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Eaton Corp plc (NYSE:ETN)

Q2 2014 Earnings Conference Call

July 29, 2014 10:00 AM ET

Executives

Donald H. Bullock – Senior Vice President Investor Relations

Sandy Cutler – Chief Executive Officer

Richard H. Fearon – Chief Financial and Planning Officer

Analysts

Steve Winoker – Sanford Bernstein

Joseph Ritchie – Goldman Sachs

Scott R. Davis – Barclays Capital

John Inch – Deutsche Bank

Andrew M. Casey – Wells Fargo Securities LLC

Julian C. H. Mitchell – Credit Suisse Securities (NYSE:USA) LLC

Jeff T. Sprague – Vertical Research Partners LLC

Christopher D. Glynn – Oppenheimer & Co., Inc.

Nigel Coe – Morgan Stanley & Co. LLC

Jeffrey Hammond – KeyBanc Capital Markets

Operator

Ladies and gentlemen thank you for standing by. Welcome to the Eaton’s Second Quarter Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. (Operator Instructions) And as a remainder, this call is being recorded.

I’d now like to turn the conference over to Don Bullock. Please go ahead.

Donald H. Bullock

Good morning. I’m Don Bullock, Eaton’s Senior Vice President of Investor Relations. Welcome to Eaton's second quarter 2014 earnings conference call. Joining me this morning are Sandy Cutler, Chairman and CEO; and Rick Fearon, Vice Chairman and CFO. As has been our historical practice, we will begin today's call with comments from Sandy, followed by a question-and-answer session.

Before we move to that, I’ll take a moment to draw your attention to the materials on page 2 of the presentation on our website, regarding certain forward-looking statements. The comments included on page 2 in the presentation, outline a series of factors that could cause actual results to differ from what we presented in these statements. These factors are also noted in today's press release and the related Form 8-K. In addition, our presentation today includes certain non-GAAP measures as defined by the SEC rules. A reconciliation of all of those measures to the most directly comparable GAAP equivalent is provided in the Investor Relations section of our website at www.eaton.com.

At this point, I’ll turn it over to Sandy.

Sandy Cutler

Great, thanks Don. I'm going to work from the presentation, which was posted earlier this morning and I’m going to start on page number 3, which is entitled highlights of the second quarter results. I would say a pretty busy quarter. We released that 8-K, a week ago, detailing the interaction of the several special or unusual items that we had in the quarter being the text of the gain on the sale of the aerospace business and our several legal settlements. At that point, we indicated we expected that our operating earnings per share would be in the $1.10 to $1.12 range and we’re pleased this morning they came in right in the middle of that range, but that were $1.11 above the original guidance that we gave when we began this quarter.

Our sales were right on the button. We’ve said they would be up 5% compared to the first quarter than they were and our margins were very much in line with our expectations. And you recall it when we gave you margin guidance for this quarter that was before the $0.08 of restructuring that we took in the industrial sector. So I will detail how that affects the full-year margin guidelines for each of those segments as we go on this morning.

Strong industrial sector, strong electrical product margins offset the weakness in the electrical systems and services margins. I will talk a little bit more specifically about electrical systems and services but the company really allowed us to command very much in line as I mentioned with our own expectations. Very strong bookings in electrical overall in both of the two segments report, obviously in aerospace as well. We also raised our guidance in terms of where we think the markets will be for that NAFTA heavy-duty truck businesses for 290,000, so a pretty good market activity in that respect. And in our integration of the Cooper acquisition, I will talk a little bit of a more of that stays a very much on track at this point.

If we move to the chart number 4, just quickly a summary of the impact of really several unusual items in the second quarter. If you recall the acquisition integration charges show up on two lines on our P&L, they have to show up both in the segments for about $30 million of the overall $37 million of expense that’s shown and about $7 million at the corporate level. Then you could see obviously the subject that we released 8-K on last week, the Meritor litigation, the Triumph litigation, the associated legal cost and then the benefits that came from aerospace business divestitures in total after-tax impact of about $0.70 and that’s how you get from the $0.41 operating earnings per share reported through the operating EPS excluding these unusual items.

We know what the interplay of all of these elements that makes following the tax line, particularly challenging in this quarter, so we try to provide a breakout from the tax rate as reported and obviously a very large negative income as a result of these litigation settlements that took place in the U.S. at obviously the high U.S. rate. You can see the tax rate excluding all of the unusual items was about 8%, a little higher than we’ve been running and reflective of the fact that our mix of business has been a little stronger in the U.S. than it has been outside the U.S. I think a good reflection of a staffing in the global economy where generally the U.S. is one of the stronger regions at this point. And the weakness that we’ve seen in our end-markets tends to be primarily in the markets outside of the U.S.

If we move to the page 5, once again, a quarter very much in line with our own expectations. Sales and margins, as I expected, slightly lower corporate expenses and offset the slightly higher – higher taxes as you can see a simply one set net of those two items and that led to the $1.11.

If we move to page 6, this is the overall financial summary. I think the one number I would want to comment on here is that if you remember our first quarter shipment number was $5.492 billion, so when you look at the $5.767 that’s exactly a 5% that’s what we have had thought we would see in terms of the growth in the second quarter from the first quarter. Overall, again, then if you look at the segment operating margin at 14.6 when you adjust for the $0.08 of restructuring that we told you would occur and this quarter would be $15.3 come back and maybe amplify now as we go through each of the individual segments. But overall core growth of 3%, if you recall, we had core growth of just slightly over 4% in the first quarter. A little stronger year-to-year market activity in the first quarter really happened in terms of the hydraulics market and the vehicle markets, which were not as much of an increase year-over-year when you look at the second quarter and versus the second quarter of last year.

Now let’s move to chart number 7, which is entitled electrical products segment. Here again, about 6% growth from the first quarter where we had revenues of $1.726, up about 4% year-over-year. I think again a very good news here in bookings, you will hear this both in the electrical products and the electrical systems and services where we saw overall bookings up some 8% in the Americas, 8% in Asia-Pacific, and then obviously the area that we’ve talked about of less strength is pretty flattish condition still in the European region.

