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Eaton Corporation (NYSE:ETN)

Q3 2010 Earnings Call

October 20, 2010 10:00 am ET

Executives

Bill Hartman - VP, IR

Sandy Cutler - Chairman and CEO

Rick Fearon - Vice Chairman and CFO

Analysts

Jamie Cook - Credit Suisse

David Raso - ISI Group

Eli Lustgarten - Longbow Research

Chris Glenn - Oppenheimer & Co.

Meredith Taylor - Barclays Capital

Nigel Coe - Deutsche Bank Securities

Andy Casey - Wells Fargo Securities

Tim Denoyer - Wolfe Trahan & Co.

Andrew Obin - BofA Merrill Lynch

Tim Thein - Citi

Jason Feldman - UBS

Robert Mccarthy - Robert W. Baird & Co.

Operator

Welcome to the Eaton Corporation Third Quarter Earnings Conference. (Operator Instructions). I would now like to turn the conference over to Vice President of Investor Relations, Mr. Bill Hartman. Please go ahead, sir.

Bill Hartman

Good morning everyone and welcome to Eaton's third quarter 2010 earnings conference call. Joining me this morning are Sandy Cutler, Chairman and CEO, and Rick Fearon, Vice Chairman and CFO. As it has been our practice, we will begin today's call with comments from Sandy and that will be followed by a question-and-answer session.

As a reminder, the information provided in our call today will include forward-looking statements concerning the fourth quarter of 2010 and full year 2010 for net income per share, operating earnings per share, fourth quarter and full year revenues, description of our worldwide markets and growth in relation to these markets and growth from acquisitions.

These statements should be used with caution and are subject to various risks and uncertainties, many of which are the outside of the company’s control. Factors that could cause results to differ materially from those are listed in our 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 our third quarter results, which can be accessed on the Investor Relations page at eaton.com. Additional information is available in today's press release, which is also loaded on Eaton's home page at eaton.com.

With that, I would like to turn the session over to Sandy Cutler. Sandy?

Sandy Cutler

I hope you all have the presentation available. I am going to start on page 3 of this morning. We had a very strong third quarter from many different perspectives and the summary of the quarter is that our confidence is building and our forward visibility continues to improve.

We had call on February of this year at our New York City meeting we shared with you a multiyear outlook for our likely performance during this economic cycle. There were a couple of high points I just want to build upon as we think about our third quarter. We had set for this next time period we really felt that our annual compound revenue would be between 12% and 14% and you recall within that was a market growth of 7% per year.

We said that we expected to exceed our all time record operating earnings per share by 2012 and that was exceeding the record that we set in 2007 and by 2014 we expect to have a 200 basis points of expansion of segment margins over our previous record of 13% and achieved $2 billion of operating cash flow.

Since we shared those projections with you at the end of February of this year, we upped our full year guidance three times including today, so as we have talked in numerous different forums, it is a reasonable expectation that we are running ahead of that original performance forecast.

With that let me comment a little bit on our third quarter. If you go to the chart 3, operating earnings per share, you saw the announcement $1.60, net income per share $1.57, up 38% from a year ago. That was based on sales in the quarter that were up 18%, but significantly this level of revenues is still down 17% from the peak, which we achieved in the second quarter of 2008. We believe there is more to come here in terms of rebuilding our momentum.

25% of the sales importantly coming from developing countries, which you will recall continue to grow at quite a premium to what we are seeing in developed nations around the world.

Our sales were up 6% sequentially from the second quarter. A good quarter of operating cash flow of 11.8% of sales $420 million and very significantly our segment margins of 13.4% nearly matched our all time record margins which were 13.5% for a quarter despite our volumes being down as we mentioned before.

Our full year operating earnings per share forecast is 10% now better than our July forecast. You recall we came in to the third and fourth quarter forecasting that the operating earnings per share would be a midpoint would be a $1.35, obviously with our $1.60 achieved in the third quarter we beat it handsomely and we have raised our guidance to $1.60 for the fourth quarter. If you look simply at the second half, we have increased our guidance by 90% versus what we shared with you at the end of the second quarter, obviously a very significant move.

If you move to chart 4, a quick reconciliation, as just mentioned, midpoint of our guidance has been $1.35. Our market came in slightly better than we thought they would in the third quarter that added about $0.10. Our operating performance added another $0.08 of improved performance even better than we had anticipated a real reflection of our cost basis really coming through in all benefits of the work we have done over the last several years. Slightly lower tax rate we had guided to the 14% in the quarter and when came in at 11.7% as you saw some improvement from currency primarily driven by the euro rebound in the third quarter so totaling $1.60 a really good quarter.

If you move to page 5, both these numbers are pretty self explanatory, 18% sales increase, 14 points of that came from market growth, 4 from outgrowth, 1 from acquisition and negative 1 from ForEx, significantly when you compare the third quarter to the second quarter of 2010 as I mentioned before the quarter-to-quarter sequential revenue was up 6%. The segment operating profit was up 16%. The net income was up 16%, so continuing to capture real leverage as we are climb back up the volume curve here.

If you turn to chart 6, of the first of our segments, this is the Electrical Americas segment, volumes up some 15% versus the second quarter of 8%, so continuing to see good recovery there. The margins 14.6% we are really pleased with and lets remember this is the low point in the economic cycle for this business, nonresidential construction still down very significantly and this strong quarterly performances one of the reasons you will see that we have raised our guidance as we get to the back of this packet for this segment in terms of operating margins this year.

Bookings up a very solid 8%, stimulus you recall we said that we would capture approximately $500 million in orders this year from stimulus package. We captured $450 million to-date, so we are very much on track to hit that goal and then distributor restocking, and every time we mentioned distributor restocking today, I will emphasize this is more of an art than a science in terms of trying to estimate where people are in this regard. We have really not seen material restocking here in this electrical area yet. One breaking piece of news this morning you saw, which is encouraging as we think about next year is that the ABI index for the first time in quite a long time went over 50 this morning albeit by just a smidge. It is looking like it is improving and we do think that prospects for stabilization of this non-residential construction market in the Americas early next year is looking better at this point. So, we are encouraged by that.

