Johnson Controls F3Q10 (Qtr End 06/30/2010) Earnings Call Transcript

Jul.23.10 | About: Johnson Controls, (JCI)

Johnson Controls (NYSE:JCI)

F3Q10 (Qtr End 06/30/2010) Earnings Call

July 23, 2010 11:00 am ET

Executives

Glen Ponczak - Director of IR

Stephen Roell - Chairman of the Board, Chief Executive Officer, President and Chairman of Executive Committee

R. McDonald - Chief Financial Officer, Principal Accounting Officer and Executive Vice President

Analysts

Richard Kwas - Wells Fargo Securities, LLC

Colin Langan - UBS Investment Bank

Rod Lache - Deutsche Bank AG

Keith Schicker - Robert W. Baird

Brian Johnson - Barclays Capital

Christopher Ceraso - Crédit Suisse AG

Timothy Denoyer

John Murphy - BofA Merrill Lynch

Ravi Shanker - Morgan Stanley

Operator

Welcome, and thank you for standing by. [Operator Instructions] I would now turn the call over to Glen Ponczak. Thank you, sir, and you may begin.

Glen Ponczak

Good morning, everybody, and thank you for joining us. I am here today with Steve Roell, who is our Chairman and Chief Executive Officer, as you know, who will be providing an overview of our markets and a little bit about the quarter; Bruce McDonald, Executive Vice President and Chief Financial Officer, will go in more detail in business results and to perform a financial review. And then that would be followed by some questions and answers concluding right around noon, if it goes that long.

And before we start, I'd like to remind you of our forward-looking statement. Johnson Controls had made forward-looking statements in this presentation pertaining to its financial results for fiscal 2010 and beyond that are based on preliminary data, and are subject to risks and uncertainties. All statements other than statements of historical fact are statements that are or could be deemed forward-looking statements and include terms such as outlook, expectations, estimates or forecasts. For those statements, the company cautions that numerous important factors, such as automotive vehicle production levels, mix and schedules, energy prices, the strength of the U.S. or other economies, currency exchange rates, cancellation of/or changes to commercial contracts, changes in the levels or timing of investments in commercial buildings, the ability to execute on restructuring actions according to anticipated timelines and costs, as well as other factors discussed in Item 1A of Part 1 of the company's most recent Form 10-K filing, could affect the company's actual results and could cause its actual consolidated results to differ materially from those expressed in any forward-looking statement made by or on behalf of the company.

And with that, I'll turn it over to Steve.

Stephen Roell

Well, thank you, Glen, and good morning. As you saw in our press release that we issued earlier today, we had a good quarter, aided by a combination of recovering markets and market share gains.

So let me just go through a couple of the highlights. We were able to capitalize on the recovery of the global automotive industry in both of the Automotive Experience and Power Solution businesses. That was also further benefited by the fact that we just had strong aftermarket demand from our Battery business. That combination then drove our sales growth to 22% in the quarter. We also saw strong growth in our new orders in our Building Efficiency business. It was led by a 50% growth in North America and 70% growth in Asia, the Middle East and South America. I would continue to see weakness in Europe and that, in fact, the demand there was actually, less than a year ago. And so that's what resulted in the net 9% growth in orders for our entire sector.

Our Building Efficiency backlog at $4.4 billion was up 1% over last year. Again, most regions were up 4% to 7% with the exception being Europe. We feel good though about the demand that we saw particularly, around the orders that came through and the backlog that was built up in our Solutions business.

Across our businesses, we see good growth opportunities, continuing in the emerging markets, and we believe we are extentially [extensively] well positioned to take advantage of those regions. The restructuring actions that we initiated in 2008 and 2009 continued to yield significant benefits for us. The strong cash flow continued in the quarter and for the first nine months, as a result of very strong balance sheet, and that will provide us with the opportunity and the ability to consider investments that will accelerate our growth over the next 12 months.

So now just turning to the numbers themselves, our sales of $8.5 billion compared to last year's $7 billion, up 22%. If you adjust that for foreign exchange, the number actually improves to 23%. We had good growth in income, as I mentioned earlier. Our segment income of $496 million was up compared to $282 million in Q3 of 2009. Our net income of $367 million was up from $154 million a year ago, and that resulted in earnings per share of $0.54 compared to $0.25 in Q3 of 2009.

And just a couple of comments about that. We did highlight the fact that the impact of currencies, primarily the euro, was $10 million negative impact in the quarter on our earnings, and we had a non-cash impairment charge on our Automotive Experience Japanese business of $11 million. Those two items contributed roughly to about a 3% impact in the quarter, just to give you a sense of that.

Up on the right hand side of the exhibit that you might be looking at, we also talked about tax items, non-recurring tax items. We have highlighted the fact that we expected to have those to hit us in Q3 and Q4, both are positive, I should mention. In the current quarter, it was $51 million or roughly a $0.07 per share impact. And at Q4, we haven't sized that, but we recognized at this point, that there will also be a positive impact in Q4 from some valuation reserve releases probably. The point is that neither one of those are included in the guidance that we provided. We just want to make sure that, that was clear.

I want to now spend just some time talking about our investing. And this really is not so much a third quarter discussion, but just sort of the progress we're making and some of the things that we're doing, investments we're making both from a capital perspective, from an M&A perspective, as well as some joint ventures. These are all investments that are going to pay off in future periods. And I thought I'd spend some time just highlighting that by business.

First of all, turning to Power Solutions. Our Mexican plant launch is continuing on plan. We had a slight delay due to some damage to an access road to our facility. But the point is that, that is nearing completion. Production will start in Q1 of 2011. In South Carolina, we now have received all the necessary permits. Construction, we think, will begin shortly. We're targeting June 2012 for that launch. Both of these are expected to have a significant impact on our margins as we go forward.