Again, we just call out here that what’s going on in terms of the LED lighting change in our business 41% of the overall sales now quite strong, obviously as we’re continuing to introduce a lot of new products in that particular area. And when you get within the three regions on my comments, just on a couple areas, that the end market strength that maybe helpful for you to understand. I’d mentioned lighting is obviously quite strong, residential has continued to be strong for us. Overall distributor demand what we’re seeing here in this electrical products segment has been strong. The weak area has been the power quality market. And then the electrical product segments is where we report of the single phase side of that marketplace, actual negative growth in that marketplace continues to be quite weak. In EMEA, the strength continues to be really a story of weak in the continents, strong in the Middle East in portions of Africa. In Asia-Pacific, recovering strength, broadly in our components, which we’re very pleased about weakness and the single phase power quality continues to parallel what we’re seeing here in the U.S. and then we’ve seen Australia where the economy continue to be quite weak there.

If we move to page 8, which is electrical systems and services segment, a couple of highlight comments here is that first sales up about 7% compared to the first quarter, when it was $1.524 billion. If you look versus last year, pretty flat, and that really reflects these slow bookings that we had. If you recall, we had a decline in bookings in the first quarter, a number of you had asked questions at that time, would that have a (indiscernible) into the next quarter because generally you have more of a backlog in this particular segment, where you don’t have a backlog in the products segment.

Margins, obviously, a 12.7% pretty flat with the first quarter and down 200 basis points from last year, I’ll comment on that in just a minute, if I could just comment on bookings first. Bookings, again, up 7% as the strongest in some six quarters. If you remember the later three quarters of last year where we actually had a negative quarter and the fourth quarter, negative quarter, and the first quarter we’re very pleased with the substantial reversal here. The strength, as I mentioned from a regional point of view, is pretty much as I mentioned for the products area. Here we’re seeing good strength. Canada has strengthened which you have probably heard from a number of competitors in this marketplace, but good activity across most of our products here with the exception of the large and of the power quality market. So again a common seeing that power quality is weaker than we’re seeing on the power distribution side of the business, again weaker in Europe, stronger in Asia-Pacific and Americas.

We talked a little bit about the margin issue. If you recall it, we had weaker margins in the first quarter and we had about $13 million that we detailed for you in the first that dealt with a lot of the weather related expediting cost we had in the business. Different situation here in the second quarter and we really rolled it out into our full year guidance for the segment. I’ll talk more about that when we get back to the page a little further in the packets here, but we really saw higher logistics costs and some unfavorable mix and this is a business where it is a mix of many, many different projects and some more competitive pricing in the segment.

We believe the second half will be stronger than the first half, you see that in our guidance. We have some view into that as a result of the backlog that we now have on hand with obviously a very substantial booking quarter here. But we do believe that some of the logistics costs and the unfavorable mix are likely to be with us as how we’re seeing the market materializes here. The particular location of where those challenges really are is it’s in the large power distribution and power quality assemblies where they are more competitive in terms of the pricing environment than they were a year ago. Those unfortunately did offset the synergies that we did get in this segment, so we‘re confident about the overall synergies we’re getting both in the electrical products, the electrical systems and services and at the corporate level, but we did have some negatives as we tried to detail here pretty clearly in terms of the impact upon margin.

If we move to the Hydraulics segment, this is page 9. Up just a 1% from the first quarter, first quarter was $782 million of shipments, up 2% from last year. The second quarter bookings being down by 2%, I think it surprise some people, but if you recall that we’ve seen a fairly substantial increase in bookings for the last three quarters and it is leveling at this point. And we really pointed two key elements. One I think is where both should not really be a surprise. First is the global agricultural equipment market seems to have gone over top. We’re seeing most OEMs talking being down in the 5% to 10% range this year. And then the China construction equipment market continues to be very weak as you have heard from a number of OEMs who come into that and over the last month or so, we don’t see that turning around here in the year of 2014. As a result, we’ve reduced the market forecast down for the full-year from approximately 3% to 1% and the real issues you think about it is the U.S. is likely to be sort of a plus 2, the rest of the world is sort of a 0 really brought down by the large construction markets in China. When we look within our own bookings, the distributor side of the business up in the order of 9%, the OEM side of business down in the order of some 15% basically for the reasons I mentioned was the mobile market have been hit by this construction and ag weakness. And you recall that this was one of the three segments that we said that we were going to take some restructuring expense. During the second quarter, you will see in that first bullet point in the yellow section of the yellow box, it was about 160 basis points without that this margin is pretty much as it was a year ago about 14.2%.

If we move to chart 10, which is the aerospace segment up volumes some 5% from the first quarter, when it was $464 million up 9% from a year ago. As you could see, we still have some small impact in this segment from the two small aerospace business units, we divested in the second quarter, but you could see the bookings up very strongly and we’re really quite pleased with a 20% increase in aftermarket orders on both – the good strong activity on both the commercial and the military side of the business. Once again, restructuring costs taken in this business, during the second quarter, reduced margins by about 40 basis points, so again margin is pretty similar to 14.6% without the restructuring expense.

Turning to page 11, the vehicle segment, first quarter shipments were about $996 million, so shipments from the second quarter up about 4%, up 3% from last year. Again after some large restructuring costs in this segment that we have said we were taking at the beginning of the first quarter, they would come up for about 230 basis points decrease in margin. So margins would have been 17.3%, so a very healthy level in the segment. Without those as we watched the June NAFTA orders coming in at almost 27 million units for heavy-duty trucks and now that whole second quarter at about 78,000 units. We’ve raised our guidance for this segment for the NAFTA heavy-duty truck build to 290,000 units, coming out of this quarter at about 74,000 units build. It’s a pretty flat forecast for the rest of the year. And, so we think lower than the sweet spot here. The offset for that is the South American markets continue to be very weak and we think are down on the order overall of about 11%, so pretty weak activities down in South America.

If we turn to chat, well really just one change in terms of our overall end-market growth, it is still 3% for the company, the change within hydraulics was not enough to kind of swing the total number and again that change in Hydraulics is the global ag market and then the construction equipment in China weaker than we have thought.