Turning to next chart, chart 7, Electrical Rest of the World segment, probably the big highlight on this entire chart is the all-time record quarterly margins of 12.3%. Really what we are beginning to see is, is what we were so confident of when we made the acquisitions of Moeller, Phoenixtec and the MGE Small Business System that we were acquiring very attractive franchises with great competitive positioning and great margin potential. We unfortunately went right into the belly of the beast with the recession after the acquisition, so you have not had the chance to really see these businesses perform, as now we are. So, we're coming back up out of this on a 6% increase in sales compared to the second quarter operating profits were up 30%. We are really starting to see the leverage in these businesses.

Our Asian power quality and power distribution markets are strong and Europe is particularly the industrial and power quality markets that are strong, our overall bookings were up 19% versus a year ago. Once again we do not believe we have really seen the distributor restock occur in this particular segment as well.

As I move us to chart 8, the Hydraulic segment had another strong quarter, our sequential sales compared to the second quarter were up 3%, 13% operating margin. Just as we had told you last quarter, we are continuing to see quite a rebuild in terms of the order size up 43%, stronger on the OEMs side than the distributor side but I would tell you versus the second quarter, we're seeing more strength now coming on the distributor side and industrial side than we had earlier this year. So, still being led by OEM and that stronger OEM volume in shipments as well is one of the reasons that the margin are down just slightly from the second quarter, that we have got a little bigger mix of OEM versus distributors as that side of the market continued to come out more strongly. Our international market growth continues to be very strong in Latin America, Europe and Asia-Pacific and we are confident we are going to continue to see this volume expand.

If we move into chart 9 which is the aerospace segment, pretty much the same picture that we described to you that we expected would occur here in the second half, sales up above 5% from the second quarter, down 1% from a year-ago. Operating profits about flat with the year-ago but up some 25% from the second quarter. You recall the first half of this year; our operating profits have been just over 13% in this segment. They popped up to 15.6% in this quarter and you remember that our full year guidance is 14.5%.

If you look down to the last bullet point in the yellow section it really explains why we are seeing this higher margin is that we are continuing to see bookings be up but most importantly we are really seeing the aftermarket get stronger. This is the second quarter of sequentially stronger after market; it’s obviously helping our profitability. We definitely saw in the third quarter a resurgence in the commercial OEM, that orders had not been stronger earlier this year. So we believe we have seen the bottom in the aerospace industry and they will begin to build as we go into 2011.

Now moving to Chart 10, the Truck segment, up 33% volume versus a year ago and really we have not seen much of a rebound here in North America. So the greatest percentage of this is really coming from our international businesses particularly out of South America where you can see the Brazilian truck and bus markets up 57% versus a year-ago. The agriculture production up 46% versus a year-ago. Very strong upturn in profitability is well up some 25% versus the second quarter, obviously up a 196% from a year-ago. We are very pleased at these low levels of NAFTA activity that we are a 13.9% operating margin in the business.

Then moving to the Automotive segment, just about flat volumes with the second quarter of 2010 of 20% versus a year ago, that in itself is quite an achievement. You all know normally the third quarter is a seasonally lower quarter for automotive activity. Our profits are at 10% just like they were in the second quarter; quite pleased that at this relatively still low level of global automotive demand, the business is performing quite well and a great quarter of outgrowth again.

Moving to chart 12, a quick look at cash flow $420 million of operating cash flow were about 11.8% of sales. We spent about $106 million in CapEx in the quarter and our forecast is still for the full year to be spending 400 as you can see. So, free cash flow is about $314 million.

As a part of increasing our guidance in terms of our earnings this year we have also increased our operating cash flow and our pre cash flow guidance by $50 million a piece and you will see that reflected in the guidance numbers here.

If we move to chart 13, a quick look at our overall market forecast this year. You recall our forecast at the end of the last quarter was that we would see the weighted average our markets grow 8%. We have increased that to 10%. The real difference, if you think about this, is occurring in the growth outside the US. Our US growth forecast was 8% and is still at 8%, but the non-US growth rate which was 8% three months ago is now 12%. The green arrows to the right gives you a sense for where we are really seeing on a global basis, our markets change and so that obviously is in the electrical rest of world, hydraulic, truck and automotive index, and those are really what are driving that 2 point increase in volume.

If we move to chart 14, the very strong margin performance in the third quarter has enabled us to increase our full year guidance for segment margins in both electrical sectors and our hydraulic sector, very pleased that we are seeing this strong level of profitability.

Moving to chart 15, which is our EPS guidance, you can see the midpoint of our full year is now for operating per share of $5.50. That is an additional $0.50 versus our previous midpoint for operating earnings per share guidance and you can see the fourth quarter of midpoint for operating earnings per share guidance of a $1.60 is up 25% from our previous guidance of $1.35.

Moving to chart 16, is simply the bridge which we have updated in the same format that we have showed you before for full year guidance, I will not go through each of the line items, obviously the big changes in the market getting larger and there are number of smaller items here that we can talk about it at your level of interest.

Moving to chart 17, a quick reconciliation of our third to fourth quarter, really only two items here. We expect the tax rate in the fourth quarter to be 11% slightly lower than the 11.7% that we had here in the third quarter. Then we have somewhat complicated mix of higher ForEx higher acquisition revenue both of those at a lower profitability and then a offset by very slightly lower seasonal volume. Normally, our fourth quarter is lower than our third quarter and a number of our businesses that happens at normal incremental, so a little higher offset and at least to the roughly negative $0.01. So, we are anticipating pretty flat fourth quarter to third quarter which is unusual pattern for us. Normally, we see the fourth quarter fall off and so we really regard this as a sign of strength and the continued recovery of our market.