Those of you that attended our CleanTech Day will recall we spent a lot of time talking about AGM batteries and Start-Stop vehicles. At this point in time, if you recall what those are, we sometimes reported those as micro-hybrids. We have some industry forecasts that predicted that more than 60% of all vehicles made in Europe by mid-decade will use the Start-Stop technology. It's about a 5% to 7% fuel efficiency gain without a lot of complexity and the cost of electrification of the drive frame.

Currently, we have about 70% market share of all AGM battery. We're increasing our capacity in Europe. And I would just simply tell you that as we look at adding lines, we are sold out already. So it's going to be a continuing investment, well, at first, probably over the next three years.

From a geographic expansion standpoint, we've talked about the fact that we are looking at and started our construction of a second plant in China. We're also currently looking at where to locate our next facility in the Chengdu Western province. We earlier had talked when we met with you, I think, most of the analysts that -- it's probable that we'll be adding a plant per year in China as we build to roughly, a 30 million unit capacity in that marketplace.

Today, we also announced the fact that we acquired 90% of the joint venture that we've been in since the acquisition of Delphi back in 2005. It's located in Seoul, South Korea. The other 10%, just for clarification, will be acquired by the local management team. It's a business that we've owned 50%. We've never consolidated it because we didn't have the control aspects of the governance aspect. We would now be consolidating. Sales will be roughly $250 million to $260 million per year. If you'll also see in the press release, we highlight the fact that we're going to be expanding our capacity of that facility as well. The transaction will be completed no later than August 15.

The Delkor brand is strong and well-respected throughout Asia. The acquisition further represents our commitment to local manufacturing presence and growth in China, and was located in Korea. Only roughly a third of the current capacity is used or the Korean market. The rest of it is for Southeast Asia and exports to China. So we just want to give you some sense for what that is. But there's a separate press release that has a lot more detail on that transaction. And as a final note, just to highlight, in terms of our lithium-ion vehicle batteries in Holland, Michigan. The battery assembly launch will again be in Q1 of 2011, and our cell production will launch later in that year.

Turning to Automotive Experience, just to highlight, we've talked about our presence in the Chinese market. In Automotive, we have over 40 plants today. We expect to add another 12 (sic) [10] manufacturing plants in the next 12 months. Our sales in 2010, just to refresh your memory, were approximately $3 billion, up from $1.9 billion. Majority of that, of course, is unconsolidated. But we just wanted to identify the fact that we continue to see the strong demand, strong growth, and we continue to penetrate the market in China.

We also made a small equity investment in a company called Tachi-S. Tachi-S is a Japanese seating supplier. It's a company that we've competed against. It's a company that we've partnered with, going back to the 1980s. It's a symbolic investment. It's not a very large investment, the contract is also 5% of their equity. So we believe the combination of Tachi-S' engineering, talent, relationships with a couple of the Japanese OEs complying with our footprint, will offer some opportunities to provide global programs for a number of the OEs who have approached us and suggested that we do exactly what we've done here.

Just on Building Efficiency, we talked about some of the investments we've been making to improve our delivery efficiency and profitability. We did and had been launching a system called NexGen, which is basically a scheduling, dispatching -- how we manage our logistics in that business. In Q3, there was a $15 million investments, and that's not capital. That $15 million relates directly to P&L. So some of you have talked about the margin pressures and the margins disappointment in BE in the quarter. I just like to point out again that there was a $15 million P&L investment related to the NexGen service technology delivery system, and that's not a surprise to us. That's what we expected to spend in this quarter.

We also looked to, as we talked, to the CleanTech data, we had shared our headquarters. We talked about the growth opportunities that we see over the near-term. And we identified the fact that we'll be hiring roughly 17,000 new positions over the next five years. That's roughly 1,000 energy engineers, 1,000 technicians that have LEED certification and 15,000 field service technicians. And so I would just tell you that we're hiring engineers in every aspect of our business today, whether it be our Service business, our lighting applications, our Solutions business. We're right now adding engineers to our workforce.

In terms of 2010 guidance, let me turn to that for a second. We had guided to the $1.90, $1.95 range. We've now come out in our press release and confirmed that we will be at the higher range and that we expect that our earnings for the full 2010 fiscal year to be $1.95. We've also identified the fact, of course, that we did see higher automotive production in North America. That's been offset by two things, primarily the euro, then some of the accelerated investments and expense decisions that we've made.

From a Building Efficiency standpoint, the markets are slowly improving. We see, as we've mentioned, the improving backlog, higher orders. Those orders and backlog will benefit primarily fiscal 2011. We see strong demand in energy efficiency solutions, and that's really where a lot of our demand came from in the most recent quarter.

We see continued double-digit growth in GWS and residential HVAC. When we're able to, we'll describe a couple more large contracts that we've recently been awarded in GWS as soon as those customers allow us to describe those in more detail. And as I mentioned earlier, we still have continuing strong momentum in most of the emerging markets.

Just a comment, on the very bottom, if you're following with the slides, there's a reference to our 2011 strategic review and forecast. We've identified that on October 12, we'll be having our outlook for 2011. It will be held at the New York Stock Exchange. What I'd ask you to do is we'll be sending out save-the-date notes to you shortly. Those will be coming to you in August, and there will be more details in early September. For those of you that aren't familiar with that, that's the timeframe when we typically provide the detailed guidance into a defragment or our businesses with our Presidents, Bruce and myself. And so we're looking forward to that. And that's sort of the '10 outlook.

I'm going to turn over to Bruce, who will go through the businesses' performance in the quarter, and also go through the financial results. Bruce?

R. McDonald

Thanks, Steve. Let me start here with Automotive, delivered another solid quarter here, with good results in all the geographic segments. If you just look at each one individually here, North America, we saw sales up 76%. That's against the production increase of about 74%. So again, outperforming the industry, which is the theme that we've been talking about all year.

