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Eaton Corporation (NYSE:ETN)

Q1 2010 Earnings Call

April 20, 2010 10:00 am ET

Executives

Bill Hartman - IR

Sandy Cutler - Chairman and CEO

Rick Fearon - Vice Chairman and CFO

Analysts

Steve Oakland

David Raso

Eli Lustgarten

Ann Duignan

Jamie Cook

Rob Wertheimer

Jeff Hammond

Andy Casey

Mark Koznarek

Operator

Ladies and Gentlemen, thank you for standing by. And welcome to the Eaton Corporation first quarter earnings conference call. (Operator Instructions). I’d now like to turn the conference over to Mr. Bill Hartman. Please go ahead, sir.

Bill Hartman

Thank you very much. Good morning everyone and welcome to Eaton's first quarter earnings conference call for the year 2010. Joining me this morning are Sandy Cutler, Chairman and CEO, and Rick Fearon, Vice Chairman and Chief Financial Officer. As has been our practice in the past, we will start today's call with some comments from Sandy, followed by a question-and-answer session.

As a reminder, the information that we are providing in our conference call today will include some forward-looking statements concerning the second quarter of 2010, the full year 2010 on net income and operating earnings per share and second quarter and full year 2010 revenues, comments on our worldwide markets, our growth in relation to these end markets and our growth from acquisitions.

These comments all need to be used with caution and are subject to the 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 first quarter results which can be accessed on the Investor Relations page. Additional financial information is available in today's press release, which is located on Eaton's home page at www.eaton.com.

And with those preliminary comments my pleasure to turn the meeting over to Sandy Cutler. Sandy?

Sandy Cutler

Thanks Bill. Good morning. Thanks everyone for joining us I’m going to work off of the presentation. I hope you’ve all been able to access it at this point. Bill covered the forward-looking statement. So I am going to move right to page three in your packet the highlights of the first quarter. We had a very strong first quarter. We are very pleased with it and certainly a very different quarter than we experienced a year ago at this time operating income per share of $0.95 excluding the non-cash Medicare Part D charge of $0.14 it would have been $1.09 net income per share of $0.91 and again excluding that non-cash charge of would have been $1.05. Sales were 3.1 billion; up 10% roughly flat was the fourth quarter which you will remember was 31, our end markets grew up 45 for the quarter from 24% of our sales coming from the developing countries where we continue to see the recovery outpacing what’s going on in the developed nations. And our operating cash flow was a negative $162 million that’s after pension contributions of 326 million. And so a fairly difficult first quarter for us and those of you who follow us know that our cash flow tends to accelerate in the second, third and fourth quarter.

Moving to page four, a quick reconciliation of our first quarter guidance, performance versus guidance, you will recall the midpoint of our guidance was $0.85 that’s the midpoint that we set for operating earnings per share in our February New York Analyst Meeting it had been $0.80 prior to that. We obviously reported operating earnings per share of $0.95. I mentioned the impact of the Medicare Part D of $0.14 our tax rate not including the Medicare Part D adjustment, it was at about 4% versus the 12% that we had mentioned that was embedded in our guidance for the first quarter. So that was about a $0.09 positive and we’ve taken it out of this reconciliation so that without the tax impact from those two items, our operating performance is about $1 versus $0.85 so an 18% improvement over our guidance. Actually 25% higher than the guidance we’ve provided in January when we started the quarter.

Now when you get inside the $0.15 of improved performance about $0.13 of that came right out of the operating performance of the businesses and about $0.02 came out of some lower spending in a variety of different corporate line items on the income statement. A year ago some of you may have noted that our other income and expense category was significantly different than we had this year. That was not the basis for our guidance in 2010. You recall a year ago we experienced a period of quite a bit of currency fluctuation. We actually had a large loss associated with that in the first quarter this year. We had not anticipated that this year and that obviously was reflected when we gave our guidance earlier this year and talked about a year ago in which we did not anticipate anywhere near the currency volatility that we saw a year ago.

Moving into page five, total financial summary, I think you’ve seen all these numbers I won’t go through each of them. I would simply point out that the $347 million of segment operating profit that you see in the first quarter 2010 column on the second line that does include one quarter of the $225 million of other costs that we talked about that would come back into our operations this year. So we are really very pleased that in spite of having stopped many of the what we call the special or other cost actions we took last year that were temporary in nature we were able to report that the strong operating results for first quarter. If you saw in our press release our market growth was 4% we did outgrow in end market by a percent of their Forex impact was about 5% in adding up to our overall 10% of sales.

