Tyco International CEO Discusses Q1 2011 Results - Earnings Call Transcript

| About: Tyco International (TYC)

Tyco International (NYSE:TYC)

Q1 2011 Earnings Call

April 28, 2011 8:00 am ET


Antonella Franzen - VP, IR

Ed Breen - CEO

Frank Sklarsky - CFO


Steve Tusa - JPMorgan

Steve Winoker - Sanford Bernstein

Jeff Sprague - Vertical Research

Nigel Coe - Deutsche Bank

John Inch - Bank of America Merrill Lynch

Gautam Khanna - Cowen & Co.


Welcome to the Tyco second quarter earnings conference call. (Operator Instructions)

I will now turn the call over to Antonella Franzen, the Vice President of Investor Relations.

Antonella Franzen

Good morning and thank you for joining our conference call to discuss Tyco's second quarter results for fiscal year 2011 and the press release issued earlier this morning.

With me today are Tyco's Chairman and Chief Executive Officer, Ed Breen, and our Chief Financial Officer, Frank Sklarsky.

As you are aware, there have been recent reports speculating about the possibility of a transaction involving Tyco International. I would like to take this opportunity to make clear that it is Tyco's policy not to respond to enquiries from the news media or others regarding rumors or speculation on transactions, which may involve the company. We do not intend to make any further comment about this matter today.

I would also like to remind you that during the course of the call, we would be providing certain forward-looking information. We ask that you look at today's press release and read through the forward-looking cautionary informational statements that we've included there.

In addition, we will use certain non-GAAP measures in our discussions, and we ask you to read through the sections of our press release that address the use of these items. The press release issued this morning and all related tables, as well as the conference call slides can be found on the Investor Relations portion of our website at tyco.com.

Please also note that we will be filing our quarterly SEC Form 10-Q later today. In discussing our segment operations, when we refer to changes in average revenue per user, backlog, and order activity, these figures exclude the impact of foreign currency.

Additionally, references to our operating margins during the call exclude special items, and this metric is a non-GAAP measure. Again, these non-GAAP measures are reconciled in the schedules attached to our press release.

Now let me quickly recap this quarter's results.

Revenue in the quarter of $4.0 billion was up 6% year-over-year, excluding the impact of electrical and metal products. And organic revenue grew by 3%. The benefit of foreign currency contributed 2 percentage points to our overall revenue growth.

Earnings per share from continuing operations attributable to Tyco common shareholders was $0.67. Earnings per share from continuing operations before special items was $0.73, representing a 26% increase year-over-year.

Now let me turn the call over to Ed for some opening comments.

Ed Breen

This was a good quarter for Tyco on a number of fronts. We continue to strengthen our competitive capabilities in our three core platforms of security, fire, and flow control. We returned excess cash to shareholders, and operationally, we saw strong operating margin improvement year-over-year.

Service revenue, which includes recurring revenue represented over 45% of our total revenue and continues to grow nicely in the quarter. More importantly, systems installation and product revenue, which represents about 55% of our total revenue, continued to see improved year-over-year order flow.

If we take a look back, orders first turned positive on a year-over-year basis in the third quarter of 2010, and since then have continued to trend upwards. Year-over-year orders improved 3% in the fourth quarter of fiscal 2010, 6% in the first quarter, and now 7% in the second quarter.

Although we are still early into the third quarter, April orders are off to a good start, coming in with year-over-year improvement of about 10%. We are very encouraged by this continued improvement in our lifecycle businesses and expect this trend to fuel our growth in the latter part of this year and into 2012.

Before we jump into each of the businesses, let me start with a few general comments.

From a capital allocation perspective, organic investments will continue to be utmost priority. The investments we made in our businesses throughout the economic downturn have not only benefited our operating margins, but have also positioned us well for the recovery in our lifecycle end markets.

Year-to-date, our capital spending levels have increased 7% on a year-over-year basis with a high percentage of our capital directed towards growth investments. We also continue to fund engineering and product development, increasing our year-to-date spend by 15%, mainly in our emerging market R&D centers.

As we move into the second half of the year, we plan to further increase our R&D efforts around the globe and ramp up our investments in sales and marketing, particularly in our ADT North America Residential Business.

As I had previously mentioned, we plan to supplement our organic growth initiatives with strategic bolt-on acquisitions. During the quarter, we announced two acquisitions, one in security and one in flow control that strengthen our leadership position in key markets and provide incremental returns to our shareholders.

Frank will walk you through the details of these two deals in a few minutes. From a balance sheet perspective, our cash balance was about $1.8 billion at the end of the quarter, $500 million of which will be used for previously announced acquisitions.

As you know, our free cash flow generation is historically much stronger in the second half of the year, which provides us the flexibility to fund growth investments, as well restructuring any efficiency initiatives. Additionally, we are evaluating a few other bolt-on acquisitions that will utilize an additional $500 million over the next twelve months. After funding these actions, we will still be in a strong position to continue return of cash to shareholders through dividends and share repurchase.

Over the last twelve months, we had repurchased about 10% of our outstanding shares for $1.9 billion at an average price of $39.35 a share. And this morning, we announced a new $1 billion share repurchase program.

Now let me give you a quick overview of our results for each of our businesses, and then Frank will provide you with more details.

Starting with Security, we continued to see good revenue growth in the second quarter. Year-over-year expansion in the account base and higher average revenue per user drove the organic growth in recurring revenue. On the non-recurring revenue side, growth was fueled by the turnaround in order activity we saw last quarter, which continues to remain strong.

Year-over-year securities operating margin expanded nicely with improvements in all geographic regions.

Turning to Fire, revenue was about what we had expected, with improving organic revenue growth in our service and our product businesses. Additionally, order activity gained momentum in the quarter with a year-over-year increase of 5%.

From an operating margin perspective, results in Fire were very solid. Stronger sales, selectivity of project work and the continued benefit of restructuring and cost containment initiatives drove the 190 basis point improvement in operating margin year-over-year.

In Flow Control, revenue and earnings fell short of our expectations. Severe weather conditions and the flooding in Australia persisted throughout the second quarter which significantly impacted our Water business. However, valves, which is by far the largest piece of our Flow Control business has turned the corner with positive organic revenue growth in the quarter.