Chart 18, just a summary of all the points I have touched down, the changes are in the market growth, its additional $250 million of volume, in ForEx additional $100 million of volume, operating EPS, and fully diluted EPS plus $0.50 in each category and then operating cash flow and free cash flow plus $50 million in each category.

Then to chart 19, final chart, just some quick (inaudible) on 2011. The economic outlook is playing as much as have anticipated. The growth is stronger outside the US which plays to our 55% non-US exposure and more particularly to our growing 25% developing country exposure.

Currencies, we were all watching. They are volatile. That tends to reinforce our manufacturing and donor currencies strategy, it is working well. While we are not prepared to provide specific forecast today we are increasingly confident that the markets are virtually everyone of our six segments would be stronger in 2011 than they are in 2010. Electrical America is the non-residential construction market, where no longer be the negative that we see it, be over this last two years. Electrical rest of world, this growing non-US markets are continuing to accelerate. Hydraulics, the industrial markets are strengthening. While the mobile growth rates will begin to cool down, but still be positive, we believe. Aerospace, as I said before, we think the industry has bottomed in 2010 and the aftermarket is once again positive. Truck the long awaited and believe me it has been long awaited and NAFTA heavy duty rebound, we believe begins a two year recovery to more normal levels. Automotive, another year we think of solid growth, not at the levels that we seen during this very fast recovery this last year, but solid growth. In short all six of our cylinders ought be firing next year.

Finally, our portfolio power management products and services across all six of these sectors, we think is really well positioned and the fact that we have a number of late cycle businesses that will begin to contribute next year means that we are quite confident we should be growing it excess for this global industrial production market, forecast, that I mean that our own markets will grow and that will have outgrowth on top of that plus what we are doing in terms of acquisition.

Finally, we think we incrementals will return more to the 30% to 35% levels and the higher levels we seen this year and the year rebound, but I would note that we are exiting the year with back to back quarters at a $1.60 operating earnings per share. That is obviously a very powerful level of earnings compared to what we came into this year. So we are feeling quite good about where this year is likely to end up.

With that Bill, I turn things back to you and we look forward this to taking your questions.

Bill Hartman

Could we now proceed to the Q&A portion of this meet?

Question-and-Answer Session

Operator

(Operator Instructions).

Bill Hartman

The first name up is Jamie Cook.

Jamie Cook - Credit Suisse

My first question, Sandy, your margins were 13.4%, you point out you’re 17% below peak sales with a lot of the late cycles that are still not recovering. At what point do you get comfortable that you raise your peak margin assumptions of 15? Do you think that will come more from just end market growth better than you expected or some internal restructuring that you have done? My follow up question, obviously the ABI numbers today were very positive. We talked about the implications for electrical. What about it on the US construction equipment market? Do you think that’s enough to encourage some restocking in the channel and have you seen any yet?

Sandy Cutler

On the first question, Jamie, we set out this 15% operating segment goal and just those numbers again where we thought electrical Americas our target there is 16%, electrical rest of the world is 13, hydraulics is 15, aerospace 17, truck 20, automotive 10. We still think those are appropriate at this point. I do think that when we talked about 2012 year for all time operating earnings per share profitability, we're doing a little better against that goal from what we've done this year. So, we will get into next year before we will revisit those targets.

On the issue of ABI, we were encouraged obviously this morning you heard us over a couple talk about the fact that we were starting to see some new commercial projects being considered. It doesn’t mean they were going in another ground; they're being considered and that’s got to happen first. So, our thought had been we would see this non-res market start to bottom out this year and then go into very low levels of growth potentially as we get through the year next year.

That’s a huge positive for us in the electrical Americas market because remember it's almost 40% of the driver of that particular segment for us. We've not seen at this point that there is a big push here in the US on construction equipment. At this point, a lot of the big activity has been outside of the US at this point, so I cannot report to you we have seen big restocking in that regard.

Bill Hartman

Next up is David Raso.

David Raso - ISI Group

I am not trying to push into any EPS guidance, but just trying to stay on the framework that you gave us for '011. If you look at your global industrial production numbers you mentioned the idea you should out grow on top of that and then you mentioned 30 to 35ish percent incremental that will get you well north of $7 of earnings next year unless there is something from corporate or whatever may be, can you just for a framework highlight some things that I should not have been taking that simple math that you threw out as how we're thinking about '011 earnings? Are there some cost below the line that I am not appreciating that it is not a simple roughly 10% revenue growth 35% incremental and you are talking 7.30ish, 7.25 on EPS?

Sandy Cutler

David, the two potential drags that I guess I would point out is at this point, and you are hearing that from many companies, one is taxes where we said we would expect the rate to go up slightly next year and in the second would be pension, which is the issue that everyone is, is challenged to be able to forecast at this point. What we have said is that for every quarter point that the discount rate declines below the 6% that we used last year and you are out there running at 5 to 5.25 rate today, it is at an incremental level of expense of just a little bit over $9 million for us. So if we get down to your end and see where this discount rate ends, we will be able to tune that up and that is probably as close as we can get to on that one at this point.

David Raso - ISI Group

Pension is not the main thing, there's nothing on the corporate line I should be thinking about with maybe a more dramatic return to incentive comp or so forth anything?

Rick Fearon

No, I do not think so David. At this point, obviously, we are in the midst of doing our planning at this point and we too are trying to get kind of centered in on what this top line is going to be at this point. We have to remember we have completed some acquisitions this year, which will give us some incremental revenue and some incremental (inaudible) they are small as singles and doubles, but there are a couple of them. We do think our own growth will be north of this global industrial production number just because we have got somebody’s longer cycle businesses such as aerospace and non-res start to get into a different portion of the cycle at this point. You got your fingers on the general right pieces.