In terms of Europe, if you back out currency, sales are up 25%. And that's versus an estimated decline in new vehicle registration of about 8%. And lastly, in Asia, which for us, is predominantly Korea and Japan, because these are consolidated businesses, our sales were up 61%, reflecting several new vehicle launches in both those countries. And as we noted before, in China, our sales are up 40% in the quarter to $774 million. And our sort of estimates that we're getting in terms of industry sales in China were up about 30%. So again, outperformance in the quarter, which really reflects share gain and some of the focus that we've had on the local Chinese customers.

In terms of segment income, we had $171 million versus a loss of $14 million last year. We feel good about our profit conversion rate on incremental sales, and we're now clearly seeing the benefit of our restructuring activities.

In terms of the Chinese top line growth, that, as you know, is being reflected in significantly higher equity income. It benefits the segment. You'll see that when we go through the financial results later on here.

In terms of the geographic margins, we've noted them in the box here. A couple of questions, I've seen the early notes about the North American margins. Maybe just a couple of points on that. I mean, generally speaking, our performance in the quarter in North America was better than we expected. If you just look at the sequential decline from Q2 to Q3 here, no real big issues, but a lot of minor issues. Say, first, I'd point to maybe the timing of some customer recoveries and the fact that with higher engineering costs in the quarter. Secondly, we had some small work stoppages in Mexico, which caused some production inefficiencies. And we also relocated our accounting and back office processing out of North America into Europe. That's going to be a cost savings for us as we go forward, although a small cost in the quarter.

I'd also remind the folks listening that this quarter, our sales were inflated by the Vistion plants that we acquired, that service Chrysler. That was about 1/3 of the sales increase in North America, and the cost of integrating those plants was a slight hit to us in the quarter. So those are really the drivers behind the Q2 to Q3 financial performance in North America. But as I said earlier, our North American results continue to come in better than we expected, and we feel very good about the turnaround in that business and the fact that we've maintained our break-even level at an extremely low phase.

In terms of our overall results here, as I said before, we did have significantly higher engineering costs and launch costs versus last year. That was worth about $42 million in the quarter, or roughly $0.05 a share. We've talked in our previous calls about some of the inefficiencies and supplier disruptions and stressed supplier costs in North America and the fact that we expected those to trend down. For the quarter, that was about a $10 million headwind for us. That's down from $25 million in Q2. We expect those three largely behind us here as we end the year here.

And I know Steve talked about earlier, we did take a non-cash charge of $11 million in our Japanese Automotive operations. That's really associated with some footprint actions that we've got planned in the early part of 2011.

Turning to Building Efficiency, you can see our sales. When you take away the rounding here, we're up about 2%. Currencies for Building Efficiency really wasn't a factor, it was worth about 1%. Our markets, as Steve indicated, beginning to improve and we saw good order activity, particularly at the back part of the quarter. In terms of the businesses that don't flow through the backlog, and that's Global WorkPlace Solutions and our North American Residential business, those businesses were up 11% and 7%, respectively. And we also saw some good performance in terms of revenue from outside North America and Europe, where we experienced revenue growth of about 8% in the quarter if you take out foreign exchange.

In terms of North America, overall, and I'm talking about both our Systems and Service business, our revenues were down about 3%. But the positive thing here is really our order performance. In the quarter, we saw 15% order improvement in North America. So this being a late-cycle business, it's going to be two or three quarters from now. That really points to a pickup here, as we get into 2011.

The other thing I noticed, our Service business was negatively impacted by a slow start to the summer cooling season. We typically see this monthly sequential pickup in our service activity here in the third quarter. May and the first part of June, were particularly soft -- I'm sorry, April and May were particularly soft. June, we finished strong, and we see good momentum as we get in here to July. So I think, our Service business, we should start to see some tailwind here associated with the weather.

Lastly, in terms of ARRA, we didn't really comment on that here on the slide, but I thought maybe I'd update the audience. We booked about $178 million in the quarter, and that's up 24% from the $143 million that we booked in Q2. In total, our ARRA orders to date, and I'm talking since the program started here, about $430 million.

Lastly, in terms of Europe, this remains our most challenging market for the quarter. You can see here that sales were down 7% if you back out the impact of foreign currency.

In terms of segment income, we were level at $190 million versus last year. Here we saw the positive impact of some of the higher volumes and productivity improvements, offset with some of the investments we're making like NexGen, the higher systems selling investments and a negative impact in terms of the higher-margin Service business that was slow flowing through in the quarter.

In terms of our backlog, it was up about 1% on a year-over-year basis, and I think the key point here, we've talked a little about some of the verticals, but the key point here is this is the first time since March of '09 that we've seen our backlog improve. And that's were driven by the momentum that we're seeing in the order intake activity.

In terms of Power Solutions, we had a great quarter here. Sales were up 30%. Although if you back out the impact of LEED, about 16%. You can see here unit volumes were up about 15%, overall, with aftermarket being up 9% and the OE up 36%. Within our numbers, we did start shipping the incremental Wal-Mart volume. That came through just in the month of June, and it wasn't even a percentage point. So we do have some volume flowing through. That incremental business is growing as we expected. But it really hasn't had a much of a positive impact in terms of our financial performance yet. We expect that to accelerate here in Q4. And in Q1, will sort of really hit our stride and be at the full 5.3 million annualized units of incremental volume.

In terms of our segment income, at $135 million, really, we're getting the benefit here of higher volumes and stronger operational performance. And I'd also like to point out, if you look at the prior year, we had some charges in the prior year that obviously didn't reoccur.

Maybe now I can just turn over to the financials. And here I think, overall, yes, we feel pretty good about the quarter. It's a pretty good number. We saw sales growth at 22% to $8.5 billion, as Steve indicated earlier, foreign exchange worth about 1 point. If you back that out, it was 23%. Good, obviously, stronger higher volume growth in all three of the businesses. And in Building Efficiency, we're clearly bouncing off the bottom here.