As we look out over the next few quarters, we believe favorable market conditions will continue to bode well for increased order activity in Flow. This, coupled with our backlog, should improve our overall operating performance as we exit this year and enter fiscal 2012.

Now, let me turn the call over to Frank to discuss our operating results in more detail.

Frank Sklarsky

As Ed indicated, we were pleased with the company's second quarter performance on a number of fronts. Revenue has improved; the benefits of better operating leverage have become apparent; and the continued focus on cost and productivity have contributed to an improved operating margin.

Operating income before special items, excluding the electrical and metal products business improved by 26% on a corresponding 6% revenue increase. And the momentum of our order conditions gives us greater confidence that the revenue and earnings will continue to show good year-over-year comparisons.

Let me review our results for the quarter for each operating business. Starting with security solutions, overall revenue for the quarter grew 12% to $2.1 billion with organic growth of 5.5%. Recurring revenue increased from 55% of security's total revenue in last year's second quarter to 58% this year, primarily due to the Broadview acquisition. Organic growth of 4.5% in recurring revenue was driven by our North American residential and small business operations.

We also continued to see good recurring revenue growth in Asia-Pacific, in Latin America, and for the first time in almost two years, recurring revenue growth turned positive in the EMEA region. Non-recurring revenue grew 7% organically in the quarter, driven by strong order growth over the last couple of quarters in all geographic regions.

Operating income before special items was $335 million, and the operating margin increased 170 basis points over the prior year to 16.1%.

Growth in recurring revenue increased volume in the commercial business, and the continued benefits of restructuring and productivity initiatives drove the year-over-year operating margin improvement.

From a regional perspective within Security, let me start with our North American residential and small business, where nearly 90% of the revenue is recurring. This recurring portion grew 33% year-over-year, reflecting the positive impact of the Broadview acquisition.

Organically, recurring revenue grew 5% in the quarter. The operating margin remained strong despite incremental investments in sales and marketing.

Our North American residential recurring account base now stands at $5.9 million customers. Year-over-year, the account base has grown 31%, driven largely by the impact of the Broadview acquisition. Overall, growth in average revenue per user of 1% year-over-year was impacted by the addition of Broadview accounts which have lower monthly average revenue. Excluding acquired Broadview accounts, average revenue per user grew 3% year-over-year mainly due to the favorable impact of higher monthly revenue rates from new accounts.

Our residential attrition rate of 12.9% improved 20 basis points year-over-year and 10 basis points on a quarter sequential basis.

Focusing on the Broadview integration for a moment, we are nearing the one year anniversary of the acquisition, and are pleased to report that we are tracking to the synergies we expected to achieve at this point as well as the cost to achieve these synergies.

Let's move on to our North American commercial business, where the mix of revenue is very different. About 60% of the quarter's revenue was derived from non-recurring systems installation and service, and 40% from recurring revenue. The momentum in top-line growth we saw in the first quarter has continued with 7% organic growth in the second quarter.

The operating margin improved 80 basis points year-over-year as a result of this increased volume. Additionally, orders grew 22% year-over-year in the second quarter.

In the EMEA region, we are clearly seeing the benefits of tax restructuring actions and cost containment initiatives. Year-over-year, the operating margin improved 570 basis points and 40 basis points sequentially to 11.8%.

In the Asia-Pacific and Latin American regions, where revenue is predominantly commercial in nature, organic revenue grew 10% on a combined basis. The operating margin, which is in the low teens also improved on a year-over-year basis.

Turning to the key metrics for our overall global recurring revenue security business, our worldwide account base grew 20% year-over-year to 8.9 million accounts or 2.5% on adjusting for the accounts acquired as part of the Broadview acquisition.

Average revenue per user, excluding acquired Broadview accounts grew 2% year-over-year on a global basis. Including the accounts from the Broadview acquisition, which shifted the mix in our account base more to residential, our global average revenue per user of $45.72 declined 2% year-over-year excluding currency.

On a quarter sequential basis, average revenue per user increased slightly as new accounts were added to the base at a higher rate attributable to our new Pulse offering. Our worldwide attrition rate of 12.7% improved 40 basis points year-over-year and remained flat on a quarter sequential basis.

And finally, security products which include intrusion, video, and access control had organic revenue growth of 14% in the second quarter. The R&D investments we've been making in this business should position us well for future growth.

I would also like to quickly comment on the acquisition of Signature Security that we announced in February for approximately $170 million. As Ed mentioned, this acquisition is right in line with our strategy to focus on bolt-on acquisitions. With its attractive customer base of recurring revenue, Signature allows ADT to broaden its sales, installation and service capabilities in the Australian and New Zealand markets and solidifies ADT as a leading electronic security provider in that region.

Several areas of opportunity have been identified to realize cost synergies over a two year period. The nature of these synergies positions this acquisition to become accretive in the near term.

Let me now turn to Fire Protection. Overall revenue in the quarter was $1.1 billion with organic revenue growth of 4%. Our service and systems installation business, which is the largest piece of fire protection reported total revenue of $804 million.

Organic revenue growth of 4% in Service was partially offset by a decline in systems installation revenue of 1.5% as a result of project selectivity. The remaining portion of our fire protection business, Fire Products, which includes the manufacturing arm of the fire business reported revenue of $305 million in the quarter with organic revenue growth of 11%.

Overall, Fire Protection's operating income before special items was $135 million in the quarter and operating margin was 12.2%. The 190 basis point improvement in operating margin year-over-year was driven by increased activity in our North American SimplexGrinell business as well as our fire protection and life safety products businesses, which are seeing good leverage as volume picks up.

Increased service revenue, project selectivity in our systems installation business as well as the continued benefit of restructuring and cost containment initiatives also contributed to the improvement in operating margin.

We are also encouraged by the year-over-year order growth of 5%, driven by our North American SimplexGrinell business, mostly due to increased demand for retrofit and upgrade work as well as increased orders in the products business.

Total Fire backlog of $1.25 billion increased 2% on a quarter sequential basis.

Moving to Flow Control, severe weather conditions and flooding in Australia which persisted throughout the second quarter significantly impacted shipments to customers. In addition to the shipment impact, these external conditions also resulted in lost productivity in the Water business, which together had a negative impact on operating income.