David Raso - ISI Group

The last question about that incremental margin comment, on a business segment basis you just did 27%. The businesses will probably get stronger next year ideally if it starts extrapolate the ABI, whatever it maybe some of the late cycle businesses that maybe inherently do not have a dig of incremental margins as some of the others. It sounds like though you are taking of course truck must have big growth, that is the big incremental margin business and you will get enough of an incremental in the electrical type businesses to support that 30, 35?

Rick Fearon

That’s our thinking exactly, David.

David Raso - ISI Group

That’s in the hydraulics probably moderate below that level.

Sandy Cutler

I'd just say remember in the non-res this year that shifting an electrical Americas segment, we did say this year that about a point came out of profitability more than we come out of a normal decremental because when the big project business tends into a period of weakness, which goes with non-res you tend to see that profitability drop and that is what we saw this year and at some point that comes back as well.

Okay I appreciate it. Thank you.

Bill Hartman

Next is [Anne Dagenais].

Unidentified Analyst

Just following up on David’s question, if I look at the mix of your businesses today and the margins, which are kind of exit that year on, if we look at truck for example with NAFTA recovering, we would expect that NAFTA is at least very strongly incremental, but probably higher profitability also, so that business should potentially see some margin expansion next year.

Aerospace is somewhat similar arena with commercial OEM particularly commercial aftermarket recovering, should not we anticipate some margin expansion in that business next year? Although maybe no big change in mix electrical North America to just on what you said maybe some margin expansion there also. So we are again thinking about the business is directionally correct from we think about mix. Going into mixture and are we missing any negative mix that might pop up in any of the segments?

Sandy Cutler

I do not think so Anna, that is a very rational point of approach to try and think this through at this point. I would say the other element obviously is remember we are still 17% right now below our peak volumes so, we think the scenario we laid a year and half ago that it would take several years to get these markets back up to full volume levels that we saw is still the right way to think about it. It has come a little faster than we thought this year. Remember, we started the year thinking we have about 5% growth; we are up to 10%. So, we probably pulled this ahead a little bit but there is more expansion to come just sheerly out of the volume levels as well.

Unidentified Analyst

Corporate and other came in a bit higher than we had anticipated, was there any one off charges in there? Or what kind of run rate should we anticipate for Q4 and into 2011?

Sandy Cutler

For the fourth quarter you ought to be thinking very similar levels to the one in the third quarter. What we've got is we've seen business strength and our confidence about 2011 has increased as well. We've decided to move ahead on some investments particularly in very fast growing areas of the world and programs to support then that we think will support us well next year. I don’t think it's going to affect your incremental analysis greatly for next year however.

Unidentified Analyst

Acquisitions, do you anticipate another (inaudible) but do you expect accretions from those acquisitions next or would they be a drag just because they're coming in at lower margins?

Sandy Cutler

No, it will definitely be accretive to our overall earnings next year. They are very small. They won't in total make a very significant difference, but it will be a small positive.

Bill Hartman

Next we have Eli Lustgarten.

Eli Lustgarten - Longbow Research

I had one clarification. I know the tax rate was up slightly but we are coming in at 11-12 this year. What should we be using for tax rate in 2011?

Sandy Cutler

Eli, it's hard to come up with a very good estimate until we've done our proper planning because we have to look where the earnings occur geographically. What we have said is that we think that our tax rate over the next several years is going to be in the neighborhood of 15 to 18%. So, mostly likely will be somewhere in that range, I just can't give you a precise number right now.

Eli Lustgarten - Longbow Research

Going back up toward sort of what we expected as opposed to what happened this year.

Sandy Cutler

I mean, partly driven by much increased US earnings because of these late cycle markets that are now stating to kick back in.

Eli Lustgarten - Longbow Research

In some of the aero, the only one that jumped off in aero was hydraulic. We had a 4% underperformance versus the market. The talk about what's going on in that market, I mean, the profitability is also a little bit lagging there also given the dynamics of the business.

Sandy Cutler

Eli, the biggest issue is, if you remember, went back to the second quarter we were seeing quite a rebuilding and of course orders have been outpacing shipments, if you look at the orders we've been reporting in each quarter. Part of that is a rebuilding of the long lead time backlog with OEMs that have been so substantially cancelled in 2008 and early 2009. We've got a bigger percentage of OEM volume running right now because they've come back up so fast and think most people in the industry have got pretty good feel of the distributor channel tends to be a little bit more wholesome in margins than the direct OEM side of things. So, that’s really what's impacted that kind of quarter to quarter.

Eli Lustgarten - Longbow Research

Do we expect this sort of underperformance to disappear as we go forward?

Sandy Cutler

Yeah, that would be our expectation. It's been challenging for everyone of these markets is you've gotten this big inventory rebuilds in OEMs that have occurred during this trying to get really good market data and how much of it is rebuild and how much is not. As I said, it is much more of an art than it is a science. It's caused some lack of imprecision on these figures.

Eli Lustgarten - Longbow Research

Can you talk about what's going on in quotes in prices across the businesses, particularly some of the commodity prices especially copper started going down? Have you hedged copper this year? What's going on?

Sandy Cutler

Yeah, we're always busy doing three things in terms of whether dealer copper or any another commodity in this (inaudible). Number one, we are always working on material substitution programs to try to minimize the impact for any of our customers and we have been quite busy again in that regard.

Secondly, we are watching these numbers and actually watching these forward potential costs and where we can offset them, but we are working on doing that. The third is that we have announced selected price increases as we detail them in the last call in the number of our businesses to deal with them as well. We still think we can do just what we have done over the last six-and-a-half or seven years as hold this relationship in terms of our margins neutral.

Eli Lustgarten - Longbow Research

Basically there is no real pressure at this point you have been able to balance that out price and copper at this point.

Sandy Cutler

Yes, partly you got it.

Bill Hartman

Next is Chris Glenn.

Chris Glenn - Oppenheimer & Co.