Nice performance on the margin side. You can see our gross profit here was 15.7%, about an 80 basis points worth improvement versus the last year. Here, you're really seeing the benefit of both better capacity utilization and manufacturing operation, as well as the positive impact of our restructuring actions.

In terms of equity income, you can see an increase of $22 million versus last year. Here, again, we continue to see the strength of our Chinese automotive joint ventures. The other benefit that we're seeing are some of the equity accounted investments that we have in our Automotive segment.

In terms of maybe flipping the page to the financing income, you'll see that our financing charges declined from $65 million to $39 million. That really reflects the conversion of our convertible debt. That's worth about $20 million of the reduction. And from an EPS point of view, that was added back to the prior year. So we really don't get year-over-year benefit for $20 million of the financing charges. We have a higher share count this year, and we don't have the add back that we had the year before. In terms of our tax provision, we came in at a clean rate of 18% for the quarter, which is comparable to the level that we had last year.

And then lastly, maybe I'll just spend a bit of time talking about our guidance in a little bit more detail. Steve indicated earlier, we're guiding to the $1.95 at the high-end of our previous range. So from a revenue point of view, we're leaving it unchanged. But that really is offsetting a couple of different factors. One, we're taking the North American vehicle build up assumption in line with CSM 11.4 million, but offsetting that, we've got a slightly weaker euro here of $1.30.

In terms of Building Efficiency, we're trimming our sales growth here a little bit from 5% to a range of 3% to 5%. That's really the impact of the euro and largely the late start to the cooling season that we saw in Q3. Our Q4 outlook for Building Efficiency is consistent with what we thought last year. So most of that shortfalls behind us are attributed to the euro.

In terms of EPS, at $1.95, we see good conversion on the incremental sales growth. The euro's hitting us for $0.03 or $0.04. And we are ramping up some of our investments, particularly in engineering and sales force to get ready for next year. So we feel comfortable with the revenue flows in Building Efficiency. But we want to get ahead of the hiring curve here. So we are going to bring some cost into the fourth quarter, reflecting our confidence in the outlook here.

In terms of segment margin, overall, they're unchanged. But we've ticked up Automotive to 3.6% to 3.7% and ticked down BE to 5.2% to 5.4%. But overall, the margin's going to be unchanged. Net financing charges, a little bit lower here, and that's really reflecting slightly better timing of cash flow, but ongoing very low short-term rates. And for the year, we continue to expect and exit the year with a very strong balance sheet. Free cash flow forecast is $1.3 billion, and our net debt to total capitalization is going to be both unchanged below 20%.

Maybe the other point I'd just like to make out is it doesn't really shock our cash flow. We don't talk about it too much. We are taking of the opportunity here to accelerate some of our pension funding and that kind of flows through on our working capital statistics. But if you look on a year-to-date basis, we've contributed about $225 million over and above what we're sort of required to increase the funding of our plants, as primarily in the U.S., and it shows through as a use of cash in the working capital section, as we build our prepaid pension asset.

So with that, I think we'll turn it back to [indiscernible] have questions.

Stephen Roell

We're ready for questions, operator.

Question-and-Answer Session

Operator

[Operator Instructions] Tim Denoyer from Wolfe Trahan.

Timothy Denoyer

Can you give a little more detail on the AE Japan impairment? What exactly was happening there?

R. McDonald

We're actually just doing some moving around of some administrative facilities, and it was charge to write down the value of an office building.

Timothy Denoyer

So just barely one-time kind of charge?

R. McDonald

Definitely.

Timothy Denoyer

You mentioned small work stoppages Mexico in the quarter. Can you give a little bit more color on what happened there, and if those are ongoing?

Stephen Roell

I guess, there were two really. One had to with a facility in Pueblo (sic) [Puebla], and that was a labor issue, which has been resolved. The second one, I think, has to do with some of the weather issues that we incurred on the Monterrey area, it's where the Hurricane Alice went through. We lost some production there. But those are the only two, and we don't expect those again obviously, to repeat.

Timothy Denoyer

Did some of the weather-related issues go into fiscal fourth quarter?

Stephen Roell

No, not really.

Timothy Denoyer

Wasn't the hurricane on June 30?

Stephen Roell

I guess, if I had to say it, if they carry on, they weren't significant, okay?

Operator

Our next question comes from Ravi Shanker from Morgan Stanley.

Ravi Shanker - Morgan Stanley

Bruce, you've mentioned that there were a few one-time issues that depressed margins in North America on the Auto side. And surely, your variable margin in the quarter was much lower than 2Q. Can you just give us a sense of how that sort of look in forthcoming quarters? Do we expect a normalization there?

R. McDonald

Well, yes. I think, one of the things that's obviously, tough to forecast is the timing of some customer recoveries in engineering. And right now, we're going through a period where we're trying to read -- we're investing incremental dollars in our engineering expenditures to try and build up our backlog. We've been very successful. And I think in the previous call, we've talked about the fact that our current backlog is looking significantly higher than the one that we talked about last year. But we are dedicating more engineering resources to bring in incremental work.

Ravi Shanker - Morgan Stanley

And so that looks like they're going to continue for a few quarters more.

R. McDonald

Well, again, like I sort of rattled off a few things in terms of engineering recoveries, the customer settlement, those types of things are hard to forecast, so I wouldn't necessarily say those are indicative of a trend. Things like the Mexico work stoppage, moving some of our back office stuff to Eastern Europe and the integration of the Visteon plants are things that are, I would say, behind us.