Moving into the individual segments turn to page six, Electrical - Americas segment, very pleased that while sales were down by 7% that we were able to achieve a 13.2% return on sales yes that's down from the 15.2 that we had in the fourth quarter but certainly in line with our full year guidance that we provided 13% and frankly we are quite pleased with this strong what is normally the weakest quarter of the year for us in our electrical businesses. Bookings were down some 4% versus the decline that we saw for bookings in our fourth quarter of 18%. We are seeing some of these early and mid cycle segments end markets are starting to come back residential up about 3%, non-residential was down 21, industrial segments were up about 3% and our stimulus orders now total about $250 million and that number does not include the over $500 million contract of that another supplier and ourselves we’ll split over the next couple of years that we released last week. So I am short on the stimulus piece that it really was very helpful in terms of us not having our bookings decline further we continue to do well in that arena and would be glad to answer questions on that later.

Turning to page seven, Electrical segment for the rest of the world, 12% increase in our sales obviously very pleased also with the 8.1% operating margins, you will recall that in this segment we've provided guidance for the period of 9% return on sale and we had said that we would expect in the early part of the year would start weekly and that we would see double digit profitability in the second half of the year. So we are very pleased with 8.1% right out of the barrel this year. Now booking is up a very strong 18% and the greatest strength has been in Asia with a little less strength in Europe but both positive numbers and you can see that in these numbers in the 12% increase in sales it was about an 8% impact from Forex.

On the hydraulics sales market on page eight, $490 million in sales up from $419 in the fourth quarter, profits really coming back quite strongly 11% return on sales versus 3% in the fourth quarter. This 11% shipment growth excluding Forex and acquisitions we think is a real reflection of the bookings increase that we've been talking about that's happening in this business and we are delighted our global bookings were up by 88% excluding Forex and acquisition, a real break out quarter and really seeing that strength in every region of the world. Now one has to note that the first quarter of last year was extremely low and perhaps artificially depressed as we saw not only low orders of bookings coming in but we also saw cancellations on the OEM markets when many large OEMs were really trying to pall in their forward commitment, what is leading is very strong surge in increase at this point is the mobile OEM side. We do believe that they are not only responding to increased demand but they are also rebuilding their own inventories and towards the end of the quarter we began to see distributor demand picking up as well not yet to what we would call detailed stocking orders but responding to line outs, line shortages that are out there quick shipment recovery and so not yet what we would call inventory rebuilding on the distributor side. So, once again this recovery is being led on the mobile side with the large OEMs being most active.

Moving to page nine, $376 million of shipments here in the Aerospace segment basically flat with the fourth quarter when we were $381, 13.3% margins flat with what we saw in the fourth quarter when it was 13.1, bookings down about 7% compared to the 25% down we saw in the fourth quarter and that the real change that we are seeing in the aerospace market is that we now think that OEM production is likely to be a little stronger than when we started the year but the weakness is continuing in the commercial after market and every time we see interruptions such as what's been going on in Europe after the volcanic eruption it just puts further pressure into the commercial airlines and so we think we are going to continue to see a weak year in terms of commercial after market activity this year.

Turning to page ten, the truck segment sales of 453 million up about 10 million from what we achieved in the fourth quarter of '09. Overall markets up some 19% really led by the agricultural market and they are very pleased to be holding a 10% operating margin in this business that these very low levels of activity and that's just a little bit weaker than what we saw on the fourth quarter when it was 11.5%. Looking forward for the year we have reduced our 2010 outlook for the NAFTA Class 8 [builds] from the 150 levels down to the 135,000 unit levels and I think that's pretty much a consensus number that you will find across the industry at this point so it means that we would see a very flat year in terms of NAFTA heavy-duty truck demand.

Turning to page 11, the Automotive segment $374 million of volume up just about $12 million, $11 million from the fourth quarter a profitability of 11.2% really very, very pleased with the profitability in this business reflecting all the restructuring work we did last year. Enormous change in market what a difference a year makes in this regard and that very strong growth is in the US then Asia Pacific then Europe and we are predicting that full year US production forecast being up about 31% and outside the US being up about 6%. So quite a year of recovery.

If we move to page 12 just a quick synopsis okay our view of the end markets, you recall in January we had provided guidance that we thought our end markets would be up on a weighted average by about 5% at our February conference in New York we moved that up to 5.5% and you’ve read in our release this morning we now think markets will be up by about 6%. No real change to our outlook in Electrical Americas a slight increase in our Electrical Rest of World up to 6% hydraulics as you could see up another point, aerospace up slightly, the truck index down as a result of the change I mentioned in the NAFTA heavy-duty market, automotive up slightly and that brings us all up from the 5.5 to 6%. So I will describe these as more fine tuning than any major changes in the market outlook.

On 13, obviously chart 13 with a very strong performance of the first quarter and in particular the real strength we see in the number of our operating segment in terms of margin production we are increasing our overall segment margins and if you look at this chart you can see that we are taking hydraulics up from 9% to 11% full year. You will recall when we started the year in January we had thought it was 8%. So clearly we are seeing volumes improve, bookings improve and our margin capture rate has improved substantially. In the aerospace market we are taking our margin expectation for the year down from 15.5 to 14.5, that’s both as a result of the mixed change that we see with more OEM shipments and less after market and then I will detail a situation on one of the following slides, the effects of particular situation that we have at one of our facilities.