Just looking in to some more detail dive into Electrical Americans outgrowth was much different number than we had in the first half?

Sandy Cutler

Probably what you're seeing now is because this is expressed in terms of shipments that you’re seeing the benefits of what we have been so successful with in terms of the stimulus programs so we have done quite well there and if you look at some of the data that’s available from the US Department of Commerce and where the money is being spent in the stimulus program, you will see the Waste Water Treatment is a very big area, where the money is being spent.

We happen to do very well in that arena. We’ve detailed we had a great success in a number of the big solar programs here in the US as well, and so I’d say it is again that big front end we have in this business that has for many years been calling in the same specifiers and so we have been able to take full advantage of that.

Chris Glenn - Oppenheimer & Co.

It seems like in certain areas you maybe have some decent share gain going on just wondering you’ve comment on some areas, where you think you have the share gain traction continuity through 2011?

Sandy Cutler

Well, it’s pretty odd to do that Chris. It’s an enormous market. You can just wait for a treatment solar two that have been quite strong in that regard what we have been able to bring new product to market and we had historic strength and medium voltage and we have done quite well there.

Chris Glenn - Oppenheimer & Co.

Last one on res, I guess still drag year-over-year, but do you seeing a return to normal seasonality at all?

Sandy Cutler

That the seasonality issue is all what’s going to be weaker in the first quarter because the construction issues and so you tend to see the second, third, and then the fourth comes off a little bit. That seasonality is just because of what happens with weather patterns it makes that happen. What we are the beginning to be encouraged about the non-res is that we think we will be through the third year this downturn and that you are getting the mixed forecast for next year, but the mixed forecast look a whole lot better than they did for this year so that big piece has been a negative because the negative 1% for the overall market for the full year of Electrical Americans even if that number just came back to flat in 2011, the whole number then goes positive for the market and for our biggest segment that is a very material event.

Bill Hartman

Next is Meredith Taylor.

Meredith Taylor - Barclays Capital

I’m wondering you can talk a little bit about the margin growth that you saw in the electricals rest of world certainly that’s happening faster than I had anticipated. Maybe if you could just bridge on a sequential basis what were some of the drivers of the margin growth and then where you see certainly the full year guidance would suggest that there is potentially some upside in the fourth quarter as well.

Sandy Cutler

First as we are seeing these volumes come back so that obviously up a 9% again from last year. We bottomed as you recall certainly after we bought a number of these franchises, the markets came apart in Europe and Asia. They’re coming back fairly strongly at this point. We are doing very well in the solar segment there as well, which have been segments that have moved quite quickly.

The power quality business, which many people forget we are actually bigger in the power quality business as a percent of the segment outside of the US than we are in the US and the power quality markets particularly the single phase side of the markets in the flow product have been really very good this year and then we have done quite well in those arena. I’d say it’s a combination of both the markets coming back, our additional penetration and the power quality markets and markets like solar, which are basically invert base, where we have got some real product advantages and a lot of new product up there in the marketplace. Again, what we encouraged by as we are just beginning really to see the power of these three acquisitions operating in almost the same markets than what we lost them.

Meredith Taylor - Barclays Capital

It sounds like what you are saying that is the margin improvements driven predominately by volume and mix as opposed to big step function in terms of the returns on some of the restructuring activities for example and how much is still to come there?

Sandy Cutler

Remember this year and last year we’ve got $0.30 per share of accretion from the restructuring program and so that’s the integration program. Those are largely dawn at this point so that we are seeing that benefit come through as well. You are exactly right there is a handsome piece due to that as well.

Meredith Taylor - Barclays Capital

This is the follow-up. With respect to the comment you’ve made about not seen any dealer-stocking on the electrical side of the business. How much do you think that this could contribute in 2011 seeing the dealer-stocking continue when pick backup?

Sandy Cutler

Again I’d repeat we think a little bit more art and the science it’s hard to know whether that’s a point or two in terms of market growth, we haven’t able to estimate that well. It will be a positive. We just really don’t know how much and we can see both looking at distributor shelves, watching monthly stock orders, watching their mix of A, B and C items. Right now they are able to pretty well pass through product and lead times haven’t gotten long enough whether they are really having put upon the shelve. That will change just the market come up and my personal anticipation is that we will see that change to our benefits some time in 2011.

Bill Hartman

Next is Nigel Coe.

Nigel Coe - Deutsche Bank Securities

Before I get in to the questions just clarification on the 2010 EPS bridge. Rick the $0.23 hits from corporate expense shortage it was new I didn’t see in the last quarter. Can you just give to that piece?

Rick Fearon

Nigel it’s really simple as if you look at the $55 million lease spent in Q3 and we are suggesting it will be like number in Q4 that compares to the $40 million that we had thought we might be spending and so is that really explains the great bulk of it. There is a little bit extra from higher amortization of intangibles both because we’ve a lot of intangibles that are denominated in euros and as the euros goes up there is more amortization plus you have the amortization from these new acquisition.

Nigel Coe - Deutsche Bank Securities

It’s mainly core expense of the coming higher to expect for this year. What does that suggest for next year? Should we use this year’s bridge or is there some exceptional charge coming through this year that we should maybe normalize next year?

Rick Fearon

Yes, that these higher corporate charges are related to functionality we are putting in to allow us to grow the business to deal with more rapid market and we expect that we will have corporate expenses next year that are probably something around the run rate of the next half of this year.

Nigel Coe - Deutsche Bank Securities

You talked about mix quite a bit already one of your competitors in hydraulic yesterday referred to improve the mix of the (inaudible) things would suggest that there will some restocking going on there. It doesn’t feel like you have got the same look in to your channel you are not saying, but certainly higher margin mix would help you the here did you think that as distribution continues to improve that you can see [signal] for those pick up margins in hydraulics?