Overall, these factors reduced revenue by approximately $30 million, and operating income by approximately $13 million, about half of which will be recovered in subsequent quarters. Adjusting for these conditions in Australia, revenue and operating income in the quarter were about what we had expected.

Overall, Flow Control revenue was $804 million in the quarter, representing an organic revenue decline of 5%. Valves, which comprises about 60% of Flow Control's annualized revenue has recovered from the trough and grew 1% organically in the quarter.

More importantly, orders in valves continued to recover in the quarter with 11% year-over-year growth, primarily driven by demand in oil and gas and solid growth in our Process and Mining end markets.

Water revenue declined 31% organically in the quarter, partially due to the severe weather and flooding that I mentioned earlier and a tough compare with the prior year quarter which included the Australian desalination project.

Organic revenue growth of 5% in Thermal Controls was driven by strong sales of products during the winter season. Typically, Thermal Controls' product revenue is seasonally stronger in the first and second fiscal quarters, as product sales are driven by the colder weather.

Operating income before special items in Flow was $91 million and the operating margin was 11.3%. As we have mentioned, we expected that the second quarter would be our trough quarter, and results were further impacted by the factors I've previously described.

Overall, total Flow orders in the quarter increased 8% year-over-year; Valves were up 11%, Thermal increased 8% and Water orders remained flat. Backlog of $1.65 billion increased 5% on a quarter sequential basis.

Based on our current backlog and order activity over the last few quarters, we expect to see a sequential improvement in third quarter and an even more significant operating income increase in the fourth quarter, as we benefit from increased volume in Valves.

As we've said previously, volume improvement in Valves in this part of the cycle typically results in about 35% flow-through to operating income.

Let me spend a few minutes on our expectations for the second half of the year in Flow Control.

Information in this regard is included on Page 10 of the slide deck. In the third quarter, we expect Flow Control revenue to grow to approximately $900 million, reflecting growth in Valves as well as the recovery of a portion of the Water shortfalls in the second quarter.

We expect Flow Controls' operating margin in the full quarter to be approximately 12% as the benefit of volume leverage in Valves is partially offset by approximately $15 million of a quarter sequential reduction in earnings in Thermal Controls due to normal seasonal reductions in heating product sales and increased lower margin installation revenue.

For the fiscal fourth quarter, we expect Flow Control revenue of approximately $950 million, predominantly driven by growth in Valves and to a lesser extent, Thermal.

We expect Flow Controls' fourth quarter operating margin to be about 14%, as we benefit from the volume leverage in Valves and the expected normal seasonal mix improvement in Thermal Controls as distributors restock product ahead of the coming winter season. These estimates exclude the impact of the KEF acquisition, which is expected to close in fiscal fourth quarter.

Once again, we are very encouraged by the orders we are seeing in Valves, Thermal and in Flow Control overall. This gives us a high degree of confidence that revenue will continue to improve, resulting in attractive leverage to the operating margin line. Given the typical lag time associated with converting orders into deliveries and recognize revenue, this improvement will be most evident as we get further into the back half, most notably in the fourth quarter, and of course as we enter fiscal 2012. Clearly, this business is now gaining momentum.

Before moving to other items, let me spend a minute on our announced acquisition of a 75% stake in Dubai-based KEF Holdings. The Middle East is a key emerging market for us, and this acquisition provides us with a strategic presence in this growing region. KEF is the region's only fully integrated valve business with local manufacturing. This will allow us to better serve both local and global customers predominantly in the oil and gas industry. We have had a longstanding business relationship with KEF, which is providing castings to some of our valve facilities for the past 14 years.

The synergies around this acquisition are a bit different than the typical cost-outs. We plan to significantly increase utilization of KEF's world-class foundry facility to provide castings for our valves in addition to KEF's existing customer base, which in turn should provide us significant operating leverage. Just as important, this region has and will continue to experience a disproportionate amount of worldwide capital spending in the oil and gas sector.

Additionally, the combination of Tyco's well known valve brands and KEF's strong growing reputation in the region positions us very well for some large revenue opportunities in the Middle East and beyond. It's also important to keep in mind that KEF is in the tax free jurisdiction in a growing emerging market.

We expect the benefits of volume leverage in KEF's foundry. All of the large regional project opportunities will make this acquisition accretive in the near term and should provide Tyco an attractive long term return on investment.

Let me now touch on a few other important items. First, corporate expense before special items was $86 million in the quarter, which is favorable to the full year run rate, mostly due to the timing of certain expenses. As many of you know, corporate expense tends to be higher in the second half of the year due to the timing of certain expenses and a number of actuarial valuations that we perform annually.

As a result, we expect corporate expense for the third quarter to be in the range of $130 to $140 million and we continue to expect that our full year corporate expense will be in the range of approximately $400 million to $420 million.

Other Expense of $6 million in the quarter primarily relates to our 49% minority interest in the Electrical and Metal Products business, which is now known as Atkore, we expect that our equity interest in Atkore will be negligible in the third quarter and slightly negative for the year.

Our effective tax rate for the quarter before the impact of special items was 15.4%. As we discussed in the past, the timing of the impact of certain tax items can cause the rate to move from quarter-to-quarter. We expect the tax rate to be approximately 18% for the third quarter and for the full year.

Now let me turn the call back over to Ed to ramp up this morning's call.

Ed Breen

Before we open up the lines for questions, I want to spend a few minutes on our guidance for the third quarter and full year. We expect revenue for the third quarter to increase to approximately $4.2 billion, a 5% sequential increase over the second quarter.

In terms of bottom-line results, improving business conditions will result in a nice sequential improvement in our third quarter operating results in all three businesses. However, this will be more than offset by an expected increase in corporate expense and a higher tax rate.

Let me comment on a few of these moving pieces. First, as Frank mentioned, we expect a sequential improvement in Flow Control operations as we leverage increased volume in Valves and begin to recover lost shipments in Water. Additionally, the seasonal nature of our Security and Fire businesses also benefits the second half of the year.

This operational improvement in Security, Fire, and Flow is expected to increase our earnings by approximately $0.06 on a quarter sequential basis. Second, our proportionate share of the earnings of the Electrical and Metal Products business should shift from a $6 million loss in the second quarter to breakeven in the third quarter. This should add a $0.01 per share to earnings on a quarter sequential basis.