Stephen Roell

Ravi, this is Steve. Just a comment, I think that it gets very difficult at this time of the year to do sequential quarter-over-quarter in Automotive, in particular. We have shutdown periods that we experienced in July and August. And I know it's hard to do comparisons against the prior year because the production levels were so much lower. But what you should expect from us in year-over-year comparisons are the conversion rates that we've talked about and the ability to bring as 15% up to as much as a 20% conversion on the sales dollars that we get. That's probably the most significant thing I would tell you. I don't think we'll see the higher engineering costs -- and Bruce talked about the recoveries. We had a tough comparison against the prior year in this quarter. That's the way I would describe that. So I don't expect to see that issue. And launch costs are there, but that's just a part of the fact we got a growing backlog, and we have launch costs.

Ravi Shanker - Morgan Stanley

On the Building Efficiency side, you took down your forecast of the year of 3% to 5% versus 5% before. But the midpoint of that range still implies a pretty strong 4Q. Can you talk about some of the trends you're seeing out there that gives you confidence that 4Q is going to be that much stronger?

R. McDonald

It's really driven by -- in terms of our ability to forecast the short term, it's the flow of the work that we have in our backlog, so we have pretty good visibility for that. I think we're very confident in terms of Q4 that we're going to see double digit. On a constant-currency basis here, we're going to see double digit both growth in income top line and bottom line growth.

Ravi Shanker - Morgan Stanley

And just finally, can you comment on your relationship with Ford on the hybrid battery side? We saw an announcement from Ford that they're going with LG for the electric focus. I don't know if you guys had that or not, but where do you see that going forward?

Glen Ponczak

It's Glen here. I think that our relationship with Ford is for the plug-in that's launching in 2012. And we also do have an electric vehicle with the Ford Transit Connect launches here soon. But I think when you look at what the OEs are doing in general and not just Ford, but in general, that I think you'll see them still in a phase here where they're trying to test various technologies and test different suppliers. And they're often using it, seems EVs, pure electric vehicles, which have smaller volume, as sort of a, less risky way of, sort of, getting a different taste for different things. So I wouldn't classify the announcement regarding LG as sort of change in [indiscernible]. They're trying different things and that's probably going to continue for quite some time.

Operator

Our next question comes from John Murphy from Bank of America.

John Murphy - BofA Merrill Lynch

I had a question on margins in the Battery business. Obviously, as you guys go through an increased level of usage of your recycled lead, you're talking about margins expanding. Obviously, there's a lot of variability around these margins. I'm just trying to understand where you think those margins might settle in, and you're alluding to them improving. We saw 12.2% in this quarter. We've been seeing as high as 17.5%, about a year and a half ago. Just wondering where we should think about those margins going forward as you ramp that recycling?

Stephen Roell

John, just so you understand, it's not so much that recycling that's causing that variation. What's causing that variation is the volatility of lead pricing, and the fact that, as lead goes up or down, it hits our top line. But we've said that with our hedging strategies and our recycling, we're able to minimize that, and therefore, profitability, it doesn't really have that same volatile nature to it, okay? It's really that factor that caused that volatility between 12% and 17%.

R. McDonald

But on a constant lead basis here, John, what we've said is that when the two smelters come online here, that's worth about 200 to 250 basis points of margin expansion.

Stephen Roell

From whatever base...

John Murphy - BofA Merrill Lynch

That's what I was getting at. I understand the variability from the spot market. Just trying to understand what base we should be thinking of for that 250 basis-point improvement?

Stephen Roell

That's tough because you have to make an assumption regarding lead. I think the important thing is -- but I understand your point. I think if you could just take our earnings this year, and just say, for the segment and use that 250, you're okay.

John Murphy - BofA Merrill Lynch

And then on Slide 9, the commercial backlog increasing 1%, that's a good thing. You alluded to the Government, Healthcare and Energy Solutions segments as strong and Education is weaker or lower. Is there a lot of dispersion? Obviously, a 1% increase is good, but it's small. Is there a lot of dispersion in those categories and are there any that are extreme positive or extreme negative in the commercial backlog?

Stephen Roell

Yes, there are. If I were to look at the government sectors, an example right now, you would find something north of 25%. And that's not just federal, that's state and local as well. You'd see double digit if Healthcare, and you would see double digit in Energy Solutions. The weakness in Education is about 7% down year-over-year, and it's a combination of both higher ed and K-12.

John Murphy - BofA Merrill Lynch

Lastly on the accelerated pension contributions, is that taking advantage of market weakness? What's the purpose for accelerating those pension contributions?

R. McDonald

We're just trying to use some of our cash to address what our shortfall was. So if you go back and look at last year's K, globally, our pensions are underfunded, about $1.1 billion, about $600 million of that is in the U.S. And what we've decided to do here is given our -- we've got a good strong cash flows and our balance sheet's significantly under leveraged. We're using some of that money to build that shortfall.

John Murphy - BofA Merrill Lynch

And it's purely discretionary at this point?

R. McDonald

Yes, our mandatory payments are zero. We've overcontributed.

Operator

Our next question comes from Chris Ceraso from Crédit Suisse.

Christopher Ceraso - Crédit Suisse AG

I have a question on the outlook and the guidance in the Building business. I guess, what I worry about is that things continue to be a little bit slow in the macro environment, and you have to bring down your expectation for sales and margin again and then again after that. Is there an argument to be made that you'd just bring the expectations down more meaningfully, allow for room for the economy to worsen and then maybe do better than expected, rather than trying to, sort of, keep a strong outlook here?

Stephen Roell

Let me try to sort out what I just heard here. I guess I would tell you that if you read the information from Global Insight and Words [ph], you'd get -- concerned about just the new construction environment. But if you look at what we see in terms of the opportunities at energy, GWS, what we can do in some of the existing retrofit areas, that's why we're confident to add work force. So while we've taken near-term guidance down, I guess, I would say that we're feeling more and more bullish about the outlook for the next 2, 3 years, and that's why we're so committed in adding to our sales force in all the areas. We think we need to build up capability, not contract, particularly around the Energy Services area. That's where we're adding [indiscernible] retrofit, that's why we did the lighting acquisition. That's why we'll continue to look for solutions salesman that can do that. I'm not sure I'm getting your point, but we're pretty bullish about what we think the future is. Just the near term, people are still being cautious. Small business still is not investing. They're not able to access funding. And so it's a little -- there are bumps on the road here. But we think over the long term, that the energy efficiency side of it, the equation of saving money is going to win, and we feel good about that.