Sandy Cutler

Yes, Nigel what I said realized this everyone can interpret this time as differently is that we have very strong bookings that you saw. The bookings are actually recovering still more quickly on the OEM side than they are in the distributor side, but the distributor side has stepped out significantly from what we saw in the second quarter. It’s really a question of degree. At some point the distributor gain, you saw we had very large bookings in the quarter, we will start to outpace what goes on the OEM side and some people call this the bullwhip effect on the OEM side.

We can’t tell you exactly what quarter that’s going to happen, but at this point it has not yet caught up with the OEM weight of increase.

Nigel Coe - Deutsche Bank Securities

Two quick ones if I may, truck next year to be maybe just give us a place suitably expect to truck builds not the truck builds the next year and looking back in history obviously the mixes shifted a lot towards Latin America and I’m just wondering what level of that the builds do you need to get back to pick revenue in truck?

Rick Fearon

Obviously, the key number for next year at this point you are saying (inaudible) out there at 238. We’ve talked about the fact that we thought replacement was on this 230 to 235 and way to think about these next couple of years is that you probably have a year that maybe a little lower than replacement or something in that order in the first year and then the second year you’ve seen people with numbers that are up toward those kind of 300 numbers. We have not put a number out for either year at this point, but ACT has got as good a number as anyone out there at this point.

Those are obviously very big increases over the 150 of this year, so that we’re talking about a 50% increase in the market next year over this year that is going to drive quite a step in terms of our revenues and our profitability. If you go back to the second part of your question, when Eaton was recording kind of 18 to 20% segment profit in the truck market, we were in this 250 and slightly above range to get there. So, it’s not that far away, I mean if we get back to those numbers.

Nigel Coe - Deutsche Bank Securities

Finally for Rick, you mentioned next year being headwind on taxes, we continue to see a drift down on tax rate this year. I mean, first of all is that because of structural mix or is that because of credits? Secondly the headwind next year is that because of the mix of North America is improving with truck recovering, or do you think that some of the changes we are seeing on legislation is moving up the tax rate next year?

Rick Fearon

No, I’ll start with the latter half of your question, the reason we think the rate will go higher next year is mainly because of the geographic mix and entire US income driven by markets, these late cycle markets recovering. The rate for 2010 has been a little below our earlier expectations for a variety of factors, part of that is mix, part of it is as we’ve trued up our final tax return and you have filed those returns in September for most of the world that has turned out that we’ve been a little over provided for 2009 tax year. There have been a few legislative changes in various parts of the world that have actually given us a slight benefit. So those one off items will not likely reoccur next year and we will have higher US income.

Bill Hartman

Next we have Andy Casey.

Andy Casey - Wells Fargo Securities

Good morning Bill, thanks and good morning everybody. Back on Electrical Americas, did the service businesses outpaced the overall business growth? Just to clarify the Q3 Electrical Americas operating margin performance, is that entirely mix or is there something else we need to consider?

Sandy Cutler

The service business tends to, and some of you gone around, tends to your business that accelerates as the year goes on and generally the last quarter of the year tends to be the biggest quarter, so no it wasn’t an unusual contributor to growth in the third quarter. It tends to be as you can appreciate a lot of people want to get projects done right at the end of the year and sometimes use the Thanksgiving and the Christmas holidays’ time to get a lot of that done.

Also the federal portion of the money tends to kind of break more loose once you get past the October authorization. On the issue of the profitability, we were very pleased with the 14.6% profit; I’d say no bluebirds or dead birds one way or the other in those numbers. You recall that we have had a lower full year level of profitability in our original guidance and we’ve taken it up. So, I’d say just got operating performance at this point.

Andy Casey - Wells Fargo Securities

A couple of other small ones, on the various markets you serve, are you seeing any supply constrains with the production ramp that we are seeing in some of these markets that are either impeding current period or likely going to cause a drag on the potential future growth?

Sandy Cutler

I’d say Andy the, let me come to truck in a minute because that hasn’t occurred yet, but it’s always an issue to keep an eye on it. I’d say the primary one is the one that we talked about in the second quarter and talked about in a number of public forums this year as the electronic components of supply chain is very tight and it’s tight as you watch, important industries such as consumer electronics, industrial electronics, or motor electronics, all have been turning out and you see this in, for those of you who cover the electronic industries, it is tight and it remains tight. What we said at the end of the second quarter is that we expect it will be tight until we get into early in the middle of next year. That’s typically what happens when the cycle turns out. I’d say that’s been the one that we’ve been managing.

Then you come to the truck cycle and obviously if we are talking about the order of potentially a 50% increase in the to heavy duty truck market 2011 over 2010. Historically, something occurs and we go up quickly. We don’t know where will be it. It typically has not been for Eaton, but it’s been for some member of the whole chain ability to build truck. So, the whole industry is keeping a close eye on that and we are working very carefully with suppliers and our customers are asking us to do that to assure that we can be in a position to provide them the ability to get up this ramp next year.

Andy Casey - Wells Fargo Securities

Okay, thanks. If I can speak one, just a clarification on the hydraulics, how should we look at the sequential pick up that you described in the distributor demand Q3 versus Q2, is that activity driven or is they are restocking in there?

Sandy Cutler

Our feeling is most of it is activity driven and I’m sure there is some degree of, as I say again it’s, you can’t be too scientific about the some degree of restocking, but an awful lot of what we see is again distributors demand that is for small OEMs, their, the lead times are enabling them to deal with that by buying and passing through at this point. Again at some point in the cycle, whether it’s electrical, whether it’s distribution or whether it’s in the truck hydraulic distribution or whether it’s in the truck market, when lead times start to get little longer and demand for lead time from the customer doesn’t fit within that, we’ll see more re-building. But our sense is we haven’t seen the big re-building in the distribution channel, we have seen it on the OEM side.

Andy Casey - Wells Fargo Securities

Last on that, great point, Sandy, is that kind of economy driven or are there other risks that like credit or political that you think are impeding it?