Third, the expected increase in corporate expense to a $130 million to $140 million in the third quarter, which compares to $86 million in the second quarter is expected to cost us about $0.08 per share. And finally, we are forecasting an 18% tax rate in the third quarter.

Given the lower tax rate we had in the second quarter due to the timing of certain items, this is expected to result in a sequential headwind of $0.02 per share. When combined, these items result in a net reduction of about $0.03 per share on a quarter sequential basis. With an expected average share count slightly above 470 million shares, we expect earnings per share from continuing operations before special items in the third quarter to be about $0.70.

Based on our year-to-date performance and our guidance for the third quarter, we are increasing our full year earnings guidance to a range of $3.02 to $3.07 per share compared to our previous guidance of $2.93 to $2.98 per share. Our full year guidance incorporates a share count of just under 480 million shares.

We now expect full year revenue of approximately $16.9 billion to $17 billion, including the $347 million of revenues generated from the electrical and metal products business in the first quarter.

Lastly, we feel good about the operational improvements we have made in our businesses, and I am very encouraged by our increasing order activity. These items, along with recovery of our lifecycle businesses should position Tyco for a solid 2012.

Thanks for joining us on the conference call this morning. And with that, Operator, let's open up the lines for any questions.

Question-and-Answer Session


(Operator Instructions) Our first question today is from Steve Tusa with JPMorgan.

Steve Tusa - JPMorgan

Just wanted to get a little more detail on the third quarter. What do you think about ADT sales and margin there? I mean, you talked a little bit about Flow; maybe just a little color on ADT or the Security Solutions business?

Ed Breen

We're expecting Steve, margins to be about the same as they were in the second quarter, but continued lift on the revenue line as we talked about.

Steve Tusa - JPMorgan

Okay, so organic growth's kind of in line with what you saw in the second quarter?

Ed Breen

Yes, about in line. Actually, one of the points I would make is, as I mentioned in our prepared remarks, we are putting in some incremental investment, both on the security products side in the third and fourth quarter. Actually we started it in kind of the middle of last quarter, and we are ramping up on our sales headcount. And that takes a couple of quarters to kind of get the productivity out of that.

So I specifically wanted here, there is investment going in both on the security side of the business and the buyer side in the third and fourth quarter of the year. But again, we expect good benefit from that couple of quarters down the road.

Steve Tusa - JPMorgan

And then one last question. Can you just talk about, philosophically, you've obviously been a part of a couple of interesting corporate events over the last 10 to 15 years. You sold your business, joined Motorola back in the 90's and obviously split up Tyco in 2007. I guess I just want to, given we haven't talked about this in a while, you guys have been operating pretty steady state, but what is your philosophy on corporate actions strategically?

How do you kind of look at portfolios and opportunities to create value? And just remind us of some of the synergy you have in your portfolio and why Tyco as a standalone in this form was better able to create value versus Tyco in its formal form?

Ed Breen

A lot of angles to that, but we split up the company three to four years ago. First of all, I would say if you go back and do the math, the combination of the value created from that I am very proud of. With the Dow where it is versus where it was then, Tyco, when you recombine it all, is at an all-time high of stock price if you look at the three.

And I'd also point out, when we did that, we always, as a management team and as a Board, always look at how do we create long term sustainable shareholder value, which is exactly what we looked at when we did the split up of the company the last time. We were not looking for on overnight top in stock price or anything like that but what's the best thing for the long term.

And I would point out, many of our investors have said this to me over the past year; all three companies are really focused on their core platforms and all three of those Tyco companies are doing extremely well and I think they are positioned well for the future. So I think it played out pretty much how we would have wanted it to play it out.

Kind of more to the current look; as you've heard me say many times, I love the status of the company now, I love the mix of businesses we have. I think they all have great dynamics coming over the next five to ten years, they all play out nice in the emerging markets and we just have nice growth opportunity coming.

And clearly, Fire and Security, we can do a lot of things together because of the nature of the customer base. But as we pointed out to you, we're looking at some pretty neat enterprise selling opportunities, based around actually the Flow Control costumer base where we can sell in a lot of foreign security like oil and gas, refinery platforms, mining platforms etcetera, etcetera.

So I like where we're at, but I will say to you as I always talk about, we always as a management team present to our Board and talk to them about all the alternatives you could have to create long term, sustainable shareholder value. We look at every analysis, the shape of the company, what should it look like, what should it be, and we will continue to do that as we move down the road.

Steve Tusa - JPMorgan

And then lastly, just on the Valves business, you are going to exit the year at a double digit growth rate. Is there anything with regards to projects compares that makes that a less relevant indicator for what we should expect over the course of 2012?

Ed Breen

No, I think what happened here, I think that's why we have been looking at 2012 to be the comeback year for the Flow Control division. You're right, you'll start to see it here in the second half of the year, but when you look at the trending of the orders we are now booking, it really hits us in the fourth quarter nice. And we start getting out of these compare problems. For instance, the last really bad compare quarter for Water is this actual quarter, we are in now the third quarter. And that reduces very significantly in the fourth quarter.

It's still a negative compare, but it's in the single digits. And then that compare problem goes away as we enter fiscal 2012. And Thermal should run very solid in 2012. Remember, as we mentioned, we do have seasonality in business; you got a stronger first and second quarter, a weaker third quarter, then you build back up in the fourth, and then you get a little higher in the first and second. So you are always going to have that seasonal trend there.

But the Valve piece, the way we are seeing these orders come through, and I'd say more importantly as I keep talking, the sales pipeline of projects we're working on feels very robust. One thing I would point out, we have not booked what I would call one of the big elephant deals yet. This is kind of the day-to day business picking up, and there are projects, I heard our competitors talk about the same thing, we are all bidding on a few big projects that are out kind of in that next six month timeframe that makes you feel good about the order trends as we move through 2012.

So you're not going to have a lot of these anomalies on compares that we had during this year, except seasonality of Thermal.

Frank Sklarsky

I know you asked about valves, but thermal, we're also seeing strong order activity coming through in for thermal, and we also have large deal opportunities there also. So that is another real gem as far as the full portfolio that we haven't talked much about.