Truck holding, 10% margin forecast we had for this year and that automotive increasing our full-year guidance from 7 upto 9%, you recall when we started the year our original guidance for automotive was 5%. So really seeing the tremendous improvements in our cost structure paying off in this segment. So overall from our last guidance taking margin up by one point from 10 to 11% on a consolidated segment basis and when you step back and reflect upon the incrementals, in January when we began the year we said that we thought we would have 35% incrementals.

In February we increased that to 38% after we had seen a very strong month of performance in January and underpinning our reconciliation, I will review within a minute, at this point is that we believe our incrementals across the segments this year will be on the order of 40% obviously very strong numbers.

Chart 14 our revised guidance let me just speak to the midpoints on these for the second quarter in terms of operating earnings per share, a $1.15 in terms of net income $1.10.

In terms of full year operating earnings per share $4.45 net income $4.30 and the $4.45 operating earnings per share is a 11% increase from our last guidance. If you did not include the Medicare Part D it would be 15%. Similarly on the net income column the increase of $4.30 is a 13% increase in terms of our guidance, without Medicare Part D it would be 17%.

Turning to chart 15 a quick reconciliation of our first quarter operating earnings per share of $0.95 to our second quarter operating per share guidance of $1.15, we obviously will not have a repeat of the Medicare Part D that is $0.14, we think we got about another $0.21 from incremental volume.

Our tax rate will move up from the 4% that we had in the first quarter and then we have a situation at a facility on the East Coast which was flooded during the terrible rains of the end of March and early April we are recovering from a total plant shutdown at that site in early April but it is unlikely that we will have this plant come fully back online in the second quarter and as a result we think it will impact us for about a negative $0.04 in the second quarter. All that leads us to $1.15 in terms of our forecast for second quarter operating earnings per share.

Let’s move to chart 16, a reconciliation of the full year, just would pick out a few items here really in terms that are different from what we shared with you twice earlier this year. The first line item, we have obviously moved the market up to 6% from 5.5% and we are using an incremental rate of 40% instead of the 38% you saw the last time.

On the Forex line we are decreasing our guidance for increased sales from Forex this year, from the $2.25 we provided at the end of February to $1.50 now and then on the top line under the several negative section in the yellow box, the tax rate change comes down now instead of being 15% full year we think it will be approximately 13%.

And then moving to the final chart in the packet, it’s just a summary of many of the subjects I just talked about. For your reference I would refer to the bottom two numbers on this chart we have not talked about them yet that we have increased our operating cash flow and our free cash flow projections for the year by a $100 million each. With that Bill why don’t we open things up for questions?

Bill Hartman

Thank you, Sandy. Leah, could you issue the instructions for the Q&A please?

Question-and-Answer Session

Operator

(Operator Instructions).

Sandy Cutler

All right names are popping up first one on the screen is Steve Oakland. Are you there Steve?

Steve Oakland

I was trying to get some fairly volatile performance versus market growth by segment either outgrowth or undergrowth, I guess is there anything we should be pulling out of there is there kind of timing issues or anything you can add?

Sandy Cutler

Yeah I think in terms of, if you go through the pieces where we had commented last fall that we sell through in situations where we were dealing with difficulty getting good information about individual markets. I would say that I think you have always have some timing issues. I would say the biggest issue that I think is one that we feel is a little bit more material is actually in the automotive arena where there obviously are some changes in sizes of equipment and what I mean there is SUVs versus CUVs versus small cars that have not placed to our advantage in that regards. Outside of that not too concerned and we think we are pretty much on page four our full year projection this year in market outflow.

Steve Oakland

Okay great and a quick follow up in hydraulics you mentioned led by mobile OEM strength, I think you guys have sort of specific exposure in the Ag side but is there sort of the little end market on you that you can peel back first there?

Sandy Cutler

Yeah I’d say it’s actually been stronger on the construction side and it’s been on the Ag side so I wouldn’t put construction as the strongest thing in the mobile area and then add secondarily.

Steve Oakland

And that’s inventory rebuilding I guess.

Sandy Cutler

Yes, I think what we are seeing is that I think that in like many sectors of the economy, many of our customers in those two areas really worked hard to get their inventories down last year and now if they are preparing to obviously shift to end users in own areas. They are having to do some rebuilding of their own inventories in their own factories and distribution centers before they are in a position really to be then getting it out to dealers and distributors.

Steve Oakland

And that’s in both construction and Ag but both construction.

Sandy Cutler

Correct.

Bill Hartman

Next, we have David Raso.