Sandy Cutler

It’s three, number one, remember distributors de-stock later than OEMs and so they are going to come back in later than OEM. Second, lead times aren’t so long, they have to restart yet. Then third is the, what do you want to call economic or political uncertainty, if someone is going to avoid putting inventory in this current environment, they will avoid putting it in. So they are not in the market where they feel it’s a 100% certain about all the policies so some other businesses will be. So they can avoid putting it in, they’re going to work really hard not to put it in.

Bill Hartman

Next we have Tim Denoyer.

Tim Denoyer - Wolfe Trahan & Co.

First on your overall headcount, can you talk about, have you begun hiring and what are your plans through yearend at this point?

Rick Fearon

Yeah, we came into this year, we said that we didn’t really expect we were going to have to do much net hiring because we asked all our employees to take a week off per quarter without pay last year and that has largely proved to be where we are at this point. There are some businesses and product lines and plants for hire, there are other areas where we had to cut back further. As you see our employment number is still right around 70,000 employees.

Tim Denoyer - Wolfe Trahan & Co.

Hydraulics be one of those areas where you're hiring?

Sandy Cutler

It depends again on the product line and the location. Yeah, obviously if you have these volume increases of 40%, we had to add some there, but in other areas we had to take things out.

Tim Denoyer - Wolfe Trahan & Co.

On North America truck, on the 2011 outlook for 50% growth, I mean was global industrial production still expected in the mid single digits? Three to six month backlog, do you think that we’re going to really accelerate that much going into the year, you mentioned in your release that there is a bit of a slowdown in truck production, was that North America related? Can you just kind of give me a sense of what kind of order numbers you will need to see over the next three months during the buying seasons for trucks to get you more comfortable that we are going to see that kind of growth?

Sandy Cutler

Just over the last several days you are seeing some information about used trucks pricing, it’s been out there, and obviously it has tightened significantly. The inventory of used trucks is not what it was and you are beginning to see a higher percent (inaudible) they all are now in 2010 engines whereas significant portion of the first half truck production was still using old engine. So our own feeling is that after three to four year near depression in the truck market, you are going to start to see this rebuild come back. So, we think the freight indication, used price inventory, used truck inventory and the prices for the available used trucks are all pointing toward the fact that you are going to have a rebound in 2011. We obviously have to start to see orders come up off those 15 million, 15,000 units per month’s level. We would hope we would see that, the later this fall and early next year.

Rick Fearon

I might also add that the production of Class A trucks in Q3 was higher than in Q2, it was 40,000 compared to 35,000 in Q3. So the industry is continuing to strengthen, obviously to get to the kind of run rate that you are going to need to get to the ACT number. It will have to strengthen quite a bit more over the next six month.

Tim Denoyer - Wolfe Trahan & Co.

With North America what you were referring to in your release, when you talked about a slower rate of sequential improvement in production in the fourth quarter.

Sandy Cutler

We were talking about the overall business and obviously we have a big portion of that business in South America and South America has been very robust thus far this year. We do not believe that those very high growth rates can be sustained for a long period, so that is really more what we were talking about.

Tim Denoyer - Wolfe Trahan & Co.

One other quick question on European auto production, have you seen any signs of inventory building there and any signs that production is slowing in Europe?

Sandy Cutler

What we talked about coming into this year is we did not expect 2010 to be a big positive year in European production. What has surprised us and most people is it became pretty good export year, so actually production has been stronger all year than we had anticipated it would be in Europe. We have not foreseen it that is a inventory build issue; we think they have really quite well in terms of their export markets.

Tim Denoyer - Wolfe Trahan & Co.

Have you seen exports start to slow now that the euro has strengthened?

Sandy Cutler

I do not think we have got any data that says that adds sense as to what happened in the last month.

Bill Hartman

Next we have Andrew Obin.

Andrew Obin - BofA Merrill Lynch

Yes, good morning. Just a follow-up question on the truck section and also hydraulics. I mean, how much other than the forecast, how much real visibility do we have by market and within these two sectors given your customer orders today, what do you think you have the most visibility by segment and what do you have, you think have the least visibility?

Sandy Cutler

It is not much different than historically. I mean aerospace is the one where we got the longest lookout in terms of production and you have obviously seen a number of production increases from both Airbus and from Boeing on single aisle, which obviously is the biggest percentage of that production which area fairly significant backlog in our Electrical Americas business of large projects, that gives us a look out number of months as well.

In our other markets, truck obviously we’re looking at forecast at this point because the backlogs are not as big as they would be as we have been watching 25,000 and 30000 units being put in hydraulics on the OEM side, large mobile OEMs, They have extended their orders and so we are back after longer visibility as part of it when I started my comments this morning I mentioned that we have got better forward visibility than we have had in some time because we are seeing these backlogs rebuild and order commitments rebuild.

Andrew Obin - BofA Merrill Lynch

Within trucks specifically South American Ag I guess, early in the year we had concerns about change in stimulus programs down the elections, just has anything changed or because there was particular robust this quarter, do you think it has to decline next year or is it to stay in about these levels or can it grow?

Sandy Cutler

Yes, the danger is to assume that the growth rate continues like this because a number of these stimulus programs or special tax programs put in place have been rolled quarter to quarter, but generally most people feel by year end or early next year they stop. That you’re going to get things not be growing dramatically from where those levels that have been this year.

Andrew Obin - BofA Merrill Lynch

That still growing?

Rick Fearon

Well, certainly the rate of growth will be a lot lower and I mean that market will have grown probably about 35% this year and so you are certainly not going to have a rate of growth that high. Having said that crop market, crop pricing is quite strong worldwide and Brazil is benefiting from that. it is a little too early to make a forecast, but I would not expect that market to soften from where it is right now.

Bill Hartman

Next is Tim Thein.