Our next question is from Steve Winoker with Sanford Bernstein.

Steve Winoker - Sanford Bernstein

So just maybe a couple of more business-specific questions. One, on Fire Protection and the emerging market progress that you're making there. Can you talk a little bit about your acceleration of growth, particularly on maybe the product side? Can you give us a sense for how quickly you're progressing that business?

Ed Breen

As you heard us mention quite a few times, we are very focused on emerging markets. And as I pointed out in my comments, that's really where we continuing to put a lot of our increased R&D efforts. So we are really ramping up for instance in our China Center of Excellence, as one example. It is very important to us that we get market position in the key emerging markets.

And the four big ones for us, there are many more than this obviously, but the four big ones for us because of the nature of our businesses and what we do is the Middle East, Brazil, India and China. I will give you a number here to point out that we are feeling really good about this.

Our Fire revenue in all the BRIC countries, the emerging market countries, it's more than those four but it's basically the BRICs. Our revenue growth in the second quarter was 22% and the first quarter was 20%. So if we can keep these type of run rates up on, as the rest of what I call the mature markets are recovering now, which we have been seeing now for about a quarter and a half, that should build well for the growth rate of the Fire business.

Antonella Franzen

We mentioned a bit of it also was about localizing the products for the Pacific region. You may have heard us talk about previously the Fire panel. That was made specifically for the China market, being a single panel versus a double panel, as well as in life safety, the breathing apparatus math that was made specifically for the China market as well. So a lot of it does revolve around localizing products.

Ed Breen

That was the key Steve, the putting in the Centers of Excellence in the emerging markets. Obviously, you are doing some work on our global platforms, on our global software capabilities, but a high percentage of it is what Antonella just said, it's localizing products for their features, their market, their cost structuring, therefore price points that they want. And we are seeing nice benefits, and we are going to continue to.

Frank Sklarsky

And we have local manufacturing.

Ed Breen


Steve Winoker - Sanford Bernstein

And are you also making progress more globally in Fire and Security in sourcing products that are currently produced by large third parties?

Ed Breen

Yes. A lot of the periphery that we use, and there are actually many markets around the country, including North America are not all our own. So we have relationships with the three or four very key partners, for instance in China, where we buy product from them. And I just mentioned China; I would point out, when we are looking at our strategic bolt-on acquisitions, just like the KEF one we announced, and we are looking at a couple of opportunities that could be very strategic for us along the lines you are just mentioning.

Steve Winoker - Sanford Bernstein

Okay, and then finally maybe you could just give us an update on Pulse and the rollout. What's been the latest penetration ARPU rates coming in, where are you in the rollout and how is your expectation been changing for it?

Ed Breen

Yes, Steve, we're feeling very good about this rollout. Our internal sales team, which is about actually half the sales people, because the other half is in our dealer network, they have all been trained to some extent, but different regions or different stages of what I would call kind of maturity of the training process, but that, as we exit this quarter, that would be pretty much completed where the initial training has all been done and all that.

By the way, we have a lot of experience of this. This kind of takes a year to get the right traction you want because of just learning to sell, getting the confidence to sell the product and all that. So we are going to track this, obviously kind of weekly and monthly.

As we mentioned, about 15% of our new sales have taken the Pulse package. I will tell you, as we were going into the back half of the quarter and into April, that is starting to move up, and I don't exaggerate this, I would say if I just look at the numbers and lump the last 30 days together, I'd say the 15% is now about 18%. So a little bit of traction occurring there.

And the other thing we are gaining a little traction on, and this doesn't surprise me, just takes time and confidence and training is that initially we were getting 85% of the people that were taking the first level package. And now it's down to 80% taking the first level package, and therefore 20% you have taken the second or third tier package.

We're averaging a right around $50 on ARPU. And I would point out I think I mentioned in last quarter that compares to ARPU that was new account up until Pulse, we were up to $43. The heritage ADT base is at $36 per month and the Broadview base is at $33. So it's $33, $36. The new accounts ex-Pulse $43 with the Pulse $50.

So we are more excited here, not only getting this thing rolled out. But the next step for us is to get the dealers trained up in the second half of the year. So by the time we get into '12, they're cranking along, that would be the other half of the sales force. And that we're putting our plan together to go back to our installed base, this $33 base and $36 base and look at to remarket to them on the Pulse product.

So that's kind of where we're at. And by the way, I would point out, which we track very closely. The IRRs are higher on the new Pulse accounts than they are on the underlying accounts we generate normally at ADT.

Frank Sklarsky

And the other thing that we think is going to be a positive dynamic overtime is because a lot of the higher-end Pulse offerings are going into custom home installations with folks with higher disposable income. And plus the fact that the customers in Pulse will have a little more skin in the game. We think this is going to help our attrition rate. So we are stickier, our product offering and help attrition rates overtime. And a high attrition rate and a higher ARPU is going to be very accretive for the business over the long-term.

Unidentified Analyst

And you still are looking at the economic thing, justifying rolling trucks for your installed base when you get to that?

Ed Breen

Yes, we do. And Steve, we haven't made final decisions on some of this, but we're looking at things like, should we sign the account up for a new three-year contract when we go do this installation. All those things that are potentially very doable in this scenario, and by the way it goes right back to Frank's point, it really helps on the ARPU side.

So the economic will definitely work for us. And as you know, this is the first time where we had the economics really worked where we can go back to the installed base. And one more there, we'll try to sell them some of these other items like carbon monoxide, and fire, and flood protection and cellular backup, all the things we've been selling in our packages very effectively the last few years that did not make sense from a return standpoint to go do, but we will be also be offering that as we go back.


Our next question is from Jeff Sprague with Vertical Research.

Jeff Sprague - Vertical Research

Just maybe a little more color on Flow if we could, Ed? I don' think price ever really got that tough in valves, obviously it softened a bit. But can you speak to what you're seeing now on price on new orders? Is there some positive price inflection, now that the order book is starting to take up a little bit?

Ed Breen

Jeff, as we mentioned, I know one of our competitors mentioned pricing. But I think they really clarified that the last couple of orders they took, a couple of bigger projects at lower margins, and I think you're going through their pipeline right now. And the rest of us really at least, I haven't heard anybody mention it, and we clearly haven't seen much pricing pressure. We saw some, but we had it covered with other cost initiatives and all that at the business. So it is very, very modest for us.