David Raso

I wanted to compare the first quarter margins you just reported with a full year. I know you’ve raised the automotive margins a couple of times. So I am just trying to think through why do we see the automotive margins in the first quarter above 11, that’s full year at nine and is that decline offset some improvement you’re looking for in the rest of the world, also even in aerospace from first quarter to the full year guidance. Can you just take me through the automotive margin degradation?

Sandy Cutler

Yeah, I think there are two things in automotive, Dave. Normally, what you find is that the first half is stronger than the second half in automotive in terms of day’s work and remember that in the industry you have very significant close downs in the third quarter that’s when a lot of the model change over is and so that if you look at just the peer play on automotive, normally the first and second are your strong, strong quarters and you get a weaker quarter in third. And then a fourth quarter that comes back with generally not at the level of the first and the second.

So that’s the first issue which is that the normal kind of sequential quarterly progression but the fact is that there has been, and in our opinion, quite a bit of inventory rebuild going on in terms of all the manufacturers quickly gearing up manufacturing in the first quarter. For us it’s not as clear at this point in terms of the second half as to what demand is going to look like not only here, but also in Europe and so in terms of the visibility issue, we have great visibility in the second half demand levels in the automotive industry. A no, at this point and so much depends upon the strength of the consumer recovery, and we just think there is still are some questions around that, so our own anticipation is that demand will be slightly weaker in the second half than it was in the first half.

David Raso

And on truck and I appreciate how much the Brazilian added transmissions are helping and even if it's outside the North American truck market broadly. For a 120,000 builds for the year in North America and we just had 35,000 in the first quarter, can you just help us out with how do you see the quarterly build play out for the rest of the year and just trying think to what the margins for the full year should only be equal to what you just did in the first quarter.

Sandy Cutler

Yes basically, the easiest way to think about that build rate for the year is that it’s basically flat that you just don't get much of an increase. You come out of this first quarter at 33 to 34 and you sell at 33 at 34 or 35 so this is an absolute flat line for the year.

David Raso

So no depth secondary quarter the backup they can afford if you just assuming a flat line.

Sandy Cutler

Yes.

David Raso

And one last quickie. On the EPS bridge and pardon if I missed but from what you reported in February in the analysts meeting, you’ve essentially raised your guidance roughly in terms of how you backed things out $0.55 to $0.60 and $0.30 is from improved market growth, also some market out growth improvements. Do you also have $0.17 benefit from the last guidance from a lower drag from higher amortization of intangibles and that amounts to third of the guidance being increased from something going out the amortization intangible. Can you just help us on that?

Rick Fearon

David, its Rick, its intangibles in a variety of other corporate items and intangibles at this point looked to be a little bit lower and we think that they are likely to be some other savings in some other corporate line items, so it's a whole variety of things for us.

David Raso

I was just thinking since February of having the business improve might be even more incentive comp pressure on the upside not the downside, I was just surprised to see such a big part of the EPS increase from kind of a random other kind of category. Is there anything material one item in there?

Rick Fearon

No, I would say really it’s a whole variety of topics and they all add up to that.

Bill Hartman

All right next is Eli Lustgarten. Hello Eli.

Eli Lustgarten

I have one quick clarification, your 430 to 460 to 445 excluded in the Medicare charge, correct?

Sandy Cutler

No, that’s after the Medicare charge.

Eli Lustgarten

The 445 would be like 460 on a pure operating basis.

Sandy Cutler

Or a 459 right.

Eli Lustgarten

When you [depart] in the same way (inaudible) back the hydraulics business you know 11%. I know you keep breaking the margins, but you were there in the first quarter and volume is going to strengthen a bit for the rest of the year from where we are in first quarter. Is that mix or seasonality or the end of inventory building. What’s causing the margins; you know we really go no where in the first the rest of year from where you are now.

Sandy Cutler

Yes I think again Eli what we’re a little cautious about at this point is that we have seen a quarter of what we think is quite a lot of inventory rebuild on the OEM side. And its always trying to fare sit out how much of that is rebuild versus how much of it is demand is. More of an art form than it is a science I am afraid and that’s what we’re trying to keep our eye on. I think as we get through another quarter and get a better view as to what the run rate is on a continuing basis we’re going to have better visibility on this. But we’re coming out of a period where we had such poor forward visibility to a period where we’re just starting to get some forward visibility. That’s our best look at this point, but I would say if there is some potential its probably going to be on the upside there, but its maybe a little early to call.

Eli Lustgarten

And it’s actually a 13% this year, does that say it won’t go up as quickly next year, it was sort of we have (inaudible) or years with 13 initially we are at 15 or we got a 17 to 19 next year, what happens as we look out?