Tim Thein - Citi

First question, quick, Sandy, coming back to your comment just a bit ago in terms of the profitability in truck and you mentioned that the 18 to 20% margins you achieved in the past and called it a 250 kind of number. Given the change in the footprint that you have in that business along with some of the mix improvements, do you think that kind of profitability can be generated on a number below 250 going forward?

Sandy Cutler

I’d love to be able to give you a definitive answer, but we have not gotten there. It has been sometime since we have been there. What you have said is that we think peak earnings for the truck segment is still realistic to think is getting to 20%. We have had to be at that sort of 250 levels or above to get the result. It is may be a little late reach to declare we could get that at this point. Having said that I do not think many people would have imagined we would have been at 13.9% in a quarter in which you have got 40,000 after heavy duty so a run rate of kind of 160 level. So, we are clearly doing better than we have to start this as a result of all of the cost restructuring, we just got to get through our planning as fast next year little better sense for what where that number is going to be.

Tim Thein - Citi

Switching gears quickly get to aerospace, what if any got to impact to a longer term margin outlook can we take away from some of the recent type being in just around the rhetoric but also the outlook with regards to the defense spending? Do you think between the mix between recovery rather than between commercial versus military in that business?

Sandy Cutler

A couple of things one we have assumed that our own planning of relatively muted defense budget going forward and the real key there is you got to be on the right program. So clearly there is going to be a real rationalization of the fighter programs and that positions as very well with the Joint Strike Fighter it is obviously the biggest program we are involved in here in the US defense side. There is a real need upgrade the rotor craft, heavy lift rotor craft program. That’s why the CA53 is such an important program for us in that regard and very well positioned there as well. We're position well in terms of a number of our NATO partners in terms of programs there are key fighter programs and helicopter programs as well. So, I'd say, we are not too concerned about that balance at this point.

Bill Hartman

Next is Jason Feldman.

Jason Feldman - UBS

First on the power quality business, do you think the end markets are doing pretty well? Has there been any chance in the competitive environment particularly in Europe following the (inaudible) at all?

Sandy Cutler

No, none that we have noted.

Jason Feldman - UBS

Also regarding M&A, there have been a few small deals so far this year. What are your thoughts going forward? Is it time that you would be going to consider a larger deal again in any particular areas of interest or focus?

Sandy Cutler

Jason, as we said kind of mid year really come in out of the first quarter as our visibility started to improve or balance sheet was getting stronger at this point we put the green light on really in terms of our deal flow again. It always takes a little bit of time to get the deal flow moving but you have seen we have done a couple of deals this year that we are pleased with. So, we are very much back in the market on these singles and doubles.

As we have said, pretty consistently larger deals become much less frequently you are likely to get getting them done is not as high. So the best planning is you see us return to more normal levels of activity which are a greater number kind of single and doubles that allow us to add on to our existing franchise.

Bill Hartman

Last, but not the least Rob Mccarthy.

Robert Mccarthy - Robert W. Baird & Co.

I wondered if you can just help on some clarifications on a couple of market growth numbers that we are looking at. In the truck segment, we have market growth up 28% with NAFTA heavy-duty production up 34, Brazil market is up 57, can you help us bridge between those giant numbers and the lower 28?

Rick Fearon

Yeah. That is the biggest difference and the NAFTA is heavy duty is much more strongly than the medium duty. Medium duty is not up very much than Europe’s not up much.

Robert Mccarthy - Robert W. Baird & Co.

Remind us again how much of the business is Europe?

Rick Fearon

Very little.

Robert Mccarthy - Robert W. Baird & Co.

So European business must be negative I guess and be able to offset these giant, the large waiting of 34 and 57?

Sandy Cutler

It is Europe but also other thing that I'd say, Rob, is it is APAC as well. APAC had a growth rate in third quarter that was just over 10%.

Robert Mccarthy - Robert W. Baird & Co.

To my pointed question about Europe was it negative?

Sandy Cutler

No, it was positive it is not as strong as it certainly in site like Brussels.

Robert Mccarthy - Robert W. Baird & Co.

I wonder if we could get a little bit more color on what you're seeing in the individual pieces of the markets served electrical Americas individual verticals. In other words power generation versus etc?

Sandy Cutler

What's happened and what's not in terms of booking, the public infrastructure remain strong. I mentioned waste water; any government funded program for energy efficiency is quite strong. Residential remained obviously as you know weak. Commercial construction is weak but we are starting to see the first signs of smaller projects starting to be done. Industrial MRO is quite strong and has been this year. Datacenters are coming back and beginning to show building strength. The single phase UPS markets are really quite strong. As we mentioned, distributors are beginning to have call sort of sample with thoughts about restocking.

Robert Mccarthy - Robert W. Baird & Co.

If I try to translate that into the numbers that we all love, it sounds like you are calling out strongest growth in UPS. That’s clear. Also seeing double digit growth in government and industrial MRO markets?

Sandy Cutler

It’s hard to get in market numbers so we could give you an accurate number on that. We know what we're seeing in projects but it's hard to get the actual market number.

Robert Mccarthy - Robert W. Baird & Co.

I'm just trying to get a scale, Sandy.

Sandy Cutler

Yeah, I would say your strong side of the markets are power quality particularly the single phase side. It's the government and waste water treatment to stimulus public infrastructure side and its industrial MRO. Those are offsetting the weakness on residential which has clearly been much flatter than we might have hoped it would have been this year and then the negative in the non-residential construction.

Robert Mccarthy - Robert W. Baird & Co.

DC positive right, datacenters?

Sandy Cutler

Yeah, datacenters are positive but they are not as strong as the single phase side of the market.

Bill Hartman

Thanks everybody for the attention and as always Don and I will be able for the rest of the day to continue to answer your questions. Thank you.

Operator

Ladies and gentlemen, it does conclude your conference for today. Thank you for your participation and for using AT&T Executive teleconference. You may now disconnect.

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Source: Eaton Corporation Q3 2010 Earnings Call Transcript
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