The only headwind we have and I think every other industry have talked about at this quarter is commodities. And our two big commodities are steel because of the Flow company. And the other big one for us is oil and gas, because of our massive fleet that we have around the world, both in our fire and security business. So if you say what's hitting you and that you say the headwind that would be a headwind.

We've approximated that commodity headwind is about $0.60 or $60 million in the second half of our year, which is about $0.06 of earning. And a high percentage of that we have offset with our own cost action to things like that. And by the way, we probably haven't covered a little bit of it, but then were getting an FX help in the second half of the year. So I kind of neutralized those out.

I would say we're about where we thought we would be. And by the way, excuse me, that $60 million I said, that's about $0.10 headwind second half of the year, not $0.06. But I think we've got two thirds of that covered in that and kind of third, we don't have cover, it's kind of covered through the FX help that we're getting. So that would be the one headwind.

But Jeff, as I look out and more specifically I think to your direct question, the projects that we're bidding on are about where our margins are. Our gross margins arise absolute. We're not feeling pressured to low ball pricing to win projects. And as we look at some of the bigger projects, I don't feel any different about them either.

We've got good unique products for these applications. And so it's not a price we're out there. And I think as you're seeing with this kind of demand starting to pick up, I will think that question will be off the table at some point. There's just so much demand. It looks like sitting out there and we're starting to see it coming in the order book.

Jeff Sprague - Vertical Research

And just taking that a step further, if we think about exiting Q4 with 14% margins, obviously there's going to be some of the seasonality through the quarters of '12 kind of along the lines of what we're talking about in '11. But can we think about that 14% as something we can build upon, if we kind of think about incremental margin construct and the like?

Ed Breen

Yes, Jeff, when you look at the detail, what you're seeing as we pointed out, and my answer is yes, but let me give you the detail behind it. You're seeing the nice fall through, and let me use the fourth quarter, you're seeing a very healthy fall through on the valve business as the volume picks up. And as Frank said, we estimate that in the mid 30% level. And clearly the valve revenue is going to pick up, because if you look at the backlog, we're building there in the order rates. Thermal starts to pick up and do all that.

So I think that's a nice baseline to plan from. I would point out one item for you. We will have 14% in the fourth quarter on a run rate basis, but the time here when we close KEF could hit us just a little bit on purchase accounting adjustments and all that. But I don't know when that is, so when we said 14%, it's probably something in the fourth quarter. But that's also kind of one-time in nature. So I think that's a good plan to build on.

Jeff Sprague - Vertical Research

And just one cleanup if I could. The impact from Australia, $30 million in revs, $13 million in OP that's kind of an implicit margin in the 40s?

Ed Breen

Yes. I'll let Frank take that.

Frank Sklarsky

Yes, on the face it is, but I would add that there are probably a few million dollars in that $13 million, upwards of half of that, which is really associated with productivity. So not direct margin with the 30m, but you have some folks that are on the site or ready to go to a site, ready to install, and your absorption, your productivity just isn't what it is, because they're waiting for the storm to end. They can't lay the pipe because the ground is too wet so and so forth. A lot of that is just straight productivity.

Let me interpret as that a 40% or there, but a good chunk of it is margin and that a good chunk of it is just one-time productivity loss. They way I would look at that is we will gain the revenue back and we'll gain about half the OI back in the second half of the year. And then to Frank's point, we're not going to gain the other half of the OI back, because we literally just lost productivity with all our installed people on all that. So that's a way I would look at it.

Antonella Franzen

And Jeff, just to add to that. Our pipes and our folks were not impacted necessarily by the weather conditions that happened. What it was really is that our customer site were very impacted. I mean they were not able to receive shipments and nor was as Frank mentioned, are able to do some installed work that was done.


Our next question is from Nigel Coe with Deutsche Bank.

Nigel Coe - Deutsche Bank

Just wanted to get a few more details on the guidance. So looking at 3Q and then obviously that implied 4Q, we got a big step up from about $0.70 in 3Q to up with the $0.89 in 4Q, which is obviously a lot greater than we normally see in terms of quarter-over-quarter. I can see the flow, I can see the corporate expenses. But is there anything else that would cause that kind of skew in earnings?

Ed Breen

Well you just mentioned actually the big ones between kind of tax and corporate it looks like as a big lift. But if you kind of neutralize those other items, maybe other way I look at it is the third quarter's more or like $0.75 if you neutralize the swings in corporate and tax. So you're building kind of off $0.75 and you're looking at if you go through our guidance, you're looking at our low-end being in the fourth quarter an $0.84 quarter to the high-end being at $0.89 quarter.

So you mentioned one of them. You get a nice move in the Flow control business, but do remember also that the fourth quarter is our seasonally strong quarter for both security and fire. And it's the seasonality of our business, because of all the weather, when we do our work and are installed, our colleges, our universities and all that, and a lot of our service work. So they trend up, so revenue trends up in those businesses.

Antonella Franzen

So Nigel, as Ed mentioned, Q3 really if you adjust for that corporate expense you're at $0.75, which then would make Q4 to be a little bit more on the $0.80 to $0.85 range, if you neutralize for the corporate expense.

Frank Sklarsky

And all three segments are going to see improvements in operating income. So there's a $0.10, $0.15 driver in that range of a wide increase, just on single operations. And that includes corporate expense, I should say and with couple of cents corporate expense.

Nigel Coe - Deutsche Bank

And then core growth of 3% came bang on plan in 2Q. But obviously we have seen some good news on the orders. I think you mentioned 10% orders in April, I think 8% in 2Q. How does core growth track over the balance of the year? And what will be baked into your guidance?

Ed Breen

Let me give you our organic, because we really don't see that begin to lift until the fourth quarter, especially because of (inaudible) which we kind of described that to you. So we with our fourth quarter, again this is very preliminary, because we're not in the fourth quarter yet. But our organic growth in the fourth quarter should be between 5% and 6%. And then I think that key is up going into '12. I won't get into quite a number, but that's not an anomaly that we would start to see the 5% to 6% in the fourth quarter.