Sandy Cutler

It’s as you know a hazardous activity forecasting the tax rate. I do think that the performances that we are going to have this year suggest that perhaps we could do a little bit better than we had suggested at our last conference call and so I do think that a number in the 16% to 18% range is probably a reasonable number to pencil in at this early juncture.

Eli Lustgarten

And it’s for next year. One final question, electrical Americas is 250 million stimulus business that you expect the 500 is a very real number and you expect profitability, it’s sort of a whole for the rest of the year in electrical as opposed to what the guidance says?

Sandy Cutler

Yes, two items in terms on the stimulus, yes, we still are very comfortable with our projection in that regard and the rate has of bookings has picked up and I think you are generally starting to hear people who are around this subject in a detail that they are seeing dollars flowing now where there were more conversation earlier. On the margin we’ve maintained the 13% guidance for the full year. We’ve always said that the most difficult thing in calling that number has been, as you continue to have non-residential go down with some of the large assemblies business that goes with it and then you have the list going on of the short mid-cycle businesses where they perfectly matching every quarter. Of the 13% probably over simplifies that. We can’t be sure that will true in every quarter this year but we’re pretty confident for the full year we are going to get that 13%.

Eli Lustgarten

I think it also involves the big project big business; it’s in competition in there. Is that going on?

Sandy Cutler

And that’s where the volume has been coming off and obviously with the 21% drop of that we talked about there for non-risk, that side of the business is coming down but we are seeing good strength and power quality, we’re seeing increase in the residential, we’re seeing increase in industrial and so I can’t tell you that every quarter is going to match exactly but we do think there is a 13% for the full year is the right range.

Bill Hartman

Okay, next is Ann Duignan, Ann?

Ann Duignan

Maybe you could provide us a little bit of color on the electrical rest of the worlds. Its although surprising to us that you continue to see strength in construction in Europe and kind of may be you could just give us a bit more color on what you’re seeing around the world is on the electrical side.

Sandy Cutler

Yes, the big plus year-to-year, in terms of bookings and volumes have actually occurring in Asia and there we continue to strengthen and we’re seeing it pretty broadly across each of our product lines and arenas that most strongly led obviously in China and so that continuing to be quite, quite strong and we’re pleased an enormous snap back from where it was a year ago but it is a continuation add up of what we talked about all last year that’s fourth quarter of 2008 and the first quarter of 2009 were kind of the low periods and since then, Asia has been coming on every quarter.

In Europe, we’re actually pleased that we’ve seen stability and we started to see some growth and that business participates not only in construction markets but industrial markets as well and obviously power quality in both these two regions is a bigger percentage of our business than actually is here in the Americas and power quality is quite strong. So we’re feeling quite good about where we are. We started the year a little bit better than we had expected we might in these margins for that sector.

Ann Duignan

Okay, and Sandy it seems that your back half at least your margin outlook across many businesses, were about conservative. Is that driven by lack of visibility on the revenue side or is it driven more by the concerns you might have on input cost versus price and may be you could address which you are more concerned by which you have less visibility into?

Sandy Cutler

Yes, I think it's far more on the former Ann. I think as I mentioned I think to Eli's question, our visibility is so much better than it was a year ago but it's still shorter than it was several years ago and so that aerospace is probably the market where we’ve got the longest visibility but you start to get down underneath and we’re still dealing with looking out just a couple of months not really being able to see detailed customer pattern looking out 6,9, 12 months and so that's where we are perhaps a little cautious about the second half because we do think in some of these markets that I mentioned you are seeing some OEM rebuilding of inventories and at some point that will come in line with the actual production.

Having said that, I think what's particularly intriguing about the markets that you conserve is that we got a couple big markets that basically have not kicked in yet and I would expect that we would see them kicking in 2011 and in response to Dave's earlier question, certainly the heavy duty truck market is going to be substantially stronger in 2011 than it is in '10 and that will provide some additional fuel obviously for our earning. We do anticipate this non-residential construction market which you recall is almost 40% of the Electrical Americas segment, will have a far better year in 2011 than it has in 2010. So while we’re pleased that we are seeing a number of our businesses come back, we don't have them all kicked in yet at this point and that's why perhaps we’re a little conservative in the second half but we think there is a very reasoned forecast that says this markets get stronger in '11 than they are in '10

Ann Duignan

Okay and just one final tiny follow up. Your incremental profits by the way you calculated some, what were they in Q1 versus your outlook for 40% incremental for the year?

Sandy Cutler

They were up towards the 70 number in the first quarter and that’s obliviously what’s caused us to say hey, they’ve got to move up.

Ann Duignan

Okay so somewhere around 70% in Q1.

Sandy Cutler

But recognize Ann when you start to do quarter-to-quarter and years to years, the biggest increase should have been Q1, so that some would want to extrapolate 70% for the year.

Ann Duignan

And surely that’s not what you’re guiding here; okay thanks I have taken up enough time.