Christopher Ceraso - Crédit Suisse AG

So the reduction to both the revenue and the margin, was that primarily the late start to the cooling season? Or what were the contributing factors there?

R. McDonald

It was that, Chris, and a little bit of the euro.

Stephen Roell

Chris, I'd also tell you that we probably have made; a conscious decision to make accelerate investments in our sales force from what we had. We go through our strategic planning with our organizations in the April through July timeframe. And as we went through that, we gained more confidence, and as we've gone through and developed our profit plans for '11, we've decided to go ahead and accelerate some of those investments.

Christopher Ceraso - Crédit Suisse AG

You outlined earlier on the call a number of investment areas. There's no real big hits though, and judging from where your balance sheet stands versus history and when you've done big deals, it would seem that you've certainly got the capacity to do a bigger deal. So the question is do you have anything of size that's brewing in the next 3 to 6 months? And are you still looking at all three business lines, as you typically do?

Stephen Roell

We are looking at all three business lines. Again, as I've indicated in the past, I think the majority of our CapEx will be targeted at our Power Solutions business in the near term because of the vertical integration that we're doing and the expansion in China. And on the M&A side, it is all three businesses, but there's nothing we could describe. We're not far enough along in any deal discussion to really describe anything to you at this stage.

Operator

Our next question comes from Colin Langan from UBS.

Colin Langan - UBS Investment Bank

Can you give an update of the -- I think in the past, you've given an outline of the stimulus, the U.S. stimulus plan being about a $10 billion opportunity? How is that still look like, it's like a $10 billion opportunity and is the size of the -- do you still think that's going to be a help going forward or is it a little disappointing so far?

R. McDonald

Colin, it's Bruce here. I think when we originally sized up the opportunity here, we said that the amount of -- our fair share was maybe $3 billion. That was, kind of, the number that we talked about. And we said that we felt that was something that we could maybe go after over the next two, two and a half years. And as we look at the, sort of, bucket of that, we're feeling pretty good in terms of the amount of suspending that's happening at the government level, but a big chunk was due to the educational market, and that's where we've really seeing slow slugging, I think. I mean, that's, kind of, the best way to look at it is, so far, as I've said, we've booked about $430 million of orders. Under that program, we originally sized the opportunity at $3 billion. For sure, it'd be fair to say, it's come in lower and slower than we had originally thought. But I guess, you said, we don't really have a current view as to how big the $3 billion is. I guess we're still hopeful that we'll start to see some flow in the educational side. But what gets difficult for us is while on the ARRA side, education is flowing slow, as Steve indicated before, the education market, in the earlier part of the year was strong, and now it's turned weak again. It's a tough market to get a read on.

Stephen Roell

If I can just make a comment, I think it's the education, which is were -- if you recall, we had the opportunity that we targeted was identified. And up to this call, I've identified the fact that we weren't seeing the education orders or business flow through the ARRA program, but we were seeing good demand otherwise. So just to give you a sense for it, even though our orders were down this quarter, year-to-date, we're up 5% and 10% year-to-date after nine months on education, and our pipelines are still good. So I think that two things have happened: One is that school boards have made the decision to find other traditional ways to finance some of the work that we would thought would go through ARRA. And I think that arguably some of the ARRA money has been basically devoted to operating budgets, just to meet and retain future. So it's a combination of both.

Colin Langan - UBS Investment Bank

Why not exclude as a one-time charge, the impairments as you did with the tax benefits? But minority interest was down a bit sequentially, is there any reason that should be -- is that seasonally low or why such a low number relative to Q2?

R. McDonald

It had to do with some launch and cost in one of our North American Automotive joint venture. So what that means is our consolidated joint venture made less money, right? So you can say we benefited from that, if you just look at that line. But overall, we lost because we have a bigger negative up above in the segment income. But it wasn't -- there are some quarterly issues, they're non-recurring.

Colin Langan - UBS Investment Bank

So that's just, kind of, return to as...

R. McDonald

You should see a tick-up here in the fourth quarter and definitely next year.

Colin Langan - UBS Investment Bank

And the impairment, anything about it that would...

R. McDonald

I think what we're trying to do here is get away from -- I think we're going to be transparent in terms of when we have these types of costs. But we want to get away from pulling out of all these things and saying, "Look, this is just for this and just for that." Here's, kind of, what the underlying numbers are. We're going to be transparent [ph] when we have them, both good and bad, but we want to, sort of, steer away from a lot of non-GAAP adjustments.

Operator

Our next question comes from Rich Kwa (sic) [Rich Kwas] from Wells Fargo Securities.

Richard Kwas - Wells Fargo Securities, LLC

Question on commercial HVAC, if you listen to UTX and some others, it seems like second quarter, there's actually an uptick in commercial HVAC. What are you seeing on that front? Was it positive for you in the quarter?

R. McDonald

We're seeing good demand in the rest of the world and certainly, recovery, Rich. I think I would also tell you though that I haven't looked at all the numbers from UT and I certainly haven't had the chance to look at trains' numbers yet this morning or Ingersoll Rand's. I would tell you that the equipment market recovers faster than others. The controls in the big projects are ones that have probably lagged and they probably hold up better because they're in the pipeline for a long time. But it's difficult for me to comment on HVAC and other parts of the competitors' data at this point in time. I don't have the data that I need to be able to answer your question, number one, but number two, I think we also have to look at what happened a year ago in terms of year-over-year comparisons.