If we move to page 13, I’d like to spend a couple of minutes on this chart today because I think it’s important in being sure that we’re all in the same page in terms of our margin expectations. If you recall when we gave margin expectations by segment at the end of the first quarter, we noted that that margin guidance did not include the then expected $40 million restructuring and as it turned out in our actuals, you saw $39 million of restructuring actually took place in the third quarter in our Hydraulics, Aerospace and Vehicle businesses. We are now taking those restructuring costs which were already in our earnings guidance for the year and simply reflecting them in the individual segments. If you recall, we did not do that at the time we shared the $40 million restructuring plan because we’ve not made an announcements to our employees yet and until we did so, we did not want to reflect it in the segments. As a result, if I can start with Hydraulics, the Hydraulics $13 million restructuring was four tenths of 1% that explains the difference between the 13.5 and 13 revised guidance. In Aerospace, the $2 million of restructuring small enough it didn’t really affect our 14% guidance that we had before in hand. In Vehicle, the $24 million of restructuring is 6 tenths of 1% and that’s why we’ve reduced from 16 to 15.5. So really no change in our underline guidance of margin for those three business segments.

Now let me go back up to electrical systems and services where we decreased from 14.5% to 13.5%. If you recall in the first quarter, we had about $13 of weather related variances. Second quarter is I detailed earlier the next logistics and pricing impact that’s why we’ve taken a point (indiscernible) margins, obviously with having been under 13% in the first two quarters of the year for us to be really we’re going to achieve 13.5 for the full year. We are anticipating the second half being stronger and as I mentioned with larger backlog we have and the knowledge of what’s in our backlog, we feel comfortable with those projections for the balance of the year, but we are taking the full year down by a point at this point. Now when you get to the bottom, the Eaton’s consolidated number of 15.2% versus the 15.7% previously, the $39 million of restructuring expenses is worth 2 tenths of 1%. The electrical system and services segment’s impact on the total company is 3 tenths and that’s the difference of the 5 tenths. Hopefully that clarifies for you at somewhat of a complex set of numbers in terms of the margins, but really you can trace from those two sets of actions.

Moving to page 14, this is our full year guidance. We did lower the top-end of our guidance due to the change of margin outlook in Electrical Systems and Services and the fact that you recall when we gave our guidance for the year, it was based upon a range of market growth numbers of 2% to 4%. At this point having a half of the year behind us and markets growing at a lower number in these first couple of quarters more on the order of 2%, we don’t think a 4% is realistic anymore and that’s why we trimmed the top end, but we’ve held the bottom end of our range at $4.50. All the numbers showing on this particular page do exclude the impact of the aerospace divestitures and the items related to the Meritor and Triumph litigation.

If we move to page 15, this is the full-year bridge and really just two changes on this full-year bridge. What doesn’t appear on this page that was there and when we gave you guidance for the last quarter was we’ve anticipated that ForEx, we’d have about $200 million negative impact on revenues this year. We no longer think that is true as we’ve seen a number of the currencies move or prepared to talk about that during questions. So that negative $0.04 is disappeared off this page and that negative $0.04 offsets the $0.14 – that negative $0.14 that you’ll see is the second item listed on the several negatives here that is new on the page here and that relates to the logistics mix and pricing in the Electrical Systems and Services area, so a net of $0.10 and that’s the difference in our midpoint obviously between the $4.70 that we have had is the midpoint of our operating earnings per share and now the $4.60.

No changes on page 16, which our Cooper synergy projections. We really just provided this for your reference. If we move to page 17, this is our bridge from our second quarter actual to the third quarter guidance, again starting with $1.11 that we’re reporting today. Obviously, we removed the industrial sector restructuring expenses of $0.08 that was $39 million that we’re incurred during the second quarter. We expect higher volume of about $150 million, or 3% very much in line with what we generally see between the second and the third quarter.

We’ve got additional synergies. We’ll be realizing from all the work we’re doing at Cooper synergies of about $10 million and that’s about $0.02 and then we’ve got higher corporate expenses of about $0.04, yes, generally you’ll see the second half of our corporate expenses run higher than they do in the first half and that’s how we get to the $1.25 for our guidance – midpoint of the guidance for the third quarter.

Moving to page 18, obviously when you look at our first half earnings, first and second quarter together earnings at $2.12 to reach obviously our full-year guidance that means its $2.48 of operating EPS in this second half and we felt that will be (indiscernible) a little bit about this. Let’s start with a top-line higher volume of about $500 million at the incremental that we’ve been talking about this year of 26%, our best estimates are that our markets grew at about 2% versus the first half. If we see some gathering strengthened and we think they will grow closer to 4% in the second half and that’s how we get to our 3% market guidance.

If you think about when you try to think through where does the $500 million of volume come from, please remember this is first half versus second half. So one of the big steps in volumes was the $275 million step up between the first quarter and the second quarter. As I mentioned to you in pervious chart when we detailed the third quarter guidance, we’re talking about volumes moving up about $150 million in the third quarter compared to the second quarter. And then it’s typical for us with our mix of businesses that volumes declined slightly in the fourth quarter from the third quarter that’s the exact same pattern that obviously that what we’re talking about that’s embedded in our guidance. We won’t have the industrial restructuring expenses in the second half that we had in first half, about $39.08 million, additional Cooper synergies of $0.05, lower pension expense of about $0.05, lower taxes of about $0.04 and then the higher cooperate expenses as I mentioned before was second half normally runs higher than the first half about a negative $0.12 and that’s how you get to the difference between the first half and the second half.

If we turn to page 19, this is simply the summary we give you kind of key elements supporting our guidance. Just a few items that have changed here, if you scroll down to, I guess that’s the sixth item the tax rate, we’ve increased that to 6% from 5% and again remember all of these numbers here excludes the impact of the aerospace divestitures and the items related to Meritor, Triumph. The real reason for the slightly higher tax rate is that our earnings are higher in some of the higher tax jurisdictions, i.e., the U.S. for example. Again, that goes back to our view how the economic outlook is laying out this year with U.S. being one of the stronger regions and many of the areas outside of the U.S. is actually being weaker. Obviously, our operating EPS for full year, we lowered that by $0.10 at the midpoint by dropping the top end from $4.90 to $4.70, we kept the $4.50 the same at the low end. And then you will notice on the operating cash flow and the free cash flow, in each case, we’ve lowered them by about $200 million, really reflecting the lower profitability that’s comes out of our guidance and also a little higher working capital that we’ve anticipated when we started the year, no change to CapEx.