Bill Hartman

Next is Tim (inaudible).

Unidentified Analyst

Can we just talk a little bit more about the North American stock market relative to Europe? Are seeing either markets particularly outperforming the other and is your exposure in Europe a bit more medium duty versus heavy.

Sandy Cutler

We have a very small exposure in Europe and what exposure we have is medium. Our primary exposure in the areas you mentioned really is North America. And here you know I think is reason to be encouraged about some of the freights. Freight numbers that have become available particularly within the last week, but having said that there has been over capacity and is taking a while for the industry to work its way through it. And that’s why we reduced our guidance from 150,000 units down to 135,000 for this year.

Unidentified Analyst

Great and just over to electrical rest of the world, is there any seasonality in that margin? Does that strengthen through the year as Americas?

Sandy Cutler

I guess the typically the weakest quarter is the first quarter and when we gave our guidance in January we said to expect in the first half would be more in the 7 to 8 range. And the second half would be double digit and that’s how we would get to the average of the 9% return on sales guide for the segment.

Unidentified Analyst

Can you give a first quarter CapEx number?

Sandy Cutler

Yes, we were under $40 million in the first quarter and as you know for the full year we’re saying the number will be around 400 and we had said we would start out quite cautiously and we did.

Bill Hartman

Next we have Jamie Cook.

Jamie Cook

On the mobile equipment side, Sandy I am just trying to get a feel for how much of the improvement is you not really believing the OEs orders first attempt taking production up again and then on the construction equipment side, how much is US or is it all emerging markets or are we seeing any increment in US and what you guys are hearing for any pre-buy on (inaudible) tier you know going with tier four coming ahead in 2011 if you assume any potential pre-buy in your forecast.

Sandy Cutler

Yes in terms of the regional differences almost nothing in terms of regional differences. Any of the [8%] increase in our bookings is pretty much the same in each of the regions of the world so we have seen a very strong rebound and as I mentioned earlier very much led on the mobile side and within mobile much stronger on the construction side. So there is a not of color to add because there is really not too much difference between the regions at this point. What we’re pleased about is that’s the difference than what we saw at the end of the year where most of the (inaudible) was being seen in Asia-Pacific. It’s not really building elsewhere.

In terms of comments on the pre-buy, no we’ve really not heard much at this point and I think what’s driving things more than anything else night now is this expectation that the worldwide economy is getting stronger that you’re starting to see shortages, you’re starting to see some lead times move out. As a result, many of our customers are starting to now put inventory and then start to produce again.

Jamie Cook

Okay and then just a follow-up question again you know, some of the comments have been made that your margin assumptions at least in the back half of the year seem, you know, a little bit conservative. Can you just help me, what are you assuming for material cost price in the back half of the year versus first half or any headwind in the back half that were not appreciating?

Sandy Cutler

No. What we said is that we would expect to match price and cost and if you look across the industry there are some price increases out in the electrical industry already. There are some that out in the hydraulics industry at this point and so I think what you’re seeing is kind of creeping commodity prices and then people’s pricing is starting to agree to take care of that.

Jamie Cook

Okay, but no headwind in the second half relative to first (inaudible).

Bill Hartman

Okay, thanks. Next up is Rob Wertheimer.

Rob Wertheimer

My first question is on aerospace after market. I know that in some cases after market sales have even dipped further than flight hours and I wonder if there could be snap backs. So I wanted to ask on the typical order cycle lead times, how does that process work, how much visibility you have and do you see any prospect for recovery and you know in the later half of the year just based on timing of orders of delivery? If you were to get stronger in other words.

Sandy Cutler

It really very much Rob depends upon the type of equipments because much of this is not the kind of stuff that is stocked in a warehouse somewhere. It’s got to be built to an order. So there is some portion that is, but so you’ve got a couple of months in there but I say that I think the conditions are such that you’re likely to see an enormous change. You know profitability is not an upward trend yet for the airlines. We just had a major interruption in terms of what’s happened in Europe, that’s going to put financial pressure on more of the airlines at this point and so these things don't tend to change in two or three months buckets. It tends to be more something happens over kind of 6-12 months time and I think you hear a fair number of people in the industry now saying that they think the commercial after market improvement doesn't really occur until you get into 2011.

So that's more of our thinking. There will be spot differences and I am sure it's always different for individual companies based upon the type of improvements they make but I think the base issue you got to think about is that while flight hours have increased, profitability is still pretty poor and there is a lot of pressure on this kind of discretionary spending.

Rob Wertheimer

Did you change what your revenue forecast would have been based on the flood and the volcano or is it kind of locked in anyway?

Sandy Cutler

Yes, two different issues. No, we’ve not substantially changed our forecast. Remember, what we said as we think OEM production is a little stronger now the outlooks are than we had anticipated but the after market is weaker so it's more of a mix change than it's a top line change.