Stephen Roell

As I said, which in our numbers, the North America, our orders were up 15% in the quarter. In Europe, they were down 14% and in the rest of the world, they're up 17%. If you, sort of, average that out, that's the plus 9% that we've talked about here. I think from the headlines that I've seen, I think those numbers stack up pretty well.

Richard Kwas - Wells Fargo Securities, LLC

I was just trying to compare and contrast there.

Stephen Roell

The problem that we've got, Richard, is twofold. One is our volume's helped by the amount of work we do in the Solutions area. And the competitors that you're looking at -- some of their numbers include everything they do from refrigeration on and off, and so it's really hard.

Richard Kwas - Wells Fargo Securities, LLC

The $15 million cost for the Information Technology improvement, does that come off here in the fourth quarter? Do we get any impact there, Bruce, in the next year?

R. McDonald

Yes, we finished the implementation. So it's been a, sort of, headwind for us for the first three quarters of this year is now behind us. So we'll see in Q4, a big pickup in our service margins because we don't have the cost, and the benefits are accelerating from making those investments.

Richard Kwas - Wells Fargo Securities, LLC

So that's why in terms of the double-digit growth and operating income for the fourth quarter, that's part of the reason there?

R. McDonald

Service margins are a big driver of that.

Richard Kwas - Wells Fargo Securities, LLC

And then lastly, in terms of the Auto North America, I know you listed a bunch of things there. Could you quantify the impact in terms of basis points?

R. McDonald

Basis points of those things?

Richard Kwas - Wells Fargo Securities, LLC

Yes or dollars.

R. McDonald

Well, let me start with -- on the sales side, so about 1/3 of the sales growth, Q2 to Q3 is due to us bringing on the Visteon plants that we acquired. And that was -- I'm not going to comment on the numbers, but that was at a negative, okay? And then if you just look at engineering, customer recoveries, the cost of moving some of our back office next year to Europe, the work stoppages etc., it's north of $20 million.

Operator

Our next question comes from Rod Lache from Deutsche Bank.

Rod Lache - Deutsche Bank AG

A couple of questions on the Building Efficiency business first. Could you just remind us what percentage of the business is government now, including state and local and K through 12 schools? Also, on the ARRA comments, are you anticipating that, that business is likely to be higher in 2011 versus 2010? And then lastly, on that unit, what was the total investment in these efficiency programs that you highlighted? And any thoughts on the payback?

R. McDonald

I'll take the third part of that question, so we can formulate our answer on the other two. The cost of that investment, Steve talked about, the NexGen, so it's sort of automating the service tech work and provides us with root planning, better pricing information, things like that. In the quarter, the cost was $15 million, on a year-to-date basis, we probably spent close to $50 million on it. And licensing [ph] before that's done. I'm not going to get into what the benefits are exactly, but I mean, it's an attractive investment for us, and we expect it to be additive to our margins. It proves the productivity of our field personnel and it also helps us get -- a big driver of it is helping us get more accurate and shorter invoicing times. So a big part of the benefit is going to come from the working capital side.

Stephen Roell

Let me try to get the other two. I guess the only thing I would tell you in addition to what Bruce describes in NexGen, the other thing we're doing in terms of sales force is try and ensure that we have double-digit growth in our Service and Solutions business. And that's really what we're doing there. So it's going to be more of a top line, help driving us in that regard in areas where I think we have very lucrative margins. In terms of your question about ARRA, just to give you some sense for it, if you recall, Rod, we were surprised. Last quarter, we told you we booked more in that quarter that we had in the previous year and a half. And in this year, in this quarter, we booked 50% more than the last quarter. So I would tell you, we're surprised by to some extent by what we're seeing here. And the sense that it's come back. We thought it wasn't going to be there at all, so we've been surprised a little bit to the extent that it's been as strong as it has the last two quarters. It's hard for me to project what's going to happen for 2011 at this stage on ARRA, specifically. And in terms of the fee percentages, I was trying to see what I could help you here. Traditionally, if I look at the government, healthcare and education, that's probably at least, it's almost 70% of our North American revenues would be in those sectors.

Rod Lache - Deutsche Bank AG

But that also includes private business, private healthcare and private education?

Stephen Roell

I don't break that out that way. I get a lot of K-12, and I get higher education, but I don't have it broken up between private and public health.

R. McDonald

We can't calculate on that.

Rod Lache - Deutsche Bank AG

We can follow up on that. On the Automotive, do you have any thoughts on how this year compares to a normal year in terms of launch costs? Do you have any update on the commodity inflation outlook? And just my last question would be, any intermediate term thoughts on the revenue and margin outlook for Europe? You've been pretty clear on the outlook for the next quarter or so, but how are you feeling about that business, just on an intermediate term basis?

Stephen Roell

The launch costs, Rod, in the quarter were up about $7 million, just to give you a feel for it, year-over-year. We'll end up giving you more information on both margins and launch costs in that October meeting. As you know, we do that, we also share with you our backlog of new business. So we'll go through them at that point in time. It's my best shot I can give on that.

R. McDonald

But I think it's clear to say, we expect -- if you go into 2011, Europe is our big driver of where our business is going to gain momentum here in Automotive. We've had a lot of launches, a lot of engineerings. Some of the difficult headwinds that we talked about, like the stress suppliers and things like that. It turned out, we have a few plants that we were not pleased with the performance that are getting better. So year-over-year, when we talk about our Auto business side in 2011, you're going to see continued strong growth in Asia, and you're going to see a big turnaround or a continuation of turnaround, I guess, in Europe. In North America, we actually -- if you go into next year, we actually -- when we talked about the fact last year that our backlog was flat from North America, in '11, it's actually down. It's a negative number. In '12, it's a positive because we have some programs with Chrysler that roll off next year. So you'll see a flattish outlook in terms of profitability, but down in sales.

Rod Lache - Deutsche Bank AG

Any thoughts on commodity inflation?