So we've been kind of running right around 3% organic, but when you'll look at everything we just said, and you'll look at the order rates, we get up to that range in the fourth quarter. And please do remember, we didn't drop as much as a lot of companies in the down term because of defensive nature of these set of businesses. So we didn't have the big drivers down, but that's about it.

Let me give you on the order side, then you can kind of extrapolate this out, I think is your planning, as you're looking at the 2012. And the way I would look at this is, remember 45% of the company is for the service and recurring business, which you kind of know where we're running that at and it's very stable. Hopefully that picks up a little bit more from where it is, because of the improving economy.

And then if you look at the total company orders, I'll read you back, maybe six months or so of orders, because I think this kind of gives you the story. Total Tyco, which is minus-45% of the company that's recurring and service. The other 55%, if you go back to first quarter of 2010 our orders were down 11%, the second quarter 2010 they were down up 3%, the third quarter they turned positive at 3% approximately, the fourth quarter of 2010 was 3%, the first quarter of this year was 6%, the second quarter was now 7% and our April orders for total Tyco were 10%. So that maybe gives you a little bit of phasing how you're going to look at it.

Nigel Coe - Deutsche Bank

And then just finally switching gears to going back to Pulse. As you look at the customers profiles, any evidence to suggest that Pulse is attracting a profile customer that wouldn't necessarily be attracted to the basic intrusion service? And then secondarily, the improving fundamentals in the U.S. business, does that make expanding the European franchise more attractive?

Ed Breen

We know that we're getting some accounts, Nigel. I'm not going to quantify this yet, because our team is kind of doing the work behind it. But anecdotally we know and we've talked to a lot of our sales managers out there, they are getting a percent of accounts. They think we are pulling in because the attractiveness of the features. And it's probably interesting, because as I just mentioned 80% of them are actually still taking the first level of package.

So if these people really like the remote capability of this on your iPhone or your iPad, the capability you have, especially if you've got kids and things like that. We think we are pulling in a set of people that it's interesting them. And you can see we've really cranked up our TV advertising, I hope you see that out there.

And that we feel we're getting leads that we would not have gotten. But we're just trying to get that quantified here over the next kind of two, three months and get our arms around that. And the other thing we probably won't have a little bit of time, but this is very interesting for the future pitch on Pulse is for us to be able to really quantify the savings that people can get if they use the system properly from energy efficiency in their home.

I am not going to get into these numbers yet. We have some examples, we know what we're actually working with a couple of the energy companies, we are verifying all this with us. But the attractiveness of the cut you get on your insurance rate for having security, in addition to energy savings you can get in become a very attractive number relative to what the service costs on a monthly basis. So there is a lot more info going to be coming out that we'll be able to use here in the future.

Nigel Coe - Deutsche Bank

And then does the Pulse make expanding the European franchise, the resi franchise a bit more attractive?

Ed Breen

Yes, sure it will to some extent. But what would be interesting on Pulse and we're not at this point yet is how can Pulse play out more in our commercial base, and our small business base, and our mid-tier business base over time. That's actually one of the things were intrigued by as you know, Europe, Asia, and Latin America is more on a commercial base than it is in resi base. And that's something that we are working on, but obviously not going to talk about launching.


Our next question is from John Inch with Bank of America Merrill Lynch.

John Inch - Bank of America Merrill Lynch

First, just a clarification, is Signature Security, the revenues and profits in your guidance because it's going to close this week, right?

Antonella Franzen

Yes, it's expected to close shortly. In our full year guidance, yes, it's in the numbers. So I would say that it is built in there. And then we'll only have about a quarter's worth of it in our results, we do expect that there are some purchase accounting related to it. But with that said, we do expect it to pretty much be neutral to earning for the year.

Ed Breen

It kicks in nice going into next year, but yes, neutral because of some of the closing, purchased stuff and all that we get.

John Inch - Bank of America Merrill Lynch

The acquisition of KEF, I mean I get the strategy. I guess, I'm having a little bit of trouble understanding what is the return framework? I mean if you take say $100 million of revenue and kind of teens cash returns, it's still sort of only gets to kind of a mid-single digit return on invested capital on the $300 million. So maybe you could help me a little bit with how are you thinking about the return on invested capital framework for that deal? And sort of when the payback gets to double digit?

Ed Breen

Yes, John, one of things I think that's hard to see in this. And first of all, the revenue in this business is growing on a percentage basis, very nicely. So there's a nice ramp going on in this business and projects out very nicely over the next few years. The piece is maybe hard for you to get, John, around is remember they've got one of the largest foundries, certainly for this type of business in the world. It's a huge facility over there that we have and it's under-absorbed right now.

Other customers use their casting facility, we use the casting facility that they have. And we have a very detailed plan laid out to really get that thing absorbed and really cranking. And by the way, a lot of that will be with our own existing products that we will pump in to there in addition to our third party customer base. So you got to realize, you've got this huge fixed cost base with this huge foundry there and we really lever that thing up to get advantage out of that.

And as Frank mentioned, we're also on a tax free jurisdiction. So anyway, when you add all that together, you end up with a business that by year or two will add our cost of capital, and we're above that by year three. And on an ROIC basis, by the time we're at year three, we're kind of around at 12% and we grow from there.

So it's a lot quicker than I think people realize, but it's because of the leverage we get, the volume build of this business, the tax free nature of the business. And if I put all of that aside, it's probably the most strategic region to make sure you have a very big presence in for our Flow control company for the future.

John Inch - Bank of America Merrill Lynch

Ed, just so I understand. Does it mean that you are going to run casting volumes that you currently procure in other parts of the world through KEF, is that what's happening? Or these are just incremental revenue synergies?

Ed Breen

No, we are taking off of some of our valve casting volume and we are moving it into our own facility. And that when you play out those numbers that is totally within our control, I don't need anything in the market or third-party to help us do it, where you just run those numbers that really leverages this things.

We didn't buy it for that reason, it protects the nice returns of this business. By the way, it is good for us, because that's extra profit to us by bringing it in house. The reason we bought it is for the strategic future in the region. But it's a real nice way to make the numbers work.

Frank Sklarsky

So you're also saying, as you mentioned this is heavy stuff. So obviously you're getting the cost down on a per unit basis. You're also setting a ton of transportation cost, because of the leverage you get from having it within the region.