Rob Wertheimer

There’s a third question I was trying to ask what are been higher ups of the flood and volcano?

Sandy Cutler

I think more specifically, I know what's going to come out of volcano is more ash. But I would say on the flood issue, there what we have done is you saw we take on our earnings down in the second quarter and that is related to having less volume.

Bill Hartman

Next is Jeff Hammond.

Jeff Hammond

Rick can you just go through the movie in pieces in free cash flow. You bumped it up by $100 million. Looks like net income certainly higher. What's was the pension contribution thought before versus actual? How are you thinking about working capital?

Rick Fearon

Jeff as we commented on our January call we made a $300 million US pension contribution in mid January were down for the year on the US side and we typically make about a $100 million into the foreign plants per year and we’re very much on track to do that this year. So no change on the pension side and really the increases due to the higher income that we’re forecasting not very much change in sales volumes, but you don’t have a lot of extra funding required for that sales volume but you do have higher margins and that’s what led to the improvement in both operating and derivatively free cash flow.

Bill Hartman

And next is Andy Casey.

Andy Casey

Couple of quick questions a lot of them have been asked already, but on the demand increase you’re likely seeing tightening capacity utilization. Are you seeing any supply chain constrains show up and if so where?

Sandy Cutler

We have not yet Andy although I would say this thing that we keep watching right now is something we talked about on each of these last several quarterly calls which is that for a small businesses and small suppliers at this point as things ramp up, they are going to have working capital challenges and that’s why it so much you are hearing about the need to get more credit available to small business. But to date it hasn’t, hasn’t caused us problems.

Andy Casey

Okay, thanks and just to follow up on that one Sandy, with the discussion about the natural disasters recently should we be concerned about the duration of no fly zone over Europe at this point?

Sandy Cutler

Yes, I don’t know that we can give you a lot of insights on that. They are starting to fly and we don’t know anything more than everyone does watching the news right now. They are starting to fly, I am not sure I want to be in the first place but there it looks like the situation is starting to modify at this point.

Andy Casey

Within the truck outlook can you help us on what you’re expecting for Brazilian agricultural production in the second half on the equipment side?

Sandy Cutler

Yes I owned and I was just in Brazil here a couple of weeks ago and had chance to meet with a number of our large customers there. Obviously this first half looks like a [warmer] first quarter certainly was there. Stock prices are holding up. Fine I think there is a sense that the Brazilian domestic economy is operating quite well which also leads to a sense of confidence. There is however fair amount of discussion that this will slow slightly in the second half and that some of the incentives that have been put in place by the Brazilian government start to end the big comp that’s attributable returned to what I would call kind of more normal levels. Having said that we’re quite confident that long term, Brazil becomes one of the real agricultural food baskets for the world and you are going to continue to see more lands and a bigger push on higher productivity for them and so I think u know continuing longer term trend it will be above trend compared to the rest of the world for Ag equipment.

Bill Hartman

Next is Mark Koznarek.

Mark Koznarek

Question about first of all the little detail here about the currency. It looks like basically this first quarter you are getting all that you are expecting for the year and the earnings contribution, it’s the $0.10 that is in the year-over-year lock that with the contribution from currency in the first quarter.

Sandy Cutler

Actually Mark, the impact on currency in the first quarter from a profit standpoint it was negligible and we did have, you are right about $130 million of revenues, so we expect a little bit of additional revenue for the balance of the year but not substantial and of course, its anybody guess as to exactly what happens to the euro, you know, which is the one that’s been the hardest to forecast our $150 million essentially assumes the euro and the riyal are about at the rate they are today. But you know, given all the moving parts, you know, that could obviously change.

Mark Koznarek

Okay, may be I’ll take that offline. Then the other question I had, had to do with the Electricals business for Americas no change here down 3% but there’s been a lot of recording recently about how strong the server market has been you know, some of the market [hundreds] have recently increased their shipment outlook to around 15% previously it was up 6%, it sounds like real boom year for products that are co-used with your product quality equipment so that is getting better. It suggests that the power distribution is worse to get your outlook unchange, can you comment about those two pieces?

Sandy Cutler

Yeah, Mark you’re exactly right that the power quality side of the market whether on (inaudible) looks at either these are large data center, our market which has returned with quite a bit of strength or where they are looking at the single phase or the flow products that are sort of in the middle of the two, the market is stronger than we thought when the year started and I’m very pleased by that.

I think what we’ve seen on the array of other markets that go under the power distribution side is that I think people are have more tampered view of the residential recovery kind of a (inaudible) goes on we’re setting new length of time that we go out with building homes and so that has been a little weaker. And I think another thought about utility spending where people I think were very much influenced by their thoughts as Mark that would be built in a month, some of the realities about how long it takes to get things done. So I would say that those segments are little slower and than non-res, it depends which index you want to look at but I would say your net conclusion is right that a little stronger on power quality business, a little weaker on the power distribution and they just kind of a mess.