R. McDonald

That's a tough one. Earlier this week, I was feeling better about the trend getting lower and now it spiked right back up the last few days. I think it's clear that we're going to see an uptick in 2011, but I guess I would remind everybody, this is an area where we have been laser-focused on the fact that we wanted to derisk our Auto business. And we feel very confident that in the face of rising commodity costs, that we've got a good portion of our business. We've talked about 90% of our global revenue where we've got indexing, full or partial in place with our customers. We do expect to see a pickup next year. It's tough to say how much, but I'd say, we're very confident in our ability that we're going to be able to recover a big chunk of that from our customers.

Operator

Our next question comes from Brian Johnson from Barclays Capital.

Brian Johnson - Barclays Capital

On the auto production, the assumptions that you're using for the full year seem to be below where the year's headed, looking at CSM. Does that imply that you've got very conservative production numbers penciled in by 4Q, just by processes subtracted, where we are?

Stephen Roell

We don't think so. I think in North America, CSM recently ticked the number off to 11.6 from 11.4 where we have it. I think if you look at some of that difference, I think, our Q3 came in a little bit higher, but again, if CSM is correct, there's a small amount of upside in the North America number. I've seen some numbers in terms of the European assumptions, and I don't -- we're going to have to go and look at that. I think we have to see what's in and out of there because we don't have a gap in Europe as some of the headlines I saw this morning.

R. McDonald

We're at 16.7 in our deck here. And Brian, 16.9 we've heard, it's in that kind of number, but it's not a picked up delta, okay?

Brian Johnson - Barclays Capital

Well, if it's in one quarter though, it could be significant?

Stephen Roell

That's fair. It's not our intention to be conservative. This is what we believe is -- we're not trying to gain the program here. We're sitting here saying this is what we think it's going to be.

Brian Johnson - Barclays Capital

Ann within this strong Europe year, you're looking to next year, any color you can give us around the mix, the type of vehicles, in particular, as one of the big debates is luxury versus volume with, in general, people more comfort on luxury growth through 2011? I'm wondering what's going to happen to the volume markets with fiscal austerity, kind of, how you're positioned between those two segments?

Stephen Roell

You're talking about through 2011, Brian. I think we better push it off to our October discussion. We're not really talking 2011 here yet.

Brian Johnson - Barclays Capital

Last question, the late start to the cooling season, a lot of people feel hot in various parts of the world, what drove that? And is this just still that deferral of preventative maintenance that landlords should be doing? Are we really ever going to get out of that? Are we, kind of, stuck with just infinitely deferred maintenance, perhaps, because of low occupancy rates?

R. McDonald

I think on the deferral -- there's two different things. On the deferral of discretionary work, yes, we're continuing to see that. And I think until we see confidence, business confidence improve, we're going to be living with that. The late start in the summer cooling season, really affects our truck-based service where people turn on their air conditioner, it doesn't work. We acknowledged it's been hot in June and July, while we're here, we're talking about the unseasonably cool weather that we had in April and in the early part of May.

Stephen Roell

I guess maybe, Brian, the one thing that I would tell you we'd seen a pickup on -- this is, again, not the truck base that Bruce has referred in terms of the weather. But we've seen a pickup in our coating activity around what we call, prime, which is the small project work, typically performed by our Service business. That's picked up and that's the area that if you go back to the deferral, that's the period that we saw soften at that point in time. It's also an area that we decided we needed to resource better, so we've actually -- that where we're adding sales force as well in our service organization, just to go after those opportunities.

Operator

Our next question comes from David Leiker from Robert W. Baird.

Keith Schicker - Robert W. Baird

It's Keith Schicker on the line for David. If we look at the launch costs, Bruce, the $42 million that you talked about in Europe, what was the change in that figure sequentially?

R. McDonald

Well, that number is engineering and launch costs, that's a global number. I don't have the Europe on hand here.

Keith Schicker - Robert W. Baird

Can you discuss how that global number changed sequentially?

R. McDonald

Sequentially from the previous quarter?

Keith Schicker - Robert W. Baird

Yes, from Q2.

R. McDonald

It was up from a couple of cents.

Stephen Roell

I use the numbers $7 million, which is a year-over-year comparison.

R. McDonald

That's just launch.

Stephen Roell

That's launch. So of that 42, seven was launched. And again, we have a tendency to look year-over-year, not sequential, because of the seasonality of our business. Be careful with sequential comparisons.

Keith Schicker - Robert W. Baird

And with the ten new plants that are going to be opened in China, can you just provide some context around that investment there, just new customers, market share gains there, just to handle growing volumes with existing customers? And what type of product is this?

Stephen Roell

It's a combination of all those. In some cases, we're actually vertically integrating and putting in component plants, electronics and things of that nature. In other cases, it's new business with customers. And really, I'm not sure how the market share plays into it, but it's basically where we've won business in and are working with our current customer base.

Glen Ponczak

Thanks, Keith. We're going to have to cut it off here because we're at the end of our time. I'd just like to turn it over to Steve for some concluding comments.

Stephen Roell

Sure, just real quickly if I could. I just want to reiterate that we're very pleased with the results for the quarter, performing, kind of, what our forecast were internally due to higher production in the auto area, partially offset by what we saw as currency headwinds in some of the investments that we're making. I think the third quarter, you should look at it as we had another proof point of our return to sustainable profitable growth. We're increasingly optimistic about the near term, continuing to recover the automotive markets, we're seeing those significant improvements in BE's orders and backlog. And again, the growth and strength of the emerging markets. We expect improvements again in Q4, consistent with our guidance. And we look forward to meeting and seeing everybody on October 12 when we give you our in-depth look of our markets, growth strategies for 2011. And with that, enjoy the rest of your summer. And thank you very much.

Operator

Thank you for participating in today's conference call. Have a great day, and you may disconnect at this time.

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