John Inch - Bank of America Merrill Lynch

Just lastly, I want to go back to the sort of the perspective, the first questioner was asking. There's this view that if somehow someone doesn't make a bid for Tyco, you're going to monetize your Flow business in some manner. That's what seemed to be pretty inconsistent with everything you've articulated up until this point.

But I guess my question is, does the book value in some way prohibit you from selling the business because of tax linkage or could you theoretically, and this is down the road, I'm not talking about anytime soon, but could you theoretically, if you came to a decision to monetize Flow, perhaps structure the deal in a way that you did with Tem to, say, avoid the tax leakage? I'm just curious what your thoughts are around that?

Ed Breen

Look, John, as I mentioned, we like the portfolio how it is. Let me mention, again, also we always look at all the other alternatives to see if some makes more sense to create long-term shareholder value with it. I am not going to get into all the details of this or that. But there is always ways to structure things in a creative ways at all that that help benefit you. And by the way, it's just like we did with electrical and metal, as an example. We did have some top cost basis issues there, but the way we were able to structure that deal we had very, very little leakage at all.

John Inch - Bank of America Merrill Lynch

So in other words if it made sense down the road to do it, we shouldn't think of taxes as some sort of a barrier to realizing that value?

Ed Breen

Yes, I am not going to maybe jump on that. But yes, taxes never, I don't think they're going to show you a good structure of things.

Antonella Franzen

Operator, we have time for one more question please.


Our final question today is from Gautam Khanna from Cowen & Co.

Gautam Khanna - Cowen & Co.

I have a couple. Since the last quarter, obviously oil prices have had a big move up and you characterized the Flow pipeline as including some elements that you're yet to book. I mean could you just talk about kind of how the RFP pipeline may have changed, given the move up? And how large some of those opportunities might be and when you might actually start to, A, order them; and B, convert them into revenue?

Ed Breen

I just think a couple of these bigger deals are in kind of the six-month window. I'd say they're in the three to six-month window somewhere there. Look I think it was already moving up. It just reinforces some of the projects we were already working on. And for instance, there is a couple of big potential new projects in the oil sands in Canada.

Oil was already at the price points a year where and these are attractive projects to do. And you know the oil sands it's a much higher cost to extract, but oil was already there. The fact that oil is just moving more, I think just make some more appetizing that those projects are, hey, let's get going, let's get building, let's get this thing moving. It's just kind of helps a little, but they wouldn't have happened anyway at this point.

Gautam Khanna - Cowen & Co.

What is the sense of size here on those opportunities?

Ed Breen

When we talk about a big deal, I'll ballpark you one without a name, you're talking about a $300 million opportunity that shifts over few years. And if you start knelling down a few of those, it starts to become pretty nice.

Gautam Khanna - Cowen & Co.

You guys have spent a lot on restructuring over the last couple years and fiscal '12 just come in pretty close. I mean how should we think about kind of annual restructuring needs? And how should we think about the cost opportunity that you have on the back end of it?

Ed Breen

This is over a multiyear period, but as we look at our back office and our infrastructure we still think over a multi-year period, we've got $400 million to $500 million of inefficiency in the company that we want to work on. So that's kind of the prize that we keep kind of chipping away at.

I would be surprised if our restructuring costs are over $100 million extra. I think there are going to be less than $100 million. I don't know how much less, but I would look at it in that kind of light. And I would tell you the stuff we're looking at, because it's back office, rationalization and efficiency, it's G&A expense and it's less costly to get out than bricks and motor. So we'll get a good payback on it, which will still be less than two years, which is kind of one of our benchmarks.

Gautam Khanna - Cowen & Co.

And you mentioned I think overall orders are up in April 10% year-on-year, what was it for Flow?

Ed Breen

I think that were right around 11% in total.

Frank Sklarsky

And it will be more than that for valves and thermal, and obviously a little bit declined on the water side, but the same rate about 10 overall.

Gautam Khanna - Cowen & Co.

And there was nothing in the compare last year that just made. I mean this is also a sequential uptick I should interpret that as?

Ed Breen

Yes, there is no anomaly's here. If there were, we would let you know what we're doing in desalination and all that.

Antonella Franzen

The rough percentage is that we quote for orders are year-over-year increasing just to be clear on that.

Gautam Khanna - Cowen & Co.

And just on M&A, you mentioned $500 million as a bogey over the next 12 months. Can you talk about, I mean how close are these and where would they be focused?

Ed Breen

The $500 million is not close. But one is that could be less than $200 million, but when I say close in the next three to four months. I would really look at it, because you never know the timing of these, I would really look at it truly over the next 12 months, nothing I don't think you'll hear from us in the next two to three months.

But some very interesting bolt-ons we're looking at. I'll give two leanings. We like to look at a couple of technology things we like and we like a couple of things that are in emerging markets that would really give us really extra oomph, may be the example like KEF that we just did in the Middle-East.

Gautam Khanna - Cowen & Co.

So I mean should we think when you say technology oriented, are we talking at ADT or we talking of Flow?

Ed Breen

It would be a combination, but don't view it at all being slow just because at a deal we just did in KEF. We're looking at interesting one or two that are either security or fire. in emerging market.

Gautam Khanna - Cowen & Co.

And last one, you've had a big move up in the stock price. You announced a $1 billion buyback. I mean how should we think about the execution of the buyback in terms of timeframe?

Ed Breen

First of all, when we announced one, we do it, so we're not announcing it and just drag it out. But I want to point out it to you, the last two that we did that added up to the $1.9 billion, we had obviously the two motivators. First of all, we like the way our share price was to be buying them back. Number two, we wanted to get the Broadview dilution shares out of the marketplace, those $35 million.

And that deal made a lot more sense the way structured it with some shares, but we didn't want to leave out shares on the market. And then you know we had the proceeds from our Waterworks business in Tem. And again, we liked the way the share price was. So we spent that money fast. The way I would look at it, we have some of these bolt-ons we're looking at, so we'll gauge it against that. But I think you know we will move at a nice pace, but probably not at the pace you watched us do the last $1.9 billion at.

Antonella Franzen

Operator, that concludes our call.


This does conclude today's conference. Thank you for participating. You may now disconnect.

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