So if we turn to Page 20, summary, second quarter results were very much in line with our guidance on revenues and margins either the guidance we gave at the beginning of the quarter or the update we gave through the 8-K of roughly a week ago. Excluding the unusual items and the restructuring costs in the industrial sector, EPS was up about 9% versus last year that Cooper integration remains very much on track. We’re very much in the midst of many of the plant moves that we’ve discussed with you at this point. We will deliver the $95 million of incremental benefits compared to 2013 here in the year of 2014 and another $150 million for 2015. The industrial sector restructuring is in place and we will yield as we have told you at the end of the last quarter about $35 million of benefits next year, so between the two about a $185 of benefits on next year compared to this year. And our best look at pension cost which we often try to share with you as we get to the middle of a year is that with this kind of rates that we used the last time that we calculated this based up on our fuller funding of these plants and the markets having done a little a better, it would be on the order of about $35 million less than this year.

Now with that I would like to add just one of the final note is that and it is not in those packet but there has been a lot of speculation about whether it would make sense of Eaton to spinoff any of our businesses in light of the transformation that we’ve been undergoing over the past 14 years. And as I have commented in many different forums that each of our businesses remain really a key contributors to our results and we continue to see real benefits from being able to apply our multiple power management technologies to meet our customers’ needs and these different verticals. But we also want to clarify that we are not able to do a tax free spin of any business for five years post the acquisition date of the Cooper transaction and that that limitation means that any spin would result in a very significant tax liability. So for the two reasons we think of our power management strategy and obviously this five year kind of prohibition that any form of kind of economic benefit means that that there is not a really compelling economic rationale for further portfolio transformation. So we hope that provide some clarification to a number of questions that a number of investors have either asked or written about over the last month.

So with that I wanted to really take the time to get through a couple of those specifics around the margins because I know they cause some confusion after our release. So with that Don, why don’t we go ahead and open things up for questions.

Question-and-Answer Session

Operator

[Operator Instructions]

Donald H. Bullock

Our first question comes from Steven Winoker with Sanford Bernstein.

Steve Winoker – Sanford Bernstein

Thanks and good morning. Just first question on ESS and S&S margin declined about 200 basis points, you call that would just takes mix in pricing pressure. You mentioned power distribution, power quality, was there any impact (indiscernible) your power systems from Cooper?

Sandy Cutler

As I said Steve, I appreciate the question, first good morning.

Steve Winoker – Sanford Bernstein

Good morning.

Sandy Cutler

It was a very much an as I mentioned that we see it in the large power distribution assemblies in the power quality business and that’s specifically where we’ve seen a competitive activity and the logistic issues lays across a number of the businesses, but again is primarily in those very big assemblies.

Steve Winoker – Sanford Bernstein

Okay. And within that you’d call that back up and I would recall the February investor presentation, roadmap to about 16% in 2015 and it looked to me like I think two thirds of that was some synergies, I mean I am just talking about this segment, electrical systems and services and the rest between market and outgrowth. I assume this changes your outlook on that basis now? Or you’re making it up something it up someplace else? Or how are you thinking about that?

Sandy Cutler

Yes, I think if you recall we also had increased our margins in electrical products and as you see, we’re pretty consistently getting that available from the revenue and bookings point of view as well as getting the higher margins. I think it’s a little early to put a number on 2015 and we would really like to get a better sense for how bookings progress here in the third quarter and obviously the second quarter was much improved in terms of the magnitude of the bookings as well as we think the quality of the booking. So a little early, I appreciate your question, but I think we will be in a better position to really be able to answer that we come out of the third quarter.

Steve Winoker – Sanford Bernstein

Okay. And then just finally on the guidance first half to second half, I looked backwards. It looked to me like normal seasonal growth first half to second half as more or like to 15% ramp and then you would called out incremental synergies being weighted towards the back half of that $95 million and I am not sure the $0.05 really reflects that. I mean you can maybe talk through that a little bit more?

Sandy Cutler

Obviously a lot of – as you get underneath that $500 million of the higher volume in the second half versus the first half, a couple of issues relative to market. As I mentioned, we saw the vehicle markets and the hydraulic markets on a year-over-year basis were far stronger in the first quarter than they were in the second quarter. I mentioned that when we’re talking about the vehicle businesses that we think the NAFTA heavy duty business will be relatively flat from this point forward and that you’ve had roughly to 74,000 units production level which is basically what you need kind of finish these next two quarters, so won’t get as much of an impact there so by deduction it was an Hydraulics here we call its generally weaker in the second half than in the first half each month so what really prepared us is Aerospace in electrical and you saw the very strong bookings in both those segments 9% in Aerospace and 6% to 7% in each of the two segments in electrical and so that’s why we’re really looking for the higher sales levels.

Steve Winoker – Sanford Bernstein

Okay. And then on the some of the incremental synergy of that $95 million now first half versus second half.

Sandy Cutler

Yeah. And that’s the additional 2% either you see of the about $25 million of additional benefits that higher in the second half than there is in the first half.

Steve Winoker – Sanford Bernstein

Okay. All right, thanks.

Operator

Our next question comes from Joe Ritchie with Goldman Sachs.

Joseph Ritchie – Goldman Sachs

Hi. Good morning, everyone.

Sandy Cutler

Good morning.

Unidentified Company Representative

Good morning.

Joseph Ritchie – Goldman Sachs

Just to stand with ESS margins for a second and can you clarify a little bit more Sandy what do you mean by higher logistical costs, because it seems like a lot of the unexpected variants was in the legacy Eaton Business. If I’m just trying to get a better handle of that.

Sandy Cutler

That’s primarily freight cost, that it’s a – it’s been a surprise to us how quickly free cost move during the second quarter and part of this has to do with the size of the equipment that we’re shipping and its moved up quiet significantly during this time period.

Joseph Ritchie – Goldman Sachs

Is that something that is expected to continue just given that you’ve had, now stronger bookings in ESS moving forward, I would imagine if that’s the business insulting that has subsides in the near-term.

Sandy Cutler

That’s part of the reason why we moved to our guidance, you’re right that’s one of the reason why we moved our guidance down for the balance of the year.

Joseph Ritchie – Goldman Sachs

Okay. And then I guess one other question on ESS, you mentioned pricing pressure and clearly, the bookings number with a positive this quarter plus seven, talk us through maybe that the pricing or competitive dynamics that you saw in the bookings that you put into your backlog just this quarter.

Sandy Cutler

Well, as I mentioned earlier we’re comfortable at the improvement that we’re forecasting the second half really is driven by what we’ve been able to successfully book here during the second quarter. I think if you look back over the last six, some quarters in this segment, you saw our bookings levels that when they were positive we’re in this kind of 1% to 2% range then you recall it they went negative in the fourth quarter in the first quarter, those tend to have in this kind of the business which is a backlog based business tend to be sort of a precursor what’s going to happen in the next quarter so, we’re pleased how we see that we had a very strong quarter in all by what I would say is the large power of quality types because that side of market continues to be weak. But the power distribution side, whether and each of the end markets are continue to be quite strong. We’re seeing good indications of continued strength in non-residential and oil and gas in particular so that we are encouraged by what we saw here in the second quarter now obviously we got to ship it and we are pretty comfortable we know how to do that but we don’t think these logistic costs are likely to go away.

Joseph Ritchie – Goldman Sachs

It's interesting to me you think about the margin for the business for the back half of the year, you are basically implying something over the 14% for ESS which you are comfortably there last year, and so I guess a one last question on ESS. Can you kind of talk through may be the puts and takes to the specific margin guidance like where could be disappoint or potentially be more positive or constructive on in the back half

Alexander M. Cutler

Yeah. I think in the guidance that we provided are they can add a lot more homework character to it is, I think that one thing we always tried to stress for people understand any of electrical systems and service business hence they have a higher data to it both when the market is expanding or contracting because it tends to be a lot of large projects are tend to go into expansion if you will, equally true in terms of what happens with the mix of projects that can change from quarter-to-quarter and we’ve obviously did not have a good quarter in that regard here in the second quarter with the knowledge of what we have got in our backlog at this point, our best view is that we’re going to see the improvements that you’ve referenced in terms of second half being a stronger half than the first half, but it’s still not to the level that we’ve had anticipated originally this year and that’s why we reduced the guidance for the second half.

Joseph Ritchie – Goldman Sachs

Great. Thanks. I will get back in queue.

Operator

Our next question comes from Scott Davis with Barclays.

Scott R. Davis – Barclays Capital

Hey, good morning guys.

Alexander M. Cutler

Good morning Scott.

Scott R. Davis – Barclays Capital

Can you give us just a little bit more color on aerospace margins in 80 bps down a year and you said half of that was from structuring. I would have thought in and up 9% sales environment you’d have been able get some operating leverage is that just more of a mix issue?

Alexander M. Cutler

Yeah its again a whole series of different projects in there, but I would say this is very much in line with our guidance I wouldn’t be as concerned myself about this thing moving a couple of tens of a point one, one direction or another, the real issue that we are particularly pleased was is the aftermarket business is starting to rebound you may recall it over the last two years we’ve talked about that one of the challenges is with the commercial OEM production increasing as quickly as it is after market hasn’t been able to keep up with that. And we’re now starting to see, seasons that fill in and we think some of the initiatives that our team has underway to help in larger aftermarket business are really starting to show up. So we’re not yet seeing a 20% increase in what we’re shipping in terms of aftermarket because this stuff has some lead time as well, but we are starting to get to a point where it’s a more representative percentage of the total business.

Scott R. Davis – Barclays Capital

Okay. Fair enough. And then question on ESS, that your comment on pricing pressures and I guess I am little surprised that incremental I mean power quality particularly in Europe has been weak now for a couple years, few years. Why is that incrementally getting worse on price. Is there – it’s just a function of excess capacity or it’s just someone in there as an rationale trying to gain share or new entrance anything that’s changed.

Alexander M. Cutler

I don’t think – the single phase piece that we’ve talked about which really is over in the product side, I think those conditions have been fairly similar with the weak server sales around the world. This tends to parallel or be a pretty good surrogate for the demand that we see then on the accompanying UPS and that continues to be much as the same issue.

I think here on the larger products which tend to be the three phase products which tend to appear for us more in this systems and services segment. We’ve got a couple of things going on, one we talked when we were at EPG this year about the fact that there is a change in the technology of the power solution in the large data centers.

I remember that’s not the biggest part of this market, but there you’re ending up with a little less power quality equipment in a little bit more power distribution equipment in average large data center. I think that’s going on its not as much of a technology change inside the UPS itself it is, it’s a change in terms of how people are utilizing them.

So I’d say that change is going on, but I would say we still have not seen the large enterprise system data center is accelerate to the extent that we’ve seen the kind of mobile or let me call them hyper scale mobile data center is really come on and so then the enterprise have typically been the people like the big financials and large industrials and they’re not spending as they were a couple years ago.

Scott R. Davis – Barclays Capital

Okay, fair. And then just clarification, Sandy you commented about that the tax status if you're to do a spend obviously that – it’s off the table, but is there anything that would impact you selling a business.

Sandy Cutler

No. Not versus any other normal sale that you’d make in terms of looking at price and looking at after-tax proceeds.

Scott R. Davis – Barclays Capital

Okay. Fair enough. Great and thank you. Appreciate it.

Operator

Our next question comes from John Inch with Deutsche Bank.

John Inch – Deutsche Bank

Thank you. Good morning everyone.

Sandra Pianalto

Good morning, John.

John Inch – Deutsche Bank

Hi. So I just, I realized there is a lot moving parts, but in a nutshell so the 500 plus second half volume Sandy, if you compare the second half of 2013 versus the first half that was up 222 what is bridging the gap is it truck, is it something else, because you’re taking your market forecast down, so I’m just – just in a very high level, what’s the accounting for the sort of $2.70 delta incremental second half volume this year versus last year?

Alexander M. Cutler

You’re continuing to have growth in the electrical markets overall, we’ll continue to grow, and obviously as we look at a 3% number, and we’re saying that overall the first half grew at roughly 2% and the second half is going to grow at 4%, you can have about 4% growth overall.

Again we’re seeing the aerospace market continue to grow fairly consistently. We’re seeing hydraulics slow in terms of that growth this year. Better vehicle year-over-year growth, and that’s different than we saw in the second quarter where it was a little solid and the rest of it’s the electrical business.

John Inch – Deutsche Bank

Would you characterize your guidance as – I’m just trying to put this into a context, because obviously, we don’t want to get into third quarter, and have to cut this forecast again, is it an extrapolation of the run rate that you see or are you leaving yourself any kind of cushion with respect to kind of the 3% and then the 4.5% out growth?

Alexander M. Cutler

Yeah, the 3% is our best estimate of these markets, and of course we can be wrong on that, but it’s our best estimate at this point. So, we are not trying to build a cushion, John – or be overly rest of it, it’s our best estimate at this point.

John Inch – Deutsche Bank

Can I ask about hydraulics, we had three quarter in a row of high-single digit or low-double digit bookings, and what exactly – why did that not manifest itself into some better top line, was it – I mean were there any sort of cancellations of orders, I mean I’ve realized, you’ve got a lot of exposure to say North American Ag, is there anymore color you can give us. We all know what the China headlines are – is there anything else, that’s going on that might account for that discrepancy?

Alexander M. Cutler

Our bookings numbers are net of cancellation, so don’t simply gross book and not report cancellation. So, we’ve seen, if you go back, really, you recall it a year ago, it was a fairly weak booking number in the same quarter. Since then, we’ve seen three quarters that were really quite strong, and then we’ve seen the second quarter, that obviously came down. I think what we’ve seen is, the industrial activity has been okay, not great. And the biggest increase was occurring in the mobile side of the marketplace. So, was these with the ag manufacturers, who have clearly backed off at this point. And construction equipment, is okay in the U.S., it’s not great outside the U.S., and it’s pretty awful in China, and I’d say that, that’s where the difference has been, China has actually gone down further.

Richard H. Fearon

In gentlemen, on the last call we’ve pointed out that often the OEs when they start ordering they’ve quite long dated orders, and so that means that you will have a surge of orders, but they extend that over a long period of time. And that’s why we had some of a gains we had in the prior quarters, as Sandy mentioned actually OE orders were down in the second quarter.

John Inch – Deutsche Bank

Rick are you suggesting that the three quarters of the strength that actually can still manifest itself even though it’s kind of in future quarters even though the markets are under the pressure you just described.

Richard H. Fearon

Yes. Some of those orders do extend out. Now they are subject to cancellation, but some do extend out into the future.

Craig Arnold

But John, we’ve mentioned in numerous forms that often what you’ll see large OEM’s do as reserved capacity through orders and they can adjust those, but if they come out of a period of weakness they are trying to ensure they are going to have forward capacity.

John Inch – Deutsche Bank

One more from me what would you say to this question that’s out there with Cooper on the ESS side you perhaps there has been pressure on you with respect to market share and so you’ve actually – you’ve actually had to take price action specifically to Eaton versus the market to try and preserve some market share. I mean, is there aspects of some of that in perhaps some of the mix within the ESS business.

Alexander M. Cutler

I don’t feel so, I think if you look across the two businesses, the channel based business where you tend to have more of a mix of product where you’d be presenting a mix of product into a channel, I think you’re seeing very solid performance and would have been more likely if your premise was right you would have seen that in the products area. The other segment tends to be one where you are bidding on individual jobs their individual transactions and they don’t always have all the products as your premise was. So I would say no I think you’d see the reciprocal of this performance if that was true.

John Inch – Deutsche Bank

Okay. Thank you.\

Operator

Our next question comes from Ann Duignan with J. P. Morgan.

Unidentified Analyst

Hi, this is Mike (indiscernible) for Ann. I just had two quick questions. Can you talk about the margins again in Electrical Systems and Services? And I guess if would have pass the 200 basis point year-on-year decline. How much would you put in each of the three buckets you identified?

Alexander M. Cutler

They are about equal. There is not an overload in any one of the three.

Unidentified Analyst

Okay. And then following up on that in aerospace you mentioned 20% growth in bookings for the aftermarket. Any idea or color around how much of that might be provisioning related.

Alexander M. Cutler

Hard for us to know exactly, because after market for us really includes spares, repairs and overhauls and so what we are beginning to see is we are beginning to see some of the news planes that came into service three years ago start to really get into the after business, but you are still seeing the commercial and you are seeing these releases from the large commercial OEM increased in double digit numbers and so that continues to put pressure and trying to get after market to catchup with that kind of number, what we are particularly pleased about in this quarter is the strength was both on the commercial side and military side. And so pretty broad-based strength in that regard.

Unidentified Analyst

Okay, thank you.

Operator

Our next question comes from Andy Casey with Wells Fargo.

Andrew M. Casey – Wells Fargo Securities LLC

Good morning. Another question on the margin guidance, I’m trying to build up the 26% incremental margin embedded in the full year guidance after – from doing the math, right what appears to be a first half 19% extra structuring in Q2, and you’ve somewhat addressed it aero side and S&S, but also within that, it looks like you’ve fairly sizeable ramp in electrical products. Is it fair to look at implied second half electrical products incremental margin to be something north of 30%?

Alexander M. Cutler

I have to do the same calculation you are doing, but yes, again remember our guidance for the segment is higher than what we have achieved for the first two quarters, so I want be sure we’re doing the math the same, but it’s – we are assuming that we continue to have even higher margins in the second half than we had in the first half, and we feel pretty confident in that.

Andrew M. Casey – Wells Fargo Securities LLC

And is that just underlying demand, Sandy or are there more synergies falling into the second half than there were in the first half?

Alexander M. Cutler

There are more synergies in the second half, if you back that chart that we referenced…

Richard H. Fearon

But that’s broken up separately, Andy. So you have the normal…

Alexander M. Cutler

Yeah. Right now, I mean – that you have in the second half of the year, and obviously a big step up from Q1 to Q2, and then you step up again, about $150 million into Q3 in revenue, and just a slight decline in Q4. And what we’re saying is, we believe of that 26% incremental is appropriate for that revenue increase second half over first half, and we’ve broken the synergies out of the separate line item.

Andrew M. Casey – Wells Fargo Securities LLC

Okay, and then just a higher level, and thanks for that Rick and Sandy, a higher level question, if you step back and look at through demand trends, just within North America, I mean we’re seeing kind of mixed performance, but in general things continue to get better, but it’s a little odd, do you have truck acting well, construction okay, but not great, and then what appears to be underlying progress and improvement for electrical businesses, and what are you seeing out there, is it just continued hesitancy for the large projects to get underway, and if so, what’s causing that?

Alexander M. Cutler

I think you describe it right, it’s okay if not super. But I guess, you look at the flash PMIs at 56%, orders of almost 60%, manufacturing industrial product was up pretty solidly high single digits here in the U.S., here in the second quarter. We are seeing more signals we think around non-residential that it looks like it’s picking up some more, the residential is drifted a little bit more and you’ve all seen those numbers, we don’t see utilities moving substantially at this point.

The construction equipment is a little better but mining is not great. I think on the ag side it’s weak. And if you think about the vehicle Markets, Class 8 is strong, light vehicle continues to be pretty strong almost a 17 million SAR in June and then weak government spending. So you do end up with a little bit of a Ying and a Yang, and that’s why we say, we think, overall you end up with subpar economic growth in the U.S., but it’s better than the rest of the neighborhood. And so when you’re looking at Europe, still struggling to get its full momentum, South America is pretty rugged, China still an attractive overall number, but very inconsistent by market vertical within China.

So I would agree Andy with your general view on it, and that’s why we say we still think the 3% is the right number we don’t think – for overall Eaton Markets we don't think four is possible with the start, that the year started with.

Andrew M. Casey – Wells Fargo Securities LLC

Okay. Thank you very much.

Operator

Our next question comes from Julian Mitchell with Credit Suisse.

Julian C. H. Mitchell – Credit Suisse Securities (USA) LLC

Hi, thanks. Just on hydraulics, the bookings numbers have been bouncing around a lot so I just wanted to check. The sort of operating earnings ex-restructuring were about the same year-on-year in Q2. When you are looking at the second half, you basically assuming a very similar EBIT progressions what you had last year in Hydraulics.

Richard H. Fearon

And generally Julian just in our Hydraulics business with its more heavy mobile loading, generally the first half is a little stronger, the third quarter tends to be the weaker quarter for hydraulics, when you look through the year. And we don’t think that’s likely to be substantially different this year.

Julian C. H. Mitchell – Credit Suisse Securities (USA) LLC

Okay, will your hydraulics earnings be kind of up or down year-on-year in the second half in your guidance?

Richard H. Fearon

Though I have to – full year-to-year comparisons, we really been looking more in terms at our first half versus our second half.

Sandy Cutler

It should follows the normal seasonality that you saw last year though, Julian. We don't see any reason for us to be different than that.

Julian C. H. Mitchell – Credit Suisse Securities (USA) LLC

Got it. And then in electrical products, as you pulled out a couple of times, you’re looking at a steeper sort of margin jump year-on-year in the second half than what you had in the first half; is that solely related to the sequencing of Cooper synergies or is there something in the underlying business that’s also driving that?

Alexander M. Cutler

You are seeing pretty strong growth, again I remember second quarter up 6% from the first quarter up 4% from last year, you’re seeing six very attractive quarters in a row of growth about what the most people consider the markets to be. So I think you are getting some leverage in the business there in addition to the fact that, then we get the synergies to drop in as well. So I think we’ve got both of those working for us quite well there.

Julian C. H. Mitchell – Credit Suisse Securities (USA) LLC

Thanks. I mean just lastly, I hate to come back to this, but electrical systems and service, is there – at some point a view on kind of the market segments that it targets or something more strategic, I guess you’ve had it for about a year and half now, you moved some costing back in Q1 out of products, so I guess is there anything changing strategically on how you’re viewing what’s happening there or is it just sort of a bunch of bad one off items in the first half and those should normalize?

Alexander M. Cutler

Yeah, I wouldn’t say it’s a change in market segments, because we serve with our market shares, we serve the very broader array of what’s out there, clearly we’ve made some very substantial progress in oil and gas, but it’s not there is a different economics if you will to that set of end markets activity which is more an issue of logistics, this particular mix.

And as we’ve said, from pricing that really comes, we think from this weaker period of demand, and so we’re encouraged with what we’ve seen with our bookings here in the second quarter. I don’t want to overplay that, but it’s the best set of bookings we’ve seen in six quarters, and I think that’s significant in itself.

Julian C. H. Mitchell – Credit Suisse Securities (USA) LLC

All right. Thank you.

Operator

Our next question comes from Jeff Sprague with Vertical Research.

Jeff T. Sprague – Vertical Research Partners LLC

Thank you. Good morning, gentlemen.

Alexander M. Cutler

Good morning, Jeff.

Jeff T. Sprague – Vertical Research Partners LLC

Sandy, I was wondering if you could come back to your comments on the spin, and may be just a little color on – or the difficulty in doing one so that speak, the color on kind of controlling regulation or law that brings you to that conclusion. And I’m also just wondering, there’s obviously been some fresh speculation from myself and others, but these questions have been out there before, I’m just wondering why, what kind of learning aside to your limitation now, does this reflect the fact that you yourselves have dug in and looked at it much more closely, and have found the roadblock or is there some other explanation?

Alexander M. Cutler

Jeff, let me comment. Because of the legal steps we had to do to complete the Transaction for Cooper, there are a couple of code sections that make it not possible to do a tax free spin for five years, and it’s a conclusion our team can do it, it’s not a simple analysis, but they came to it and then several outside advisors corroborated that. So, we are very certain of that analysis is accurate.

And, Jeff it’s not new knowledge, we’ve been well aware of this all along and I have tried to indicate that, we had no intent to do any such actions, we’re just trying to help make it clear for people that it’s not simply an issue of will, it’s also an issue of some very technical issues at this point.

Jeff T. Sprague – Vertical Research Partners LLC

And if you were to proceed with a spin or similar transaction the spin would just be treated as an asset sale. You can still spend something but it was just be treated as a sale for tax purposes?

Richard H. Fearon

It actually would be taxed higher than just an asset sale for some complex reason.

Jeff T. Sprague – Vertical Research Partners LLC

Okay.

Richard H. Fearon

So that has been difficult to make work economically.

Jeff T. Sprague – Vertical Research Partners LLC

Okay. And then just shifting gears back on price, one of your competitors noted that there was some price pressure in lighting and some of the low voltage areas of their portfolio. Are you seeing that anywhere in the lighting specifically or any of the other kind of industrial low voltage businesses?

Richard H. Fearon

Again our lighting businesses and our electrical products segment in terms of just thinking where it appears for us and you can see our margins are continued to be quite strong there. I think as the LED conversion goes on, clearly there and we’ve talked to this on a couple of occasions, there is a payback competition if you will between LED and to the traditional lighting sources that were very comfortable with – where we are positioned with our technology leadership there.

Jeff T. Sprague – Vertical Research Partners LLC

And then, just finally from me just a comment on pension, I get it it’s an early read but the market could be in all kinds of gyrations between now and year-end with paper and everything else, that does your comment reflect something idiosyncratic at Eaton intention or is it just the general view on where we think rates and other kind of items might be?

Alexander M. Cutler

We were simply trying to give some general indication of what would likely happen to our pension expense next year and the easiest way to do that was simply to say if interest – discount rate stayed about the same, just based on our asset performance and based on some particular things that happened in 2014. We believe that you would see a reduction on expense of about $35 million next year. That can change and will change but it give you a rough indication of what might happen.

Jeff T. Sprague – Vertical Research Partners LLC

Okay. Thank you guys.

Operator

Next question comes Chris Gleynn with Oppenheimer.

Christopher D. Glynn – Oppenheimer & Co., Inc.

Thanks. Good morning

Alexander M. Cutler

Good morning

Richard H. Fearon

Good morning.

Christopher D. Glynn – Oppenheimer & Co., Inc.

I just had a question in the wake of the two legal settlements if you could comment on, if there is – you see any potential for customer backlash and market place push back?

Alexander M. Cutler

I really can’t comment, we don’t expect any at this point, but no further comments.

Christopher D. Glynn – Oppenheimer & Co., Inc.

Okay. And then on the tax rate, we have 6% for the year. There are a number of adjustments obviously, so it would be helpful if you could just address the 3Q and the two second halves specifically, what we’re looking out for tax rate?

Alexander M. Cutler

We are expecting the tax rate in the third quarter will be much like the second quarter, it will drop we believe based on our visibility right now, a bit in the fourth quarter.

Christopher D. Glynn – Oppenheimer & Co., Inc.

Okay. Thanks.

Operator

Our next question comes from Nigel Coe with Morgan Stanley & Co.

Nigel Coe – Morgan Stanley & Co. LLC

Yeah, thanks. Just a couple of clarifications. I hate to dive back into ESS margins, but Sandy can you put finer points on what's causing the second half improvement versus the first half and you’ve mentioned price mix and freights and hopefully then we have the higher volumes coming through in the orders, is it repetition of Boeing leverage on the order pick up or is it, are we seeing improvement in price mix. And if you can just give us – if you can just give us quite a bit of detail on price mix delta you’ve seen, second quarter and second half?

Alexander M. Cutler

I’d say it’s both of the items you mentioned, one is obviously it’s having the far stronger quarter of booking. We start the quarter with a full backlog, and secondly we’ve got, I’d say an improved look in that backlog versus what we had as we came through the last quarter. So I’d say bulk of those items are – were influencing our thinking relative to the second half being stronger than the first half?

Nigel Coe – Morgan Stanley & Co. LLC

And what’s caused the improvement in price mix in the last three months?

Alexander M. Cutler

It’s better pricing. I don’t mean to be flip about it, but it happens to be the mix of projects and there are 100s and 100s of individual projects that are represented in any one month. So it’s very hard to be, it’s this project or it’s that project, but it’s a collective math of what we’ve seen in terms of projects in the marketplace and what we’ve landed.

Nigel Coe – Morgan Stanley & Co. LLC

Okay, great. And then, Rick, just coming back to the pension of $35 million, does that bake in the penalty schedule?

Alexander M. Cutler

Yes, it does. Again, this is still half year away. But it does bake that in.

Nigel Coe – Morgan Stanley & Co. LLC

Okay. Thank you very much.

Operator

We are going to have time this morning for one additional question because of the number of other calls going on simultaneously, we want to be respectful of that. So we have time for one more question this morning. And that comes from Jeff Hammond with KeyBanc.

Jeffrey Hammond – KeyBanc Capital Markets

Hey, guys. Most of my questions have been answered. Can you just talk about what’s driving the better free cash flow guidance?

Alexander M. Cutler

That’s slightly lower free cash flow you mean, and we reduced both operating cash flow and free cash flow by $200 million and it's two factors as our working capital performance has not improved to the extent that we had thought it might and then secondly the reduction in the net point of our earnings guidance that’s what behind the $200 change.

Jeffrey Hammond – KeyBanc Capital Markets

In the working capital is that related to the Cooper deal that you’re hoping to get improvement there or.

Alexander M. Cutler

No. It’s much more broadly just in terms of where we really seen receivables and inventory so far this year. So, it’s really a tuning up based upon where we are at high year.

Jeffrey Hammond – KeyBanc Capital Markets

Okay. Thanks.

Alexander M. Cutler

I want to thank you all for joining us today. As always, we'll be available for a follow-up question both this afternoon and the remainder of the week. Thank you very much,

Operator

That does conclude our conference for today. Thank you for your participation. You may now disconnect.

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