going to be possible. We think that puts us in very good position competitively.

Henry Kern - UBS

Can you talk about where you have taken market share?

Alexander Cutler

We don’t talk about market share specifically. No.

Operator

The next question comes from the line of Jeffrey Hammond - Keybanc Capital Markets.

Jeffrey Hammond - Keybanc Capital Markets

You lowered your forecast in hydraulics and aero for the year. Where are you specifically seeing incremental weakness versus where you thought it would be?

Alexander Cutler

I think on the hydraulics side we simply stated that it is not getting any better. Not that things got additionally weaker from where they were, they just didn’t get any better. We hoped we would see some recovery here late in the year.

On the aerospace side I think what we are seeing is pretty much what you are reading on a daily basis. It doesn’t matter where one looks today. The general booking activity, the general market activity is weak. Business jet is one we have clearly we have been reading a lot about, regional jet has been down. You have seen the commercial after market continues to be weak and so we think we are just into this process where it is a late cycle business. There is pressure on the airlines. Profitability has not been as good. Fuel has taken another pop up again and we think the prudent side is to expect the market is going to be a little weaker.

Jeffrey Hammond - Keybanc Capital Markets

A housekeeping item for Rick, fourth quarter tax benefit, how are you thinking about it? What would be a reasonable expectation for a tax rate in 2010?

Richard Fearon

The tax rate for the fourth quarter I would put in the same as the third quarter. The third quarter was 17% so I would expect a rate very similar in the fourth quarter. So that will bring the full year in the neighborhood of 22-25% tax credit. Looking at 2010, again we aren’t at a point of giving formal guidance but I would pencil in a number that is much more typical of a rate we had prior to 2009 so a number somewhere in the 16-18% kind of range.

Operator

The next question comes from the line of Nigel Coe - Deutsche Bank Securities.

Nigel Coe - Deutsche Bank Securities

Quickly following onto that question, if we just sort of stop the clock here with a run rate at the current quarter with mix and [levels] profitability, why would we see the tax rate flipping from your negative to a positive 16-18%?

Richard Fearon

It has to do with where your earnings, profits or losing money. This year given the sharp downward movement of the markets in the United States that has severely impacted the profitability in the United States. The U.S. has a very high tax rate. As you start making more money in the U.S. then that raises the tax rate.

Nigel Coe - Deutsche Bank Securities

Is it basically an assumption of the U.S. pre-tax income growing faster than your overseas income?

Richard Fearon

Yes.

Alexander Cutler

I would add just one comment to that. Remember we had very large severance charges this year as we resized the U.S. and that further depressed operating earnings in the U.S. versus what it would have been on a run rate basis.

Nigel Coe - Deutsche Bank Securities

The chart on industrial production growth in 2010, if we do get IP growth of 6% in 2010 would you expect your short cycle businesses to grow faster than that level? Without really giving guidance, typically industrials grow at a multiple of [inaudible]. Would you expect to grow faster than expense?

Alexander Cutler

What we have said is we have said industrial production has been a multiple of GDP and we think industrial production has been a surrogate for thinking about end market growth for Eaton and that we tend to outgrow industrial production because we try to outgrow our end markets by 50%. While we have not specifically tuned those numbers for next year that is how we tend to think about it.

Nigel Coe - Deutsche Bank Securities

It looks like you are looking for electrical Americas and aerospace to be down in 2010 as 2009. On the electrical Americas, obviously you are looking for the stimulus money to come through. You have put out a number of $5 million. Will you expect to be down year-over-year even with all this coming through?

Alexander Cutler

We have not given specific guidance for that. We will have guidance for that in mid January and similarly for the aerospace business.

Nigel Coe - Deutsche Bank Securities

Are you seeing any additional pricing pressure? I know you have answered some questions already on pricing but specifically within the electrical Americas and specifically within the longer cycle businesses, are you seeing any pricing pressure there?

Alexander Cutler

I think what I would say on that subject is the big peak in the market was late last year and early this year when capacity was tightest so I would relate it much more to a kind of capacity issue. I would say it is nothing abnormal for this part of the cycle.

Operator

The next question comes from the line of Christopher Glynn - Oppenheimer & Co.

Christopher Glynn - Oppenheimer & Co.

I am just wondering you can gauge or if you have any thoughts around if any of this looks more like alternative funding for some projects that might have happened anyway?

Alexander Cutler

I think a lot of people have asked that question and it is very hard to be definitive. I would just state from having seen a number of the projects that either we have won or that are being bid, we have seen many of these projects before and they weren’t any projects that didn’t get funded. So this isn’t going to make you feel good as a tax payer but may make you feel good as a shareholder. Many of these projects fell below whatever the hurdle rate was for getting funded and they are getting funded now. I would say those will not be pull-aheads because they just weren’t going to get funded. There are some you have to say people have found an alternative source of funding and it is very hard to try to parse through exactly what that balance is.

Christopher Glynn - Oppenheimer & Co.

On the bookings you had down 33 electrical Americas last quarter. Can you talk about the flow between your reported revs and the bookings, what portion of the business that really speaks to?

Alexander Cutler

Those bookings they are 100% analogous to the business wins. So the only place you end up with a big disconnect between timing is in some of the longer projects business and again I think the way to think about that is approximately 40% of the business; some of this longer assembly type business. The general direction I would hope you would take away from it is we are seeing these long cycle markets particularly for the electrical Americas business, that being non-res construction, decline through 2009 and we believe it will decline in 2010 again. That is consistent with what we have said. But the short-cycle business whether it be single phase, power quality, residential, whether it be on the industrial side, we would expect to start to see increasing. In fact you have seen some I would call minorly encouraging numbers around residential after a period of time that has seemed like it has been hard to remember the last time it was up. That is the balance we think we will start to see develop here.

Christopher Glynn - Oppenheimer & Co.

Some directionality and magnitude of pension into 2010?

Richard Fearon

Again it is highly dependent upon the assumptions one wants to make as to where the discount rate ends up and what the final return on the pension plan is. The return, as you can imagine thus far in 2009 is quite good given how the equity markets have rebounded and given our 85% roughly equity weighting. It really is premature to come up with an estimate at this point.

Operator

The next question comes from the line of Mark Koznarek - Cleveland Research Company.

Mark Koznarek - Cleveland Research Company

A follow-up with regard to electrical Americas, the short cycle businesses that are showing some signs of life, how did they perform in the quarter? How much better were resi and single phase relative to the overall markets down 20?

Alexander Cutler

We don’t break out the individual pieces. I will tell you they were positive numbers versus where we were in the second quarter so we think we are starting to see some uptick.

Mark Koznarek - Cleveland Research Company

Positive meaning less negative year-over-year?

Alexander Cutler

Growth from where we were in the second quarter.

Mark Koznarek - Cleveland Research Company

But they are still down pretty sharply, double digits I imagine?

Alexander Cutler

No question.

Mark Koznarek - Cleveland Research Company

So we are talking about just sort of a bounce off the bottom?

Alexander Cutler

I think that is the right way to think about it. We are in the early phase of that recovery and at some point we will see them cross the point where they were in their high tide but we are nowhere near to that.

Mark Koznarek - Cleveland Research Company

The reduction in force benefit in 2010, what kind of assumption is that built around with regard to your absolute headcount? Is that on a flat headcount basis or is there an underlying add back to headcount based on some expectation of volume recovery?

Alexander Cutler

That is assuming basically flat with where we are now. Remember again built into that $225 million savings is this one week off per quarter for employees without pay. We essentially have about a month of capacity in the company just by people taking one week off without pay. We think we can handle quite a bit of an upturn without having to increase employment levels.

Mark Koznarek - Cleveland Research Company

So that is the answer to why you didn’t change that savings with regard to your 2010 economic assumptions going up? IP going up and therefore you have to build more stuff?

Alexander Cutler

We can build more stuff with our current headcount. That is exactly right.

Operator

The next question comes from the line of Dan Dowd – Sanford Bernstein.

Dan Dowd – Sanford Bernstein

Let’s assume you get the GDP growth and the industrial production growth in page 19 in 2010 as you talk about. Does that imply you would need to start building inventory in your own system in Q4 or would that need to start to start to build inventory wait until 2010?

Alexander Cutler

I think the latter without having laid out next year. We would not anticipate an inventory build here during the fourth quarter. If I can add one other comment, please keep in mind I think this relevant question about we have peeled a lot of capital out of working capital. How much do we have to put back in? I think it is relevant to be thinking about the fact that as of the end of the third quarter our days on hand are 13 days lower than they were at the end of last year and we would not expect our days on hand to go back up. We will enter this next cycle with an even more efficient working capital model.

Dan Dowd – Sanford Bernstein

So in effect you would expect your own inventory rebuilding process to be much more muted and presumably your customers as well?

Alexander Cutler

I can speak for our own because I know what we have accomplished. I think people will be cautious in terms of rebuilding inventories. I think the real key is which firms have demonstrated in a period of contracting volumes that they would actually reduce their days on hand. That is normally when those statistics explode. In our case we were able to bring our inventories down in real dollars but also in terms of the days on hand. I think that is a particularly important achievement this year.

Dan Dowd – Sanford Bernstein

One last thing, as you think about the ways in which you have taken out cost, one way is you have simply reduced the cost structure across the world roughly uniformly. Another way you could reduce it is you could systematically cut far more costs in high cost, high tax markets and much less so in lower cost, lower tax markets which would imply across the next up cycle you would presumably be even more flexible than you are now. Have you taken out more costs structurally in the high cost, high tax markets than you have in other places in the world?

Alexander Cutler

I think a way of answering that is we believe the developing nations will continue to grow more quickly than those so called “developed” nations. The U.S. being a surrogate for that as we have had to align our resources in line with what our future expectations for growth are in the U.S. So without having approached it exactly the way you mentioned in your question I think it ends up with somewhat the same result.

Operator

The next question comes from the line of Ted Wheeler – [Buckingham Research Group].

Ted Wheeler – [Buckingham Research Group]

On some of the end markets you talked about, the NAFTA forecast for truck, I just wonder what do you think production for North America and Europe auto build will be. What do you think that will be next year?

Alexander Cutler

We haven’t put out a forecast but I would say that our thinking leading to the forecast we will share with you in January is you have probably seen more pull ahead in Europe in the passenger car market because of the so-called Cash for Clunkers types of programs in Europe have been going on for much of the calendar year and in some cases are being continued. We think the magnitude of that stimulation which led to less of a decline over there means that you are likely to see much less of a positive growth number going into 2010 in the passenger car markets. Here in the U.S. we don’t think the pull ahead was so large in terms of numbers of vehicles so we think there will be positive growth in the U.S. light vehicles growth next year.

Ted Wheeler – [Buckingham Research Group]

It sounds like the way you phrased it that Europe might be up a little bit, likely not down next year?

Alexander Cutler

We don’t think there is going to be much growth in Europe next year. That is for the auto light vehicle market.

Ted Wheeler – [Buckingham Research Group]

The other question I have is on aerospace you have a lot of new programs coming and you are spending some money. I wonder if you could just kind of give us an indication of the spending levels on the new programs next year versus this year and the timing of when revenues on some of these new programs starts to show up?

Alexander Cutler

We don’t break out specific spending on individual programs.

Ted Wheeler – [Buckingham Research Group]

I just meant in the aggregate. Your spending on let’s say an index of 100 on new programs in 2009. What do you think it would be in 2010?

Alexander Cutler

That gets to be pretty confidential information as you can imagine in terms of competitive information. I will tell you though that you will begin to see in many of these programs we have been spending quite a bit on over the last 4-5 years start to come to market this next year and clearly one of the most important of them is the joint strike fighter program which really begins its ramp now and that one you are watching projections of that change on a regular basis. It seems to be one of the programs that is holding up quite well in terms of its funding. You have seen 787 get moved out so it is not going to be a big impact for next year but I would really be looking at some of these programs like joint strike fighter as going to be what really starts to drive the boat for us in our aerospace segment.

Ted Wheeler – [Buckingham Research Group]

That will be moving up in revenues right from the get go in 2010?

Alexander Cutler

The numbers are up but it will start to increase in 2010 but the real ramp will be in 2011 and 2012 but 2010 will be substantially above where we were in 2009.

Operator

The next question comes from the line of Elliott [Pritchard] – No Company Listed.

Elliott [Pritchard] – No Company Listed

Bookings in rest of world, would you mind sharing that number? You gave it last quarter.

Alexander Cutler

Our challenge on bookings in the rest of the world and frankly it is one of the reasons we didn’t quote it this quarter is that our data isn’t quite as detailed as we had in the U.S. and we would like to work on that data a little bit more. The business is clearly down from where we were, as I mentioned, a year ago. Down some 28%. That is a pretty good surrogate for what happened in bookings as well.

William Hartman

Thanks everybody. As usual, I will be around for the rest of the day to continue to answer your questions. Thanks for your participation.

Operator

Ladies and gentlemen that does conclude our conference for today. Thank you for your participation and for using AT&T Executive Teleconference. You may now disconnect.

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