Mark Koznarek

Okay. And then when we take a look at the Electrical Americas margin it down shifted quite a bit here in the first quarter relative to the fourth quarter at almost, it was like an 80% incremental margin if you look at it sequentially. What changed so much in this current quarter versus fourth is their anything unusual that one time that will reverse out over the course of the year?

Sandy Cutler

Yes. So you have two things here Mark. One is the normal fact that your third and fourth quarter's tend to be quite strong quarters easily in this business and the weakest quarter is always the first quarter. A lot of that has to do with how it relates to construction; the construction tends to be slower in the first quarter of each year. You also find that some of the power quality activity starts a little slower in the year as well as some of the IT channels tend to fill fairly heavily in the fourth quarter. So I think the great majority of that is the normal, seasonal pattern if you would. We had commented in our guidance for this year for 2010 that we expected to see about one point margin deterioration due primarily to the declining volume in the non-residential project to our assembly’s business and the pricing deterioration that we had associated. We had planned as we come with that, so I say this is playing out about as we’d thought. I would have expected that our margins would have actually been less than 13% in the first quarter. So I made my comments earlier, full year guidance of 13 when we started with 13 is really good news.

Mark Koznarek

Okay great thank you.

Operator

Next is Rob McCarthy, Good morning Rob.

Rob McCarthy

Good morning everybody.

Sandy Cutler

Good morning.

Rob McCarthy

Sandy, I’d like to ask you about the heavy-duty truck market in different way. Are you surprised to find yourself in how do you reconcile lowering your outlook for heavy duty truck in North America for this year at the same time that you are raising expectations pretty much across the board, I mean varying degrees but you know a little bit stronger market outlook you know everywhere else. And there seems to be you know broader confirming macro data that would support a little bit stronger you know macro outlook?

Sandy Cutler

That say maybe two of aspects on that Rob one which I don’t is the question you are asking but I will take this case and answer it anyway. Which is that I think it comprise of with the balance Eaton now has that we can be lowering the guidance and what has always been one Eaton’s most important end market and we still can increase our guidance not including Medicare Part D by 15%. Having said that and now let me come back to your question on the heavy-duty market which is, you know we came in this year thinking we’d see with all of the recovery in the markets, 5% we had average increase in markets that we would have see the truck market be about a 150,000 units.

In saying that, we said that we thought by the March-April timeframe we will start to have to see orders returning to the high teens to low 20s level and that clearly does not happen so what’s going on. What we think is going on is that there is still kind of over capacity of trucks that are out there that are still very viable to use that aren’t being utilized in high levels. We are seeing the front end of freight picking up which is one of the things that have to happen first to start to absorb that but it hasn’t moved people off the sidelines yet when they are looking at new vehicles that cost more money than the vehicles did last year so this period of digestion of the higher prices in the new vehicles plus the inventory need to be absorbed without that. Its happening less quickly than we anticipated, that’s how we think the 15000 lower and yeah we are surprised, we thought this would come back more quickly but we think the prudent thing to do at this point is to plan on the 15000 lower, having said that, having been through this four or five times in my career about the time that you think things wont increase is about the time things take off so at some point this market will comeback and when it comes back it tends to comeback quite quickly and that’s why we think 2011 plan or forecast that’s over 200,000 units makes a lot of sense.

Rob McCarthy

More like in terms of increase, sure but you basically, by understanding correctly, we are postponing the inflection in the order cycle until 2011.

Sandy Cutler

Yeah I would say we will postpone, we will find the shipment till 2011, that’s right and it would be in that cycle is got to start to come up sometime in the second half of this year

Rob McCarthy

Okay and the other question I want to ask is I realized that some of this requires a reasonable range around estimation but when we say non-residential 40% of North American electrical, first thing that comes to my mind is exactly when? Because we’ve had you know, a differential growth rate last year, well again this year so that we you know, sort of size or foundation correctly going-forward. What we are talking about this business bottoming out at like 30% of the segment, 25%?

Sandy Cutler

Yeah, we’ve not resized that at this point Rob, what we did was we provided in our February, New York Analyst Meeting. We had provided sort of pie chart if you recall on each of these and that was based off of our volumes in 2009. We’ve not recorded at this point, we will as we get out to the end of this year.

Rob McCarthy

Okay, very good. Thanks.

Bill Hartman

Thanks everybody, that completes the Q&A session and we appreciate your interest and as always be available for the rest of the day to continue to answer your questions. Thanks again.

Operator

Ladies and gentlemen, that does concludes your conference. Thank you for using AT&T executive teleconference service. You may now disconnect.

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Source: Eaton Corporation Q1 2010 Earnings Call Transcript
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