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Rockwell Automation (NYSE:ROK)

F4Q06 and Full Year 2006 Earnings Call

October 23, 2006 5:00 pm ET

Executives:

Tim Oliver – Vice President, Treasurer

Keith Nosbusch – Chairman, Chief Executive Officer

James Gelly – Chief Financial Officer

Analysts:

Bob Cornell – Lehman Brothers

Mark Koznarek – Cleveland Research Company

John Baliotti – FTN Midwest Securities

Scott Davis – Morgan Stanley

John Inch – Merrill Lynch

Jeff Sprague – Smith Barney Citigroup

Steve Tusa – JP Morgan

Presentation

Operator

Thank you for holding, and welcome to the Rockwell Automation quarterly conference call. I need to remind everyone that today's conference is being recorded. Operator instructions. At this time, I would like to turn the call over to Tim Oliver, Rockwell Automation's Vice President and Treasurer. Mr. Oliver, please go ahead.

Tim Oliver – Vice President, Treasurer

Good afternoon and thank you all for joining us for Rockwell Automation's Q4 2006 earnings release conference call. We did deviate from our typical process this quarter by holding our call this afternoon after the market closed. We needed to do so because we needed to work around our Automation Fair, our annual Automation Fair that starts early tomorrow morning. We appreciate your flexibility very much. I also want to mention that the investor conference that at one time was tentatively scheduled to occur at the Automation Fair will be rescheduled at a later date that minimizes the conflicts for all those involved and we'll obviously keep you posted. It's likely we will defer that until after the January earnings season.

Our results were released this afternoon and have been posted to our website at www.rockwellautomation.com. A webcast of the audio portion of this call and the charts that will be referenced during the call are both available at that same website. These will remain there for the next 30 days. With me today are Keith Nosbusch, our Chairman and CEO, and James Gelly, our CFO. Our agenda for today includes some opening remarks by Keith and then James will walk us through both the quarter and the outlook. We'll leave plenty of time at the end of the call to take your questions and again ask that you limit yourself to two questions per participant.

This call is expected to last a little less than an hour. As always with these calls I need to remind you that our comments today will include statements relating to the expected future results of the Company and are therefore forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Our actual results may differ materially from our forecasted projections due a wide range of risks and uncertainties that are described in this earnings release and are detailed in our other SEC filings. With that, I'll turn the call to Keith.

Keith Nosbusch – Chairman, Chief Executive Officer

Thanks, Tim. Good afternoon and thanks for joining us today. Q4 capped another very good year for Rockwell Automation. In the quarter we delivered 9% organic revenue growth with particularly strong performance in Europe. We posted conversion margins that improved substantially to well inside our targeted range of 30 to 40% and we generated free cash flow in excess of net income. Beyond our performance metrics, there were also a couple of other important takeaways from our fourth quarter.

First, this quarter again illustrates that extrapolating any previous quarter's result is not a good way to predict our future results. While Q3 delivered very strong top line growth and less impressive conversion margins, Q4 shows lower revenue growth but very strong productivity-led conversion margins. Taken together, the results are very consistent with our expected performance. As we have described many times over the last couple of years, while we are confident in the ability of this business model to deliver results over time, the composition of those results in any one quarter are harder to call.

Second, it is another proof point that our pure play business model is both durable and flexible. In Q4, intensive productivity efforts were sufficient to offset the continued dramatic correction in our traditional US automotive market and the related tough product profitability mix, especially Logix and PLCs. This organization lives through periods of acceleration and deceleration that cause oscillation around a longer term trend. This variability causes us to work harder every day to both expand the breadth of things we can control and to better execute on those things we already can. Today, we have more levers and we use them more effectively. We have more degrees of freedom than we've ever had. Our revenue base is more diverse, both geographically and by industries and applications we serve.

Our technology portfolio with continuing innovation is in a leading position. Our products are differentiated and our productivity maturity path is hitting the sweet spot where the more you do, the more opportunities you see. We have and will continue to dedicate more talent, resources and energy to a productivity culture that has accelerating momentum and impact.

As I said earlier, this was a very good year for Rockwell Automation and while I typically leave the charts for James, I would like to reference the first chart in the materials we posted to the web. This chart summarizes our full-year results. I don't intend to walk you through all the numbers on this page, but before we launch into a more detailed dissection of both Q4 and 2007, I did want to pause for a second. The numbers on this page depict a very successful company by any measure. The 7% growth in Europe is important not only because it reverses a trend of many quarters of flat revenue, but it is also the best example of the power of our reinvestment model. The initiative was simple, reduced G&A expense strategically redeployed to customer facing resources to capture carefully targeted share gain, and the results were very impressive.

The 6% productivity number is extremely important. Productivity is an essential lever in our model. Terrific working capital performance improved turns by about a half a turn and all of these things combined to drive our ROIC up nearly 4 percentage points to 22%. This company, led this year by our power centric businesses, has performed exceptionally well, has exceeded its commitment and is in great financial shape. Our results are a credit to the focus and hard work of employees around the world. Enough said. That's all the time we have for reflection and I can tell you that our leadership team is too busy to spend much time looking back. The number of things that we still have to work on leave no room for complacency.

We continue to stretch this organization to do more and to do it faster in both expanding our served market and enhancing market access. I am still not satisfied with the growth rate in integrated architecture. We still do not have sufficient traction in the consumer facing verticals and we need to generate more consistent and uniform growth across the entire Asia region. We have invested heavily in each of these initiatives and we are waiting to make any further significant investments until we see the returns we expect.

For 2007, as James will elaborate, we have laid out a balanced plan. For us, this plan raises expectations for execution, accelerates the pace of change and requires a continued sense of urgency. As for our shareholders, it furthers our commitment of driving longer term value creation. This plan has been translated into preliminary guidance that we have provided today. We look forward to getting back to you with more specific guidance once we have more clarity on the Power Systems divestiture and what the post-Power-Systems Rockwell Automation will look like. With that I will let James walk you through some of the details on both the quarter and our outlook. James?

James Gelly – Chief Financial Officer

Thank you, Keith, and again, thanks to everyone who dialed in. Let me go to the next slide, which is entitled Q4 results summary, which shows the Q4 income statement. Starting at the top left, revenue was $1,453.7 million, as Keith said an increase of 9% over 2005. Segment earnings were $270.2 million, up 26% YoverY. A quick calculation will show that conversion margin on the incremental dollar of sales was 48% YoverY. Adjusting for higher pension and option expense this year, as well as the $21 million in restructuring we took last year, conversion was about 39%. This is better than we had last quarter and inside the range of 30 to 40% conversion that we'd been targeting.

As Keith mentioned, this was produced despite a significant decline in our traditional North American automotive business which was a good bit worse than we talked about last quarter. At nearly 50% the drop in this business cost us about three points of top line growth at Control Systems, about three points of growth in overall US sales, and because our book of business in that district is very rich in terms of Logix and PLC products, it cost us about 5 percentage points of YoverY conversion. Going forward, we're not looking for any real improvement. I guess the best that can be said right now is that automotive will have a smaller and smaller negative impact on our quarterly comparisons beginning next quarter.

Walking down the page further, you'll note that general corporate net was an expense of $24.2 million, up about $10 million YoverY and this is primarily due to the inclusion of stock option expense and lower interest income. On the next line entitled gain on asset sale, you can see a $19.9 million pretax gain. As you may recall in the quarter, we completed the divestiture of our 50% interest in Rockwell Scientific. The other half is owned by Rockwell Collins and we both sold out to Teledyne. This transaction resulted in a $0.07 gain and we received our half of the proceeds and our half was $83 million in cash during the quarter.

Moving down the start, you can see that interest expense was up due to higher interest rates and higher short-term debt balances and when you see our 10-Q you'll see that we had about $219 million in outstanding commercial paper at the end of the quarter. Let me turn now to the income tax line where we have had a lot of variability this year.

When you do the math on this line, you'll calculate a fourth quarter tax rate of about 26%. This quarter's tax rate included a $14.4 million one-time tax benefit and if you excluded that, the Q4 rate was about 31%. When you see the full-year tax rate for 2006 it's going to look like about 29.5% but making the same adjustment, that is removing the $14.4 million one-time benefit in this quarter, brings the full-year rate to about 31% as well. Both of these results are below the year ago results and, as I said, our tax rate this year, both guidance and actual, has moved around a bit.

So if you look at the matter from 50,000 feet, just for a minute, Rockwell's effective tax rate is in the process of declining and this is because the rising proportion of non-US taxable income in our total. Since many of our overseas markets have tax rates that are well below the combined US, federal and state tax rate, this globalization is acting to lower our blended average rate and that's a good thing and reflects a lot of effort by many people across the Company. Looking out over 2007, 2008 and beyond, we see an effective tax rate no higher than 32% as a result of the rising proportion of non-US taxable income.

Let me now drop down to the line entitled change in accounting. As you can see, this quarter's reported earnings also included an $18.1 million pretax charge for the adoption of FIN47. Other companies on calendar end fiscal years adopted this accounting change last December and it basically represents the long-term obligation to decommission assets like real property. That brings us down to diluted EPS from continuing operations before accounting change of $1.04 but you should probably think of this quarter's EPS as about $0.88-0.89 a share when you remove the accounting change, the gain on the asset sale and the tax item. For the record, that compares with about $0.69 in the year ago quarter.

And finally, down at the bottom, you can see average shares outstanding in the quarter were 176.7 million shares, a 4% reduction from a year ago. During the quarter we got busy and repurchased 5.3 million shares. Let me now go o to this next slide which is entitled EPS from continuing operations YoverY.

Since we are a full-service investor relations shop we stuck in a couple of waterfall slides to help you with all that goes in and goes out this quarter. This chart shows how Q4 EPS walks from last year's Q4 to this year. You can see on the left the effect of higher volume and margin expansion, about $0.20 per share, or 29 percentage points of EPS versus last year. Earnings were also aided by a lower share count and to the right you can see the other items that affected YoverY results including the one-time gain in accounting change that I already mentioned.

Let me go to the next slide which shows the same thing but walks sequentially from our Q3 results to Q4. Sequentially, higher volume and margin expansion added about $0.03, or 4 percentage points of EPS growth. Like the prior slide on the right, you can see the impact of share count and tax rate and so forth. Hopefully these two slides will help you get a little more clarity about a complicated quarter. So let me move on to our traditional Q4 results Rockwell Automation which shows total Rockwell results over the past five quarters. As I said before, organic revenue growth was 9% YoverY, or about 7% excluding the favorable impact of currency translation. Sales were up 2% sequentially.

From a regional perspective as you'll see more shortly, growth was led by Latin America, Europe and emerging Asia. Over on the right hand side of the chart, operating margins expanded by 2.6 points to 18.6% margins. You can't see it on the chart but our trailing Q4 return on invested capital was over 22% and that's up 4 percentage points versus the year ago average. Let me go to the sixth slide which is titled Q4 results control systems. As you can see on the left, sales were $1,188.8 million, up 8% YoverY, sequential growth was 2%. Logix sales in the quarter were up about 12%. As Keith said a minute ago, Logix was heavily impacted by the sharp decline in automotive markets and would have been a lot closer to 20% growth without the heavy cutbacks in automotive projects.

Our legacy PLC sales were down about 13% in the quarter, more than we had been projecting. Remember that Logix is now about twice the size of legacy PLC sales. Like Q3, our Q4 was probably one of our worst in terms of mix, with must slower growth in our most profitable products. However, as Keith said, this quarter's margins and conversions show the impact of more aggressive cost productivity. In total, we executed about 6% total productivity in the quarter and that is the result of very heavy focus across the board. Rockwell is coming down the learning curve in terms of broadening and accelerating cost reduction efforts and this will come in handy as we work to sustain this kind of performance quarter in and quarter out.

As I said last quarter, we're managing to live through these tough comparisons. And again, the best that can be said is that we're rapidly diversifying the markets and geographies we serve and demonstrating improved operating flexibility. You look over on the right hand side of the chart, operating earnings were $228.6 million, representing margin expansion of nearly two points to 19.2%. Control Systems earnings benefited from a combination of volume leverage, productivity and price, partially offset by inflation and the mix that I've just described. I should point out that also affecting YoverY comparisons were the $16.5 million of restructuring charges taken last year in Q4. You should probably net that against the $9 million in higher pension and option expense this year.

Let me turn to the next slide which covers our Power Systems business. As you can see on the left, sales were $264.9 million, up 15% YoverY and up 1% sequentially. As you probably know, the end market served by Power Systems continue to enjoy strong momentum driven by high energy and resource prices and probably some degree of under investment in past cycles. We think the outlook for these businesses is very good. Look at the right hand side, you can see that margins expanded more than six points to 15.7%. If you exclude the $5 million facility closure charge taken in Q4 last year, margins still expanded by nearly four full points. Both Dodge and Reliance continue to benefit from a combination of volume leverage, balanced price, cost dynamic and ongoing productivity initiatives.

Since it's on everybody's mind, I should say that the divestiture process is going well. We're pretty much on schedule and the current thinking is that if we stay on schedule, the deal can be done by December's end. Let me leave our segment results and turn to the next slide, which covers geographic breakdown of our fourth quarter sales.

On the far right of this slide, you can see organic growth rates excluding the impact of currency translation. As you can see in the chart, we had a pretty strong mix of overseas sales in the quarter. The US and Canada came in at 4% growth, and as I said earlier, we think business in our traditional Great Lakes territory in the US and Canada probably cost us three points of growth in the quarter. This has historically been our stronghold in terms of installed based but we're seeing much better growth and momentum in the western districts and in most of the south. Latin America sales on the other hand were up 22%, with continuing strong performance throughout that region. Dropping down to Asia Pacific, sales were up 10% with revenue in China, India and southeast Asia up more than 20 combined. Compared to these emerging Asia countries, our results in the more mature developed Asia were not so impressive.

Our 10% average for the quarter gives you some idea of how different the results are. Asia will continue to be a heavy focus for us and we're working to sustain a healthy growth rate across the region. Last but not least, our European sales were up about 15% in the quarter. This is a nice development and continues the progress that you saw in the last couple of quarters.

As you may recall, Europe was our largest single growth investment over the last few years, and as Keith said, we basically took cost out of the back office and reinvested every dime into targeted market share growth. This growth this quarter is a welcome tailwind that we're proud of the team's execution in Europe and we're optimistic that we'll see continued momentum there, especially since there appears to be some improvement in macro economic factors. Let me turn now to the chart entitled Q4 results cash flow walk, which gives detail behind our Q4 and full-year cash flow. Starting on the lower left, we had $232.8 million of free cash flow in Q4, which is well in excess of net income.

Working capital was a $64 million source of cash in the quarter. Moving to the far right column, almost the biggest thing on the page is the $472 million in voluntary pension contributions we made during fiscal 2006. We are now basically fully funded and we're working hard to stay that way. For the full year, working capital was $39 million, but I should point out that this is about a 3% increase in net working capital as compared to a 9% YoverY increase in sales. So we're working to maintain the level of continuous improvement going on here with a goal of continuing to ratchet up our working capital turns.

Capital spending for the full-year was $150 million, about 100% of depreciation and amortization and apart from selected investments to globalize some of our business units and, of course, our SAP investment, we believe we can sustain our asset light business model and keep capital spending to 3% of sales or less. Looking at the lower right, full-year free cash flow was $323.5 million. But excluding the after-tax impact of the pension contribution, cash flow was pretty close to 100% of net income.

Let me go to the chart entitled preliminary guidance headwinds and tailwinds, and these are basically the assumptions that went into our 2007 operating plan. We start on the upper left with revenue headwinds. While we expect growth to continue, we are planning for a deceleration in the US industrial economy. To pile too much more on top of automotive at this point would be overkill but we do expect weakness to continue in the traditional North American consumer durable space in 2007.

Moving down the chart, Asia, where we are intensely focused, there could be a continued headwind from the slower growing developed Asia countries. This outcome is largely within our control and we're working to improve execution but 2007 may look a lot like 2006. As you can see from our Q4 results, we experienced slower growth in our integrated architecture platform as we exited 2006. The goal of continuing to compound an ever larger revenue base at a 20% rate is a stretch assignment for our sales, solutions and marketing organizations worldwide, but an achievable one we think. Still, we're entering 2007 with a somewhat slower momentum in integrated architecture growth and that can be a headwind.

You go to the lower left which are earnings headwinds starting with inflation, we'll still face cost inflation and for planning purposes, we didn't assume the same kind of price pass-through that we got in the last year or so. Moving down the chart, we have not approved any significant incremental growth investments since mid 2006, but we will face the full-year run rate from the investments we approved during the first half of 2006. Right now we're focused on getting the maximum payback from last year's investments rather than making any new ones. Before all theses headwinds start to seem like wind shear or something, let me spend a minute on the right hand side of the slide on tailwinds.

First on the upper right, revenue. On the plus side, as we mentioned earlier, we believe revenue growth can continue at healthy rates in Europe and we're working hard to keep the momentum going there. We also expect to see the top line benefit from our initiatives, the ones that we talked about to expand our market presence, such as batch hybrid, integrated motion, safety, our focus on the global machine builder channel and others. Differentiated technology, deep domain expertise are the true drivers of our growth and we think that's what makes the business model such a strong one. Of course, we've invested heavily also over the past several years to build a market presence, build and improve our market presence and develop channel partners in emerging markets, Asia, Latin America, central and eastern Europe. As you saw in the quarter, these should help us to drive organic growth and raise the average going forward.

Looking at the lower right, earnings tailwinds, earnings will continue to benefit from the numerous cost productivity initiatives we've launched across the enterprise. As I said earlier, we're quickening and intensifying cost productivity and we’ve brought on board some of the best people in manufacturing in six Sigma and we've never had more energy and expertise applied as broadly in this area. As we've described in the past, 2007 will also benefit from lower pension and retiree medical expense. This is due to both the lower discount rate which we set last June, which we use to calculate future obligation and a little bit from a full-year effect of having a fully funded plan.

Volume leverage: our business model is capable of generating solid conversion margins on incremental sales as you can see in a quarter like this one. The planned volume growth in 2007 combined with our strong productivity focus should mean solid operating leverage in 2007. Lastly, EPS will benefit from a lower share count. As I mentioned, we had about a 4% reduction in average shares outstanding this quarter YoverY.

That brings me to my last slide, 2007 summary guidance. Before I go into the details, let me explain why we're calling it preliminary guidance. It's based on the company as it exists today, that is, as though we owned the Power Systems for the whole year. And why assume that? We are feeling comfortable with the deal time line, but there are still many unknowns surrounding the Power Systems divestiture, including timing of the transaction, the after-tax proceeds, the use of cash, but you should assume the share repurchase is the default mode, and we don't know the timing of share repurchases or, obviously, the weighted average price so we don't know the level of pro forma dilution from the divestiture with any exactness.

We also don't like making diluted divestitures so we're working on plans to mitigate dilution but we're not in a position to say much about that today. In short, we will know a lot more in 90 days. When we come back to report first quarter earnings in 90 days, we'll have a lot more data on all the things I mentioned and can refine our guidance at that time. So having said all of that, our full-year organic revenue growth is forecast at 7 to 8% and we expect that both Control Systems and Power Systems will be in this range. Now this comes after three years of double-digit organic revenue growth, but for 2007 we are expecting growth rates more in line with our long-term averages. 7-8% would be the net impact of our heavy focus on growth across regions, products, verticals, channels, balanced against slower US and Canada growth rates and due to the tough conditions in our traditional consumer durable space.

Moving down the chart, we expect conversion margin to be in our targeted 30-40% range. Taken together, with ongoing share repurchase, these should produce diluted EPS between $3.70 and $3.90 in 2007. You can probably compare these with the 2006 diluted EPS, excluding the Q4 investment gain and tax gain, which comes in around $3.35 a share. So using $3.35 as a base, $3.70 to $3.90 earnings per share would mean about 10-15% EPS growth in 2007. In terms of free cash flow, 2007 should be about equal to net income. Finally, we expect to sustain our high return on invested capital in 2007 and beyond. I know this been a lot of data so let me conclude. I'd like to summarize by saying that a combination of solid organic growth, relentless productivity, strong cash flow should make for another good year in 2007. As a management team we're very focused on execution and, of course, on maximizing shareowner value. Thanks for your patience and now we'd be happy to answer any questions you might have.

Question-and-Answer Session

Operator

Operator instructions. Your first question comes from Bob Cornell – Lehman Brothers.

Q - Bob Cornell – Lehman Brothers

I guess the first thing I would wonder is how this quarter would differ from what you anticipated when you reported the July quarter? I mean at that point you expected the automotive business to be down 50%, the contribution margin to be 25%, so forth and so on. What really was different in this quarter relative to that expectation?

A - Keith Nosbusch

I think two things. First was that we were not surprised by the overall level of growth in the quarter but we were pleasantly surprised with the very strong results in Europe. Unfortunately, those were offset by an even more dramatic correction in our traditional automotive installed base than we predicted. So I guess I would say that the Detroit phenomenon migrated from not just the Detroit-based OEMs, but to also the supply chain and the broader automotive supply chain in the Great Lakes states, as well as Canada. And so I would say that was weaker than we had thought when we talked about it. We thought it would be pretty similar QoverQ and in fact it wasn't. And then finally, I would say we were also very pleased with the drive in productivity that we were able to accomplish. I would say that the last time we talked in quarter three, quite candidly, we probably felt a little more victimized by the activities in the automotive segment. I think the management team really put their heads down and worked very aggressively at driving productivity, doing that in the SG&A lines as well as the cost of goods sold and really ended up with a much more positive contribution and participation from productivity than we had in Q3 and were able to offset even a weaker revenue line in some very rich margin mix businesses with that productivity. So I would say positive Europe, positive productivity, more negative automotive market and the supply chain around the automotive segment. So that would be how I would characterize it, Bob.

Q - Bob Cornell – Lehman Brothers

That does flush it out. One other thought, though, I mean you mentioned the momentum in the integrated architecture platform. Could you give us some more color on what you see going on there? Is it macro economic? Is its industry specific? Geographic? Big, small projects? I mean what's causing that comment about the momentum in the IA platform?

A - Keith Nosbusch

I think the biggest comment would be simply a very hard comparison. If you remember last year in Q4, we had very, very strong Logix growth, as well as basically zero degradation in the PLC business so it was a very, very tough quarter. The positive aspect was we still saw 2 to 3% sequential growth in the Logix platform. So I would say the tough quarter comparison in addition to the need to drive a little hardener the mid range part of that product portfolio on a global basis, and that's an area that we're very focused in and certainly the impact of the auto projects took a little steam out of a traditional strong contributor. So those are a little more of the pieces of that, Bob.

Q - Bob Cornell – Lehman Brothers

Could you just explain what that means in terms of order rates and book to bill? Earlier this year you talked about your salespeople were just thrilled about the business and activity level in the channel. Are they just as thrilled or are they taking some time off?

A - Keith Nosbusch

Well, I think everyone is just as thrilled on the product portfolio and, in fact, probably more excited with the capabilities that we have now in the batch, hybrid space, the introduction of integrated safety and the ability to have another price point in the mid range products. So I don't think it's the enthusiasm for the portfolio.

A – James Gelly

Let me try and add to that. You asked about book to bill, Bob. I think in the case of a Logix project, you should think about this is something that in some cases takes three months, five months, as much as 11 or 12 months to get from the beginning of the engineering study to the actual order of shipment and so the book to bill is basically a hard concept to apply to the Logix business. But it's fair to say that you had a downdraft in big projects, certainly, to Keith's point in the traditional wheelhouse in the Great Lakes area and offsetting that is smaller projects, both globally and in other places and, in particular, going in the compact Logix front which is at a, call it a more higher volume, lower price point type of project. So it's, I would call we're in the midst of the adjustment process but hopefully that's helpful.

A - Keith Nosbusch

Bob, I guess the only other comment I'd make on that would be during the year, we've added a number of sales resources specifically focused on the architecture. Those take a little bit of time to come up to speed and contribute and I would say we're in the early stages of some of those. We're getting the benefits of what we did a year ago in Europe. We probably still have more of an opportunity to get that benefit in Asia going forward than we've seen to date. So it's back to what James talked about which is the ability of the timing of the investment and getting the benefit of that investment in a short period when a lot of the work is around projects as well as the training and getting the productivity up to speed of those new hires.

Operator

Your next question comes from Mark Koznarek – Cleveland Research.

Q - Mark Koznarek – Cleveland Research

Just a clarification to start with. Last quarter I recall James took us through a little bit of a tax walk and I thought that we were supposed to have a relatively high reported tax rate in the 37 or 38% range. So what happened there beyond this $14 million of tax gain?

A – James Gelly

That's a good question, Mark. If you look just at the Q4 mix of revenue, which as you can see is up 3 or 4% U.S. and is up on average for the non-U.S. part of the company 10%, and you add that to a lot of the work that's going on to move a lot of our businesses to more global structures, we've basically reached sort of a tipping point and the originally anticipated effective tax rate for 2006, which you correctly mention a high rate in Q4, that was in order to reach something that originally was in the 33% effective tax rate for 2006. And as you can see, what we're telling you is that the effective tax rate for 2006 ultimately came in closer to 31 and is almost entirely driven by the rising proportion of non-U.S. taxable income. So it's, I would say, we've been battling to some degree a structure and revenue base in the Company which is very U.S. taxable centric. People have been working for several years now to change that stance. And with some of the success of growth initiatives and some of the faster growth outside the United States than inside the United States, we have driven the kind of blended average tax rate down and you're seeing that coming to fruition in the form of this Q4 rate and the rate for the year.

Q - Mark Koznarek – Cleveland Research

Thank you for clarifying that. The question I've got is with regard to the automotive and related supply chain outlook because it seems like a quarter ago I got the impression your expectations for Q4 was similar kind of shortfall from the third quarter but it looks like it's two or three-fold the degree of decline and so embedded in your 2007 outlook, what is the sort of the new understanding or new expectations from automotive? What kind of headwind is the absence of that expected to provide? Because I think a quarter ago we were kind of brushing that aside that it'd all be concluded by the end of this quarter but it seems much more severe.

A – James Gelly

I think the range of outcomes as we look at automotive in 2007, you know, it's kind of a knock-off another point or two, as we point out, it was as heavy as three in Control Systems and three in the United States. I don't think it'll be that bad in 2007 but it probably is a point or two of the average for that reporting segment and region.

Q - Mark Koznarek – Cleveland Research

Okay. That's for the full-year and I presume a similar kind of incremental margin on that shortfall?

A – James Gelly

It certainly as I said before, it's of declining importance but it's not turning into a positive that we can see over the planning horizon. So it's getting smaller and smaller but yes, it's got pretty good mix.

Operator

And your next question comes from the line of John Baliotti - FTN Midwest Securities.

Q - John Baliotti - FTN Midwest Securities

A question, it looks like if we run out Detroit, just to clean that up through 2007 given the declines, it would look like Detroit's going to be something like less than 2% of sales in 2007, less than the second half, maybe a little bit closer to 2% in the first half. I was wondering if we could maybe focus on some other end markets that are bigger percentages of your revenue and maybe what kind of growth rate you saw in some of those other end markets this quarter?

A - Keith Nosbusch

Sure. If we look at the quarter four, we had very strong growth in oil and gas, semiconductors, mining aggregates and cement and the life sciences. Those were all around 20% growth. If we look at the full-year, oil and gas, mining, aggregate and cement, water, wastewater and semiconductor were all above the Company average, well above the Company average. Food, beverage, the home health and beauty and the life sciences grew in the mid to high single-digit range and automotive was about flat. So some good performance across a number of the vertical industries that we are focused on.

Q - John Baliotti - FTN Midwest Securities

James, you mentioned in the headwinds on slide 10, investment spending effects of 2006 growth. Is there a way to give us a sense of just magnitude year-over-year, 2007 over 2006, sort of maybe the dollar or maybe earnings delta that you're talking about?

A – James Gelly

I guess I would say the full-year impact of the increment, that is the run rate for the full-year, is probably I'm going to say it's not a point of revenue. You know, it's probably in the half to a point of overall revenue there.

Q - John Baliotti - FTN Midwest Securities

Okay. So versus 2006 over 2005 it's a lot less?

A – James Gelly

Yes.

Q - John Baliotti - FTN Midwest Securities

Okay. And then just to finish one last on your assumptions in the guidance with respect to pension, can you give us sort of a high altitude delta what you think that that's going to be versus 2006?

A – James Gelly

You know, we probably have a $40 million improvement in pretax related to the whole company look at pensions, just from the lower discount rate and the fully funded plan.

Operator

And your next question comes from the line of Scott Davis - Morgan Stanley.

Q - Scott Davis - Morgan Stanley

I just want to clarify guidance a little bit. If we look at the $3.70 to $3.90, not to be nitpicky here but you commented that that included Power Systems revenues and profit for full 2007. Did I hear that correctly?

A – James Gelly

Yes, you did.

Q - Scott Davis - Morgan Stanley

Explicit if it's somewhat dilutive to sell Power Systems, I guess it depends where your stock price is certainly, that guidance would be adjusted appropriately afterwards?

A – James Gelly

Let me try and go through that again because you're right, it is fair to say that the points that we're trying to make is I don't know the hour in which the transaction will close. So I don't have the exact timing. I don't know the proceeds within any tolerance that I'd like to talk about on this call. I don't know the timing of the share repurchase. I don't know the price at which I repurchase the stock and as I said before, we don't like making diluted divestitures so what we'd like to do is take 90 days to figure out how to minimize the amount of dilution that's obviously got a component to it which involves figuring out what the right level of SG&A and other things are. So that's a lot of variables and what we're sort of saying is for now, you could leave it in the guidance and assume that in 90 days we'll get back and be a lot smarter on all those variables and including what I can do to mitigate the dilution.

Q - Scott Davis - Morgan Stanley

I understand. And maybe Keith, not a fair question necessarily, but when you just talked about the strength in the verticals, a lot of those key verticals, particularly things like oil and gas are businesses that's are primarily for the Power Systems business. When you think about excluding Power Systems and excluding those businesses, clearly you're comfortable with the 7 to 8% outlook that you've laid out for Control Systems but maybe you can talk specifically about which of those verticals you see as key drivers.

A - Keith Nosbusch

Sure, sure. For fiscal year 2007 I'm assuming you mean.

Q - Scott Davis - Morgan Stanley

Yes, forward-looking.

A - Keith Nosbusch

First, just to make sure we all have the same perspective, 40% of Control Systems serves the power centric industries that we talk about so it is not a Power Systems only story and it's a very important part, which is one of the reasons we talked a lot to the community about intelligent motor control and our capabilities in that area and how we linked that to the integrated architecture and asset management and the whole support of the plant floor environment. So we have a very strong power centric portion in the Control Systems business. It's not 100% like in Power, but it's a very important part of our business and we had some great growth across those businesses this past year. If we look going forward, certainly we believe that we will continue to see good strength in the oil and gas area, the mining aggregates and cement. These are areas that continue to generate good growth because of the ongoing expansion and investment, because of the resource pricing that's going on as well, as James mentioned earlier, the lack of investment over an extended period of time and, also, just the fact of the cost of energy and that we have a large portion of our business in our power centric area that actually helps customers save energy, reduce energy costs and can mitigate the ongoing increases in energy costs as an input to their manufacturing processes. So we see a lot of opportunity to continue to drive productivity and cost reduction for our customers, somewhat, not totally, but somewhat independent of just their investment in expansion. So we see that as an ongoing viable revenue stream for us into 2007.

Q - Scott Davis - Morgan Stanley

Keith, I haven't heard you speak in quite some time about some of the key hybrid markets like food and pharma. Can you talk about the health of those markets?

A - Keith Nosbusch

Yes. Actually, we're having a very good year in the pharmaceutical life sciences area. We had a weaker 2005 and we talked about growth in 2006 and in fact we saw a lot of growth on a global basis. There was a lot of multi-plant rollout of our information platform, the MES platform, that came to us from the Propack Data acquisition and we've strengthened our position at a number of customers in that space. Food continues to be steady growth. As we have said, food by itself is our largest vertical industry. It doesn't have dramatic swings either way, which is why we like it, quite frankly, because it is a steady growth performer. We expect that to continue and now that we have introduced the mid range product, the compact Logix product, we think that has a great bit for some of the smaller machines and mid-sized equipment in the OEM community and at the end user. So we're looking for a good contribution of expansion in our mid range product, particularly at the OEMs, in the consumer facing industries that we focus on. So in 2006, we also launched the home health and beauty vertical, which is an important extension of our consumer products portfolio and we'll get a little more punch out of that going into 2007 and that's the areas that are focused some of our larger global accounts. They're doing the things, the diapers and paper products that are used across a wide continuum of applications and end user needs, so, customer needs, I should say. So that's an area that we put a little additional investment in and look for good returns there as well.

Operator

Your next question comes from the line of John Inch - Merrill Lynch.

Q - John Inch - Merrill Lynch

Thank you and thanks for taking my call. I guess first question, James, what kind of profit conversion rate should we be thinking about for Control Systems and Power Systems? Are they both going to fall within the 30 to 40? How should we think about that?

A – James Gelly

You know, I would say probably they both, as you have seen over the last year or two, they both have fallen in that range, sometimes above, sometimes a little below. But when we get a strong architecture growth and the mix is in that direction, then clearly there's upward pressure and you can get to the top of the conversion range. If you have all our architecture all the time you get above the top of the 30 to 40% conversion. I would say Power Systems, you know, given the kind of businesses they're in, they're very well managed with great productivity and are probably in the quarter like this they came in very strong. The other thing I would say is if you look at Control Systems to the extent that there's a mix of solutions businesses, you know, services, it doesn't have much of an investment base, in fact, there's no investment base except for a little receivables, and there they probably come in at the low end but not below the low end of the range.

Q - John Inch - Merrill Lynch

So basically it sounds like you're saying all else equal, Power Systems convert at a slightly higher rate than Control Systems, again, within the 30 to 40% is part of your thinking?

A – James Gelly

I kind of would have said that other way around. In other words, other things being equal, I think Control Systems has the kind of businesses which, when you have the average mix, you can get to the top end of the range at Control Systems pretty handily and I think Power Systems does well to be in the range and probably over time is able to be in the range but probably not as high as Control Systems.

Q - John Inch - Merrill Lynch

And then just my follow-up. So it sounds like we're looking at a, what, about a $0.15 pension tailwind from 2006 to 2007, roughly speaking?

A – James Gelly

Yes, that's probably about right.

Q - John Inch - Merrill Lynch

So when we sell Power Systems, I mean, there's going to be some pension contribution as part of that $0.15 that goes with that. Is that a fair way to look at it or, you know, do somehow you retain the pension assets?

A – James Gelly

First of all, we're in the midst of a negotiation, but let's just say it would be a decent assumption for you to assume that I keep every asset and I own all of the prior year benefits that have already been earned and accrued. So the only thing you have going forward from a post divestiture standpoint is whatever the interest cost on the prior Power Systems benefit already earned and that would be it and that would be matched against the asset base that I have retained. So basically I don't think so. I think I keep the amount that you're talking about.

Q - John Inch - Merrill Lynch

The whole $0.15?

A – James Gelly

Pretty much. Okay. Great. Thank you.

Operator

And your next question comes from the line of Jeff Sprague - Citigroup.

Q - Jeff Sprague – Citigroup

Thanks. Good afternoon, everybody. I guess just picking up on that pension question first before I go to my main question, if I've got 15 or $0.16 of pension, kind of my adjusted base for 2006 is $3.50 so I'm looking at 8% earnings growth in the midpoint of your range in 2007 which is kind of equal to your revenue growth target, so there's apparently no operating leverage there so I'm just wondering what else I might be missing in that equation.

A – James Gelly

Well, yes, you would have heard earlier that we talked a little bit about the full-year impact of growth investments that come through, that is, no new ones have been approved but you get the full-year benefit of the growth investments that were already approved. But no, I think it's fair to say that the basis of the guidance here is kind of conservatism on price cost, conservatism on volume, some decent productivity and the full-year effect of previously approved kind of reinvestment and then, clearly, we're trying to highlight, give us some time, maybe 90 days is too much to ask. But give us a little time to see if we can improve both the rate of productivity, some of the cost structure stuff we've been talking about and do a little better than is shown here but based on what we see today and looking at the fourth quarter, this is kind of the October guidance.

Q - Jeff Sprague – Citigroup

I mean, my opinion it sounds like post deal we're still at $3.70 to $3.90 but we'll give you the 90 days on that.

A – James Gelly

Thank you, Jeff.

Q - Jeff Sprague – Citigroup

I was just wondering on the incremental margins, Keith or James, are they materially different geographically? Any notable effect with the strength in Europe and/or Asia positive or negative to the incrementals?

A – James Gelly

No, you know, Jeff, these are global. Basically the premise of the Company is a global technology platform so Logix doesn't know when it leaves the factory whether it's going to Europe or Asia. And our customers can pretty well much pick us off now if there were wide differentials. So all that leaves rather than individual product average selling price is mix and what you find is we have a little more architecture centric mix of business outside the United States, so all in all, you know, except for mix, there's no real difference from a geographic standpoint and the SG&A as a percentage of revenue is getting a lot of attention. So gross is pretty high and SG&A can be managed and still drive growth and have a nice result, which is fairly uniform. We have a little more cost in the United States to support the R&D and kind of development some of the corporate overhead and whatnot, which makes the U.S. profitability a little lower than the total but not so much that it really tilts your model.

Q - Jeff Sprague – Citigroup

And then I was wondering, Keith, at EPG you were pretty bullish on Asia in the second half. The performance in the quarter, is that more reflective of old Asia being tougher or you just haven't gotten the sales traction with the new people in new Asia that you hoped for?

A - Keith Nosbusch

I think it's a combination, Jeff. We certainly, old Asia, mature Asia, pulled down all the growth that we had in the developing Asia. Having said that, though, given the opportunity and our market share in developing Asia, we believe we can grow faster than we currently are and part of that does boil down to the fact that it's taken us time to ramp-up new salespeople. I'll take that one as an execution issue. But the reality is you have to find people. You have to train them. That's not always the easiest thing to do. You can't always find a ready to go person. That's been a little easier for us in Europe, quite frankly. We're having to do a lot of the training of our people and so the cycle time to get a new hire up to a full contributing at the productivity level that we want and that we expect in the region is taking a little longer than it does in other parts of the world. So a little slowness in the ramp-up, but also still a great opportunity and we think we can grow a little faster, even without that delay in the ramp-up.

Q - Jeff Sprague – Citigroup

Thanks. And maybe ask just one quick one for James. James, if we kind of normalize to a 31% tax rate why would we go back up towards 32? You said go forward no higher than 32. Shouldn't we be drifting down further?

A – James Gelly

It could be the case that we drift down further but rather than go whole hog here, I'm just going to hold out 32 as the ETR guidance and if we continue to execute on some of the global plans that we've got in place, we certainly could, Jeff, come in there.

Operator

And your last question comes from the line of Steve Tusa – JP Morgan.

Q - Steve Tusa – JP Morgan

I just wanted to maybe just break out your total auto exposure and then you've mentioned what Detroit is but then what's kind of the peripheral revenue base with regards to suppliers, just kind of break that down I guess in total auto and then international U.S. and then Detroit, if you could at this stage of the game.

A - Tim Oliver

Steve, this is Tim. Think of transportation being about $550 million in aggregate, about 100 of that is non-auto, so think 450 auto globally, think about $100 million of that 450 being not U.S. leaving you $350 million in the U.S., about half of which is big three direct and the other half is supply chain.

Q - Steve Tusa – JP Morgan

Okay. And that's the total that you're talking about had such an impact on the three percentage points of growth and that kind of thing.

A - Tim Oliver

It’s very hard for us to get specifics on the half that's the supply chain. It's much easier when it's direct to the big three. It's very easy when it's one office in Detroit. We have very good data on a particular office in a particular region and we can attribute most of that to one industry. The rest, we have to extrapolate a little bit to the pain that's spread across the Great Lakes region.

Q - Steve Tusa – JP Morgan

Okay. Do you still think you're on track for, you know, as Logix comes up against tougher comps and gets bigger, do you still think you're on track for your 2009 target there in the revenue base?

A - Keith Nosbusch

Yes, yes, we're still targeting that in that timeframe. We expect to cross the billion dollar mark and little continued growth rates at little over 20% gets us there a little after 2009.

Q - Steve Tusa – JP Morgan

Last question – I was just wondering if I do a little bit of math on the midpoint of your range with the 7.5% growth at a 35% incremental margin and that's reported operating profit, correct? That 30 to 40% incremental?

A – James Gelly

Yes, segment profit.

Q - Steve Tusa – JP Morgan

I'm getting about $0.55 of benefit which gets me to about $3.90. Are there any significant, you know, you don't have to even give numbers but directionally significant moving parts below the operating profit line that are going to change? I know interest was a little bit higher this quarter. You know, how should we think about those other accounts kind of below the operating line for 2007 directionally?

A – James Gelly

I think you hit the main below the line item which is somewhat higher interest and no, there isn't another big thing moving around beneath the waves that take away from your analysis.

Q - Steve Tusa – JP Morgan

Sorry, One last one. I'm going to slip one in here. What are you guys, outside of auto now, what keeps you up at night? What are you most worried about when you see the end market, the macro environment for 2007, I guess, this cycle, just kind of your commentary on where are we in the cycle?

A - Keith Nosbusch

Well, where we think we are in the cycle is we've kind of paraphrased this in innings before and we think we're into the sixth inning which is really we're, after three plus years of growth, we certainly believe we're at the point where we're seeing decelerated growth but still growth and now I'm speaking mainly of the U.S. So we're in the period of time where we're going to see growth. It's going to slow some. But still, still growth and opportunities for us to grow share and as we talked about we're expanding our served markets so we continue to see gains walked around the country. The west and the south we're doing very well many and the Great Lakes region is the drag at the moment. But certainly we don't see a large change in what our outlook is, other than the automotive industry, and one measure that we look at is the financial health of companies and I don't think there has been more cash on their balance sheets than at any time. So we're still seeing a reluctance to spend so it's still very measured investment, but we're seeing continued investments so with the help of the companies, with the cash position, we expect that capital expenditures in 2007 will continue to be positive and generate the growth opportunities that we're talking about for 7 to 8%. So overall in the U.S., we still see a generally strong economy and with a big impact in the automotive sector and the supply chain that supports it. But other than that, we don't see much change from where we're currently at.

Tim Oliver

That ends our call. Thanks for your help and thanks all for joining us.

Operator

That concludes today's conference. At this time you may now disconnect. Thank